Convertible instruments in EPS calculations

Convertible instruments in EPS calculations

Convertible instruments are instruments other than stand-alone options that by their terms may be converted in whole or in part into the ordinary shares of an entity, such as convertible bonds or convertible preference shares.

If these instruments fall in the scope of IAS 32 Financial Instruments: Presentation, then they can contain a derivative recognised at fair value through profit or loss, a financial liability and/or equity components, depending on their terms. For example, a bond with an embedded option to convert it into ordinary shares of the issuer is a compound instrument, containing a financial liability and an equity component, if the conversion option is classified as equity. [IAS 32.26–32]

Although this is less common, a convertible instrument may fall in the scope of IFRS 2 Share-based Payment if it is issued in exchange for goods or services. In this case, the convertible instrument is generally regarded as a share-based payment with a choice of settlement. If the entity has the settlement choice, then the instrument is classified as either equity-settled or cash-settled, depending on whether the entity has a present obligation to settle in cash. If the holder has the settlement choice, then the instrument is classified as a compound instrument. [IFRS 2.34–43]

This chapter does not deal with:

• the extinguishment of liabilities with ordinary shares as a result of a renegotiation of the terms of the liabilities: see Chapter 5.5; or
• stand-alone options issued in conjunction with liabilities, such as a bond that is tendered as payment of the exercise price of an option and a bond that is required to be redeemable using proceeds from the exercise of options: see 5.9.40.

For further discussion of contracts that contain settlement alternatives, see Chapter 5.12.

EPS implications

Generally, convertible instruments impact only diluted EPS. However, instruments that are mandatorily convertible into ordinaryshares do impact basic EPS.

Potential impact on basic EPS	Potential impact on diluted EPS
The numerator is not affected, the denominator might or might not be affected.	The numerator and the denominator are affected.
Generally, ordinary shares issued on the conversion of convertible instruments are included in the denominator from the date on which interest ceases to accrue (see 3.3.20). [IAS 33.21(d)] However, ordinary shares to be issued under a mandatorily convertible instrument are included in the denominator from the date on which the contract is entered into (see 3.3.20). [IAS 33.23]	Convertible instruments, other than those that are mandatorily convertible, are POSs because they may entitle their holders to an entity’s ordinary shares. The potential adjustments to the numerator include the post-tax amount of any dividends or interest, fair value gains or losses and other consequential changes in income or expense that would result from the assumed conversion. An example of ‘other consequential changes in income or expense’ may be the adjustment to the depreciation expense if the interest on a convertible instrument has been capitalised into the cost of property, plant and equipment in accordance with IAS 23 Borrowing Costs (see 4.3.10). [IAS 33.33–35, 49]
If early conversion of convertible preference shares classified as equity is induced through favourable changes to the original conversion terms or the payment of additional consideration, then an adjustment in the numerator may be required (see 3.2.50).	The potential adjustment to the denominator is based on the additional ordinary shares resulting from the assumed conversion. Conversion is assumed to have occurred at the beginning of the period or, if later, on the date of issuance of the convertible instrument. [IAS 33.36]

Dilutive or anti-dilutive?

Generally, a convertible bond is anti-dilutive when its post-tax interest (and other consequential changes in income or expense) per ordinary share obtainable on conversion exceeds basic EPS from continuing operations. Similarly, a convertible preference share is generally anti-dilutive whenever the amount of the dividend on such shares declared in or accumulated for the current period per ordinary share obtainable on conversion exceeds basic EPS from continuing operations. [IAS 33.50]

Unlike for options, warrants and their equivalents (see 5.9.30), the market price of ordinary shares relative to the conversion price of convertible instruments is irrelevant in deciding whether a particular convertible instrument is dilutive. A convertible instrument may be dilutive even though the embedded conversion option is out-of-the-money.

Convertible preference shares – Differences on settlement

If the redemption or induced conversion of convertible preference shares affects only a portion of the previously outstanding convertible preference shares, then any excess consideration discussed in 3.2.50 is attributed only to those shares that are redeemed or converted for the purpose of determining whether the remaining outstanding preference shares are dilutive. In other words, no numerator adjustment for this excess is required for the remaining outstanding convertible preference shares in diluted EPS. [IAS 33.51]

Contracts with multiple conversion features

In some cases, an entity may issue an instrument with more than one conversion feature. This can lead to uncertainty over which conversion feature should be considered when determining the POSs for inclusion in the diluted EPS calculation. The goal in computing diluted EPS is to calculate the maximum dilutive effect and, therefore, the entity needs to calculate diluted EPS under the various conversion features to determine which feature is the most dilutive (see 4.6.30). [IAS 33.44]

Convertible bonds may be issued with two conversion features attached to the non-mandatory convertible instruments: an option for early conversion and an option for conversion at the end of a contingent period. In our view, the entity should compute separate diluted EPS calculations for the early conversion feature and the conversion at the end of the contingent period to evaluate which feature is most dilutive. The presentation of the diluted EPS should be based on the most dilutive scenario.

Options to purchase convertible instruments

Options or warrants to purchase convertible instruments – e.g. an option to purchase convertible preference shares – may also be considered POSs. In many cases, these options do not meet the requirements for classification as equity instruments under IAS 32 and are accounted for as derivatives under IFRS 9 Financial instruments.

