[Opinion] Accounting for IRR-Linked CCDs Under Ind AS

In an era where capital raising structures are intricately tailored to meet investor expectations and project constraints, the use of Compulsorily Convertible Debentures (CCDs) with fixed conversion ratios and IRR-linked interest payouts has gained prominence, particularly in infrastructure, real estate, and private equity-backed ventures.

These instruments often appear simple; after all, if conversion is fixed and compulsory, surely the whole instrument is equity?

Unfortunately, accounting doesn’t look at labels, it looks at economic substance. And Ind AS 32 and Ind AS 109 dig much deeper than just the presence of a fixed conversion clause.

This article delves into the nuanced and under-discussed accounting implications of such CCDs, especially when they promise an IRR-based top-up interest contingent upon surplus cash flows and project return thresholds.

1. Applying Ind AS 32 – Financial Liability vs Equity

Para 15 of Ind AS 32

“The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.”

Para 16 of Ind AS 32

“A financial instrument is an equity instrument only if:

(a) the instrument includes no contractual obligation:

(i) to deliver cash or another financial asset to another entity, or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer, and

(b) if the instrument will or may be settled in the issuer’s own equity instruments, it is:

(i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments…”

Even though the CCD is compulsorily convertible at a fixed ratio, the issuer has an obligation to make variable payments based on IRR calculations, a fact that triggers financial liability classification for part of the instrument.

2. Is It a Compound Financial Instrument (CFI)?

Yes. The instrument has two distinguishable legs:

(a) A financial liability, due to contractual obligations to pay 1% interest p.a. plus an IRR-based top-up.

(b) An equity component, due to fixed conversion into equity shares i.e., no variability in settlement terms.

Para 28 of Ind AS 32

“The issuer of a financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets, or equity instruments in accordance with paragraph 15.”

3. The Embedded IRR Clause – What Lies Beneath?

This clause entitles the CCD holder to receive a top-up payment in Year 5 such that the total internal rate of return equals 9.32% over the full 5-year term.

This clause is:

• Not fixed
• Not based on the time value of money
• Dependent on the performance of the underlying project and available surplus

Let’s now look at the Ind AS 109 requirements around embedded derivatives.

Para 4.3.3 of Ind AS 109

“An embedded derivative shall be separated from the host contract and accounted for as a derivative if, and only if:

(a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;

(b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

(c) the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (i.e., a derivative cannot be separated if the entire contract is already FVTPL).”

Para B4.3.8(g) (Illustrative Guidance) of Ind AS 109

A unit-linking feature embedded in a host financial instrument or host insurance contract is closely related to the host instrument or host contract if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund.

“An example of an embedded derivative that is not closely related to the host debt instrument is a provision that links interest payments to the issuer’s net income, EBITDA, or similar variables. Such a feature exposes the holder to risks not typical of a basic lending arrangement.”

The IRR-linked clause qualifies as a separable embedded derivative requiring FVTPL accounting.

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