The following example illustrates the application of the debt and equity test to the issue of convertible notes.
Example: Convertible notes
A company issues 15 year convertible notes on 1 July 2010 for $9 each. The notes have coupons of 7% paid annually on 1 July. The obligation to pay the coupons is not subject to any contingency and can't be deferred or waived in any circumstance.
At any time after 1 July 2016, the company can terminate the arrangement early. However, on either early termination or at the original maturity date (1 July 2025), the noteholders have the option to either have the notes redeemed for $9 or converted into shares at a ratio of 4 shares per note. The shares are currently trading at $1.75. The company's ordinary debt rate is 8%.
End of exampleTest steps
The following steps determine if it is an equity interest or a debt interest.
Equity test step 1: is the interest an equity interest?
The interest is an equity interest because it gives the holder the right to be issued with an equity interest in the issuer. Alternatively, the interest is an equity interest because it may convert into an equity interest in the company.
Equity test step 2: is there a scheme?
There is a scheme in the form of an arrangement between the company issuing the notes and the holder.
Equity test step 3: is there a financing arrangement?
The contract in respect of convertible notes is an arrangement entered into to raise finance for the company.
The interest is an equity interest unless it is a debt interest.
Debt test step 1: is there a scheme?
There is a scheme. See step 2 above.
Debt test step 2: is the scheme a financing arrangement?
The scheme is a financing arrangement. See step 3 above.
Debt test step 3: does the issuing entity receive a financial benefit under the arrangement?
The issuing company receives a financial benefit under the arrangement, being the issue price of the convertible note – namely, $9.
Debt test step 4: does the issuing entity have an effectively non-contingent obligation to provide a financial benefit?
The issuing company has an effectively non-contingent obligation to pay 7% for the term of the note to the note holder. The company also has an obligation to repay the investment of $9 at maturity or earlier termination, provided that the note holder doesn't exercise its right to convert the note into shares. A right of this sort doesn't of itself make the obligation to repay the investment contingent. In this case, it is considered that the obligation to repay the investment is an effectively non-contingent obligation.
Debt test step 5: is it substantially more likely than not that the financial benefit to be provided will be at least equal to or exceed the financial benefit received?
The performance period is more than 10 years because, although there is an option to redeem at the end of 6 years, there is no effectively non-contingent obligation to do so. Therefore, the valuation of the benefits is calculated in present value terms.
The value of the financial benefit in present value terms is:
Amount or value of financial benefit in nominal terms ÷ [ (1 + Adjusted benchmark rate of return) n]
In this formula, (1 + Adjusted benchmark rate of return) is raised to the power of 'n', where 'n' is the number of years in the period starting on the day on which the test interest is issued and ending on the day on which the financial benefit is to be provided. If the period includes a part of a year, that part is to be expressed as the fraction.
The value of the financial benefit received by the issuer at issue date is the issue price of $9. On the assumption that the convertible note will be held until maturity, there will be 15 coupon payments and a return of the principal at maturity. Using the present value calculation method, the value of the financial benefit to be provided by the company in relation to each note is calculated as follows:
- the coupon amount per coupon period is $0.63 ($9 × 7%)
- the adjusted benchmark rate of return is 6% or 0.06 (8% × 0.75).
- the return of principle is $9 at maturity.
The present value is the sum of all discounted payments is:
[0.63 ÷ 1.061) + (0.63 ÷ 1.062) + ... + (0.63 ÷ 1.0614) + [(9 + 0.63) ÷ 1.0615] = $9.87
The value of the financial benefit to be provided by the company ($9.87) is more than the value of the benefit it received ($9), so the interest is a debt interest.
Tiebreaker rule
The interest meets both the equity and the debt tests. Therefore, it is characterised as debt.