Defining a Convertible Bond
A convertible bond is a type of debt security that gives the investor the right to exchange the bond, at certain milestones, for a pre-determined percentage of equity in the issuing company. This investment vehicle has both equity and debt features.
Since this type of investment gives investors the potential for equity conversion into a company, the debt/bond side of it may present investors with a nominal coupon remittance or a potentially zero-coupon payment. However, there are important accounting considerations for this type of investment vehicle via generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
IFRS
When it comes to IFRS, convertible bonds are considered blended securities because they are partially debt and partially equity. The debt piece is accounted for by discounting the principal and interest paid out to the bondholder at the company’s cost of straight debt. The following example illustrates how it’s calculated:
The business presents a 10-year, $250 million convertible bond, providing investors with a 2.5 percent coupon rate and a 9.5 percent straight cost of debt. Based on discounting these variables, the present value of the principal and coupon payments is: $182,805,096 (assuming end-of-year, annual coupons). To determine the equity proportion, we must take $250 million and subtract $182,805,096, which equals $67,194,904.
Looking at the journal entry, we have the following breakdown:
Cash: Debit $250,000,000
Convertible Debt Component – Liability = $182,805,096
Equity Component – Shareholder’s Equity = $67,194,904
Looking at the interest expense this is calculated as follows:
The 9.5 percent (straight debt cost) is multiplied by the net present value of the beginning debt liability balance of the first year ($182,805,096), which is $17,366,484.12. Since there’s a coupon payment of (2.5 percent X $250,000,000 = $6,250,000), the difference between $17,366,484.12 and $6,250,000 = $11,116,484.12 should be “accreted” to the debt liability or the debt balance.
The journal entry would be as follows:
Debit: Interest Expense $17,366,484.12
Credit: Cash $6,250,000
Credit: Accretion of Debt Discount – Liability = $11,116,484.12
Now, if at the bond’s maturity, the investor is unable to convert the bond to equity according to the terms of the convertible note, the entire $250 million bond will be paid back to the investor. The journal entry will be as follows:
Debit: Convertible Debt $250,000,000
Credit: Cash $250,000,000
If, however, the investor of the convertible bond is favorable to it being exchanged, the journal entry will be as follows:
Debit: Convertible Debt $250,000,000
Credit: Share Capital – Shareholder’s Equity = $250,000,000
This explanation assumes that convertible bonds are only able to be converted into company equity. However, if the bond is cash-settled, there are alternate considerations. It’s also assumed that the bond is issued at year’s end and makes its coupon payments once a year.
GAAP
Under generally accepted accounting principles (GAAP), present standards treat it as straight debt. This accounting practice changed from GAAP’s previous treatment of bifurcating it, similar to IFRS’ current treatment.
At issuance, the journal entries are as follows:
Debit: Cash $250,000,000
Credit: Convertible Debt $250,000,000
With this accounting treatment, it’s recognized as an interest expense. Since this contrasts with IFRS, no accretion is required under GAAP. This assumes there are no additional debt issuance costs when calculating interest expenses. Therefore, assuming the same initial debt amount at par and the coupon rate for year one, it’s the rate for the debt issuance multiplied by the full debt amount ($250,000,000).
The journal entry is as follows:
Debit: Interest Expense $6,250,000
Credit: Cash $6,250,000
If the convertible debt doesn’t present a good opportunity for the investor, they’ll receive the principal back. The journal entry is as follows:
Debit: Convertible Debt $250,000,000
Credit: Cash $250,000,000
If, however, the convertible debt presents the investor with an opportunity to convert to equity, and it’s exercised, the journal entry is presented as follows:
 Debit: Convertible Debt $250,000,000
 Credit: Share Capital – Shareholder’s Equity $250,000,000
Conclusion
While these examples do not explore all the potential scenarios when accounting for convertible debt, they show what considerations accountants must keep in mind when analyzing a transaction.
