A convertible loan is a type of loan that can be converted into shares of the borrower’s common stock at the option of the lender. In accounting, a convertible loan is typically accounted for as a liability, with the potential conversion option being accounted for as a separate instrument, either as a liability or as equity.
According to International Accounting Standard (IAS) 32, “Financial Instruments: Presentation,” a convertible loan should be initially recognized at fair value, with any difference between the loan’s fair value and the proceeds received from the lender being recognized as a gain or loss in the income statement. The loan should then be subsequently measured at amortized cost, using the effective interest method, with any difference between the loan’s amortized cost and its redemption value being recognized as a gain or loss in the income statement.
The potential conversion option should be accounted for separately from the loan. If the conversion option is classified as a liability, it should be initially recognized at fair value, with any difference between the option’s fair value and the proceeds received from the lender being recognized as a gain or loss in the income statement. The option should then be subsequently measured at fair value, with any changes in fair value being recognized in the income statement.
If the conversion option is classified as equity, it should be initially recognized at fair value, with any difference between the option’s fair value and the proceeds received from the lender being recognized as a contribution to equity. The option should then be subsequently measured at fair value, with any changes in fair value being recognized directly in equity.
For example, if a company borrows £100,000 from a lender and the loan includes a conversion option that allows the lender to convert the loan into shares of the company’s common stock at a conversion price of £10 per share, the company would initially recognize the loan at fair value. If the fair value of the loan is £105,000, the company would recognize a gain of £5,000 in the income statement. The loan would then be subsequently measured at amortized cost using the effective interest method, with any difference between the amortized cost and the redemption value being recognized as a gain or loss in the income statement.
If the conversion option is classified as a liability, it would be initially recognized at fair value. If the fair value of the option is £10,000, the company would recognize a gain of £10,000 in the income statement. The option would then be subsequently measured at fair value, with any changes in fair value being recognized in the income statement.
If the conversion option is classified as equity, it would be initially recognized at fair value. If the fair value of the option is £10,000, the company would recognize a contribution to equity of £10,000. The option would then be subsequently measured at fair value, with any changes in fair value being recognized directly in equity.