In such cases, the options are assumed to be exercised to purchase the convertible instrument in diluted EPS only when:

• the average price of the convertible instrument is above the exercise price of the option;

• the average price of the ordinary shares obtainable on conversion is above the exercise price of the option; and

• the conversion of similar outstanding convertible instruments, if there are any, is also assumed. [IAS 33.A6]

However, IAS 33 is not clear on how to calculate the impact of these instruments in diluted EPS. Because they are options, in our view one acceptable approach is to use the treasury share method in determining the impact on the denominator, assuming that the options would be exercised directly to obtain shares on conversion (see 5.9.40). The post-tax consequential changes in income or expense would be adjusted in the numerator.

Case – Convertible debt

The following basic facts relate to Company P. Net profit for Year 1 is 4,600,000. The number of ordinary shares outstanding on 1 January Year 1 is 3,000,000. The following facts are also relevant for Year 1. On 1 January, P issues 1,000,000 convertible bonds for 1 each. Every 10 bonds are convertible into one ordinary share at the holder’s discretion. The interest expense for the year relating to the liability component of the convertible bonds is 100,000. The interest expense is tax-deductible. The applicable income tax rate is 40%. Workings The EPS computations for Year 1 are as follows. Basic EPS Diluted EPS 1. Determine the numerator No adjustment is necessary until the convertible bonds are converted and ordinary shares are issued. The numerator is 4,600,000. 1. Identify POSs The convertible bonds are the only POSs. 2. Determine the denominator There is no change in the number of outstanding shares during the year. The denominator is therefore 3,000,000. 2. For each POS, calculate EPIS Potential adjustment to the numerator for EPIS: The full conversion of the bonds on issue would increase profit or loss for the year by the post-tax amount of the interest expense: (interest expense on the convertible bonds) x (1 – income tax rate) = (100,000) x (1 – 40%) = 60,000 Potential adjustment to the denominator for EPIS: The full conversion of the bonds on issue would increase the number of outstanding shares by 100,000 (1,000,000 / 10). EPIS is calculated as follows. EPIS = 60,000 / 100,000 = 0.60 3. Determine basic EPS Basic EPS = 4,600,000 / 3,000,000 = 1.53 3. Rank the POSs This step does not apply, because the convertible bonds are the only class of POSs. 4. Determine basic EPS from continuing operations Basic EPS is 1.53 (see Step 3 of basic EPS computation). 5. Identify dilutive POSs and determine diluted EPS The potential impact of convertible bonds is determined as follows. picture Accordingly, P includes the impact of the convertible bonds in diluted EPS. Diluted EPS = 1.50

Case – Options over convertible preference shares

The following basic facts relate to Company P. Net profit after tax for Year 1 is 4,600,000. The number of ordinary shares outstanding on 1 January Year 1 is 3,000,000. The following facts are also relevant for Year 1. On 1 January, P issues 500,000 options over convertible preference shares. Each option is to acquire one convertible preference share at an exercise price of 50. Each preference share is convertible into two ordinary shares. The following average prices are also relevant for the period: Market price of convertible preference shares: 65 Market price of P’s ordinary shares: 30. The options are classified as derivatives. The expense for remeasurement of the options at fair value is 100,000 for the year. The remeasurement expense is tax-deductible. The applicable income tax rate is 40%. There are no other similar convertible preference shares in issue. Workings The EPS computations for Year 1 are as follows. Basic EPS Diluted EPS 1. Determine the numerator No adjustment is necessary until the options are exercised and convertible instruments are converted and ordinary shares are issued. The numerator is 4,600,000. 1. Identify POSs The options over convertible preference shares are the only POSs. 2. Determine the denominator There is no change in the number of outstanding shares during the year. The denominator is therefore 3,000,000. 2. For each POS, calculate EPIS The exercise price per convertible preference share (50) is lower than its average market price (65). The exercise price per ordinary share on conversion (50 x 500,000 / 1,000,000 = 25) is lower than its average market price (30). There is no similar outstanding convertible instrument. Therefore, the exercise of the options is assumed because they are in-the-money. Potential adjustment to the numerator for EPIS: The options, if they are exercised, would increase profit or loss for the year by the post-tax amount of the remeasurement expense: (remeasurement expense on the options) x (1 – income tax rate) = (100,000) x (1 – 40%) = 60,000 Potential adjustment to the denominator for EPIS: As discussed in 5.11.70, one acceptable approach is to calculate the impact using the treasury share method (see 5.9.40), as follows. Picture EPIS is calculated as follows. EPIS = 60,000 / 166,667 = 0.36 3. Determine basic EPS Basic EPS = 4,600,000 / 3,000,000 = 1.53 3. Rank the POSs This step does not apply, because the convertible bonds are the only class of POSs. 4. Determine basic EPS from continuing operations Basic EPS is 1.53 (see Step 3 of basic EPS computation). 5. Identify dilutive POSs and determine diluted EPS The potential impact of convertible bonds is determined as follows. picture Accordingly, P includes the impact of the convertible bonds in diluted EPS. Diluted EPS = 1.47