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"; html += ""; html += "Defining a Convertible Bond
A convertible bond is a type of debt security that gives the investor the right to exchange the bond, at certain milestones, for a pre-determined percentage of equity in the issuing company. This investment vehicle has both equity and debt features.
Since this type of investment gives investors the potential for equity conversion into a company, the debt/bond side of it may present investors with a nominal coupon remittance or a potentially zero-coupon payment. However, there are important accounting considerations for this type of investment vehicle via generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
IFRS
When it comes to IFRS, convertible bonds are considered blended securities because they are partially debt and partially equity. The debt piece is accounted for by discounting the principal and interest paid out to the bondholder at the company’s cost of straight debt. The following example illustrates how it’s calculated:
The business presents a 10-year, $250 million convertible bond, providing investors with a 2.5 percent coupon rate and a 9.5 percent straight cost of debt. Based on discounting these variables, the present value of the principal and coupon payments is: $182,805,096 (assuming end-of-year, annual coupons). To determine the equity proportion, we must take $250 million and subtract $182,805,096, which equals $67,194,904.
Looking at the journal entry, we have the following breakdown:
Cash: Debit $250,000,000
Convertible Debt Component – Liability = $182,805,096
Equity Component – Shareholder’s Equity = $67,194,904
Looking at the interest expense this is calculated as follows:
The 9.5 percent (straight debt cost) is multiplied by the net present value of the beginning debt liability balance of the first year ($182,805,096), which is $17,366,484.12. Since there’s a coupon payment of (2.5 percent X $250,000,000 = $6,250,000), the difference between $17,366,484.12 and $6,250,000 = $11,116,484.12 should be “accreted” to the debt liability or the debt balance.
The journal entry would be as follows:
Debit: Interest Expense $17,366,484.12
Credit: Cash $6,250,000
Credit: Accretion of Debt Discount – Liability = $11,116,484.12
Now, if at the bond’s maturity, the investor is unable to convert the bond to equity according to the terms of the convertible note, the entire $250 million bond will be paid back to the investor. The journal entry will be as follows:
Debit: Convertible Debt $250,000,000
Credit: Cash $250,000,000
If, however, the investor of the convertible bond is favorable to it being exchanged, the journal entry will be as follows:
Debit: Convertible Debt $250,000,000
Credit: Share Capital – Shareholder’s Equity = $250,000,000
This explanation assumes that convertible bonds are only able to be converted into company equity. However, if the bond is cash-settled, there are alternate considerations. It’s also assumed that the bond is issued at year’s end and makes its coupon payments once a year.
GAAP
Under generally accepted accounting principles (GAAP), present standards treat it as straight debt. This accounting practice changed from GAAP’s previous treatment of bifurcating it, similar to IFRS’ current treatment.
At issuance, the journal entries are as follows:
Debit: Cash $250,000,000
Credit: Convertible Debt $250,000,000
With this accounting treatment, it’s recognized as an interest expense. Since this contrasts with IFRS, no accretion is required under GAAP. This assumes there are no additional debt issuance costs when calculating interest expenses. Therefore, assuming the same initial debt amount at par and the coupon rate for year one, it’s the rate for the debt issuance multiplied by the full debt amount ($250,000,000).
The journal entry is as follows:
Debit: Interest Expense $6,250,000
Credit: Cash $6,250,000
If the convertible debt doesn’t present a good opportunity for the investor, they’ll receive the principal back. The journal entry is as follows:
Debit: Convertible Debt $250,000,000
Credit: Cash $250,000,000
If, however, the convertible debt presents the investor with an opportunity to convert to equity, and it’s exercised, the journal entry is presented as follows:
 Debit: Convertible Debt $250,000,000
 Credit: Share Capital – Shareholder’s Equity $250,000,000
Conclusion
While these examples do not explore all the potential scenarios when accounting for convertible debt, they show what considerations accountants must keep in mind when analyzing a transaction.
DisclaimerÂ
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact a professional regarding the topics in these articles. The images linked to these articles are protected by copyright and should not be copied for any reason.
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