Change in fair value of derivative financial instrument

In February 2010, we issued convertible bonds in the amount of $413 million due 2015, convertible into TMK's Global Depositary Receipts (GDR). The bonds carry a coupon with a 5.25 interest rate per annum, payable quarterly. The convertible bonds represent a combined financial instrument containing two components: (i) a bond liability and (ii) an embedded derivative representing a conversion option in foreign currency combined with an issuer call. In accordance with IFRS, a bond liability of $368 million (net of transaction costs of $9 million) and the liability under the embedded conversion option of $35 million were recognised at the initial recognition date.

As of 31 December 2012, the carrying value of the bond liability and the fair value of the embedded conversion option were $412 million and $11 million, respectively. As of 31 December 2011, the carrying value of the bond liability and the fair value of the embedded conversion option were $386 million and $3 million, respectively. As a result, we recognised a loss of $7 million on the change in the fair value of the embedded derivative in 2012 as compared to a $45 million gain last year.

As of 30 September 2012, the carrying value of the bond liability and the fair value of the embedded conversion option were $406 million and $4 million, respectively. In the fourth quarter of 2012, we recognised a $7 million loss on the change in the fair value of the embedded derivative as compared to a $1 million gain in the previous quarter.

Management believes that the IFRS accounting treatment of the conversion option of the bond does not reflect the expected outflow of resources under the conversion rights. The conversion option, whether exercised or expired, will not result in cash outflows. In the event of the bond not being converted, the liability under the conversion option will be recognised as a gain in our income statement. In the event of the exercise of the option, the liability will be transferred to equity (together with the carrying value of the converted bonds); no gain or loss will be recognised on the transaction. Additionally, the accounting treatment of the conversion option requires that changes in fair value of the embedded instrument be recognised in the income statement. The price and volatility of TMK’s GDRs have significant impact on fair value of the embedded derivative. In the event the GDRs perform well, the liability under the conversion option will increase and result in losses in the income statement. Changes in fair value may be material in comparison to our net income and may cause distortions in the income statement.

As such, for the purposes of this report, in addition to net income as reflected in the consolidated income statement, it has been decided to present, in this report, an adjusted net income so that it does not reflect gain or loss on changes in fair value of the derivative financial instrument with respect to the embedded derivative component of the convertible bond. The adjusted net income is an alternative performance measure that is not reflected in our consolidated financial statements and has not been audited or reviewed in accordance with ISA.

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