A compound financial instrument is a financial instrument that contains both a liability component and an equity component. The liability component represents a contractual obligation to deliver cash or another financial asset to another entity, while the equity component represents the residual interest in the assets of the entity after deducting the fair value of the liability component.

When a compound financial instrument is issued, the components are measured separately on initial recognition. The liability component is initially measured at the fair value of a similar liability that does not have an equity conversion option. This value is then adjusted for any transaction costs directly attributable to the issuance of the liability component.

The equity component is initially measured at the fair value of the residual interest in the assets of the entity after deducting the fair value of the liability component. Any transaction costs directly attributable to the issuance of the equity component are accounted for as a deduction from equity.

If the compound financial instrument includes a detachable warrant, the fair value of the warrant is allocated between the liability and equity components based on their relative fair values on initial recognition.

Once the liability and equity components have been initially measured, subsequent changes in their fair values are accounted for separately. Changes in the fair value of the liability component are recognized in profit or loss, while changes in the fair value of the equity component are recognized in other comprehensive income.

The separate measurement and subsequent accounting for the liability and equity components of a compound financial instrument is important to ensure that the financial statements accurately reflect the economic substance of the transaction, and to enable users of the financial statements to understand the nature and impact of the instrument on the entity's financial position and performance.

Here's an example of a compound financial instrument:

Suppose a company issues a bond that includes both a debt component and an equity component in the form of an attached warrant. The bond has a face value of $1,000 and a maturity of 5 years. The warrant entitles the holder to purchase an additional 100 shares of the company's common stock at a price of $20 per share.

On the date of issuance, the fair value of a similar bond without the warrant is determined to be $950. The fair value of the warrant is determined to be $50.

To account for the compound financial instrument, the company would measure the liability component at $950, which is the fair value of a similar liability without the warrant. The equity component would be measured at $50, which is the fair value of the warrant. Any transaction costs directly attributable to the issuance of the bond would be allocated between the liability and equity components based on their relative fair values.

Subsequent changes in the fair values of the liability and equity components would be accounted for separately. For example, if the fair value of the liability component decreases to $900, the company would recognize a gain of $50 in profit or loss to reflect the decrease. If the fair value of the warrant increases to $60, the company would recognize a gain of $10 in other comprehensive income to reflect the increase.

The separate measurement and subsequent accounting for the liability and equity components of the compound financial instrument provides a more accurate picture of the economic substance of the transaction and helps users of the financial statements understand the nature and impact of the instrument on the company's financial position and performance.

The liability component of the bond is initially measured at the fair value of a similar liability without the warrant, which is determined to be $950. The equity component, represented by the warrant, is initially measured at $50.

Any subsequent changes in the fair value of the liability and equity components are accounted for separately. For example, if the fair value of the liability component decreases to $900, the company would recognize a gain of $50 in profit or loss to reflect the decrease. If the fair value of the warrant increases to $60, the company would recognize a gain of $10 in other comprehensive income to reflect the increase.

The separate measurement and subsequent accounting for the liability and equity components is important to ensure that the financial statements accurately reflect the economic substance of the transaction and enable users of the financial statements to understand the nature and impact of the instrument on the company's financial position and performance.