A financial instrument that can be split into equity and liability components from the issuer’s perspective. A compound financial instrument is, thus, embedded with a conversion option (that allows the holder to convert it into an equity instrument).

Upon issuance, the split is made to the effect that the equity component of such an instrument is measured as the difference between the fair value of the instrument and that of its liability component. Later on, the split is not revised for subsequent changes in relevant factors, including market interest rates, share prices, or any other event that may impact the likelihood that the conversion option will be exercised. In other words, the equity component is assigned the residual amount after deducting the fair value of the compound instrument from the amount separately assigned for the liability component.

Examples of compound financial instruments include convertible bonds, debt issued with detachable share purchase warrants, etc. A convertible bond has two components: 1) a financial liability (i.e., the issuer’s contractual obligation to pay cash), and 2) an equity instrument (i.e., the conversion option- the holder’s option to convert into common stock).