It is explained that these book losses—which are unrelated to a company’s actual financial condition—inflate net losses, potentially leading both creditors and shareholders to misjudge the company’s value. In the market, there are growing calls to distinguish the nature of gains and losses on derivatives when evaluating companies to ensure accurate assessments.
According to the financial investment industry on the 26th, there have been a series of cases—particularly among companies that have recently issued a large volume of mezzanine securities—where rising stock prices have actually worsened their profit and loss. Mezzanine securities are financial instruments that fall between bonds and stocks, with convertible bonds (CBs) and bond warrants (BWs) being the most representative examples.
A convertible bond (CB) is a corporate bond that comes with the right to convert it into the issuing company’s stock at a predetermined conversion price after a certain period. A bond with warrant (BW) is a corporate bond that retains its bond status but is attached with a “warrant,” which grants the right to purchase new shares at a specified price. Investors profit by converting the bond into stock when the stock price rises. If the stock price does not rise, they continue to hold the bond and receive interest and principal.
The reason why losses increase even as stock prices rise lies in accounting treatment. Under Korean International Financial Reporting Standards (K-IFRS), if a bond includes terms such as “refixing”—where the conversion price is adjusted based on the stock price—the conversion right is classified as a derivative liability rather than equity.
Derivative liabilities are revalued at fair value at each reporting period. As the stock price rises, the value of the conversion right—which allows the holder to receive shares at a lower price—also increases. From the company’s perspective, this is treated as an increase in the carrying amount of the liability, and the increase is recognized as a derivative valuation loss in current period profit or loss.
Once recognized as a derivative liability, it is reclassified as equity when the bondholder converts the debt into stock. If the bond matures without conversion, the conversion right loses its value and is extinguished. Unlike the repayment of the principal amount at maturity, no cash outflow occurs in connection with the conversion right. This explains why it is considered more akin to a book liability than a debt that must be repaid in cash.
HLB INC.(028300)is cited as a prime example. According to HLB INC.’s interim report for this year, the company recognized a derivative valuation loss of 27.6 billion won on a consolidated basis in the first half of the year. This represents more than a fivefold increase compared to the 5.2 billion won recorded in the same period last year. The losses were all reflected in the second quarter. The impact on earnings was also significant. Derivative valuation losses accounted for 22.8% of the first-half net loss before income tax of 120.9 billion won. Looking solely at the second quarter, they amounted to 34.4% of the net loss before income tax of 80.1 billion won.
The same trend was evident in the debt-to-equity ratio. HLB INC.’s financial liabilities from derivatives rose by 33.5 billion won (42%) over the past six months, from 79.6 billion won at the end of last year to 113.1 billion won as of the end of June this year. This amount represents 23.3% of total liabilities of 485.5 billion won. The debt-to-equity ratio—calculated by dividing total liabilities by total equity—stands at 114.9%. Excluding derivative liabilities, the debt-to-equity ratio drops to 88.2%.
As of the end of June, HLB INC. held five convertible bonds (CBs) and one bond with warrants (BW). The total outstanding face value is 299.4 billion won. During the first half of the year, 434,030 new common shares were issued as bondholders exercised their conversion rights. In this process, approximately 22.2 billion won was reclassified from liabilities to equity. In effect, liabilities were converted to equity without any cash outflow.
The problem is that such losses can distort investors’ judgment. Valuation losses resulting from rising stock prices exacerbate net losses, making the company’s financial condition appear worse than it actually is. From a creditor’s perspective, financial indicators such as the debt-to-equity ratio may appear to have deteriorated, potentially leading to a lower credit rating. It has also been pointed out that shareholders may misjudge the company’s value by focusing solely on the scale of the deficit. Conversely, when stock prices fall, valuation gains occur, creating the illusion that earnings have improved.
Experts advise that to avoid this optical illusion, gains and losses from derivatives should be categorized by nature. A company’s gains and losses on derivatives can be broadly categorized into three types: △gains and losses related to mezzanine conversion rights; △gains and losses from operational hedging against fluctuations in commodity prices or exchange rates; and △gains and losses from financial speculation unrelated to operations. Experts explain that gains and losses related to mezzanine conversion rights should be excluded from the evaluation of the company since they do not involve cash outflows.
On the other hand, it is argued that gains and losses from derivatives linked to operations should be viewed differently. This includes foreign exchange hedging contracts entered into by exporters to lock in sales prices and derivative transactions designed to hedge against fluctuations in raw material prices. In such cases, since these gains and losses are directly linked to the profitability of the core business, they should be included in operating income to accurately assess the company’s fundamentals.
An official in the financial investment industry pointed out, “Losses on derivatives arising from mezzanine conversion rights are not losses involving an actual outflow of cash,” adding, “Since these are book liabilities that disappear upon conversion to stock or at maturity, they should be excluded when evaluating the company.”
He continued, “If one does not understand the structure where losses increase simply because the stock price has risen, both investors and creditors may misjudge the company’s financial condition,” adding, “One should not just look at the net loss figure but must examine the nature of the loss.”
