Accounting for Convertible Bonds
Convertible bond is a type of bond which allows the holder to convert to common stock. The conversion can be done at any time before the maturity date and it depends on the bond holder’s discretion. It allows the holder to choose between receiving the guaranteed interest on bonds or convert to the company’s share to get the dividend and trade the shares in the capital market.
Convertible bond contains both elements of debt instrument and equity instrument. The holder has the option to obtain cash at the maturity date or convert it to the company’s common stock. Due to this option, it allows the company to issue bonds at a lower interest rate without any discounted.
In accounting, it is very important to recognize both elements into the financial statement. The financial liability will initially measure by using discounted cash flow of interest payment and bonds nominal value. Subsequently, we need to record the additional balance which arises from the difference between interest expense and interest paid. The interest expense depends on the effective interest rate while the interest paid to investors depend on the coupon rate.
The variance between cash receive and initial financial liability is classified as other components of equity and it will not subsequently measure.
Convertible Bonds Example
Company ABC issue 5% 2,000 convertible bonds with par value of $ 1,000 each. They are the convertible bonds that give the right to holders to convert to a common share at the maturity date at the conversion rate of 20. The bonds will mature in 3 years with interest paid annually. The effective interest rate is 8%.
Solution
As we have mentioned above, convertible bond creates both debt and equity instruments. The debt will be measured by using discounted cash flow and the remaining balance is recorded as equity.
Fair value of debt = $ 1,845,300 (check below table)
Othe equity components = $ 2,000,000 – $ 1,845,300 = $ 154,700
| Year | Cash flow | DF at 8% | Present value |
|---|---|---|---|
| 1 | 100,000 | 0.9259 | 92,590 |
| 2 | 100,000 | 0.8573 | 85,730 |
| 3 | 2,100,000 | 0.7938 | 1,666,980 |
| Total | 2,300,000 | 1,845,300 |
Summary of Financial Liability
Every year, the company needs to pay fixed interest to the holder $ 100,000 ($ 2,000,000 * 5%) which is based on the bonds interest rate. However, the interest expense is calculated by the outstanding balance of financial liability (PV of FL) and an effective interest rate. The difference between interest expense and interest paid will increase financial liability balance. At the end of bond maturity, the financial liability balance will reach the par value ($ 2,000,000).
| year | PV of FL | Interest Exp | Interest Paid | Financial Liability |
|---|---|---|---|---|
| 0 | ||||
| 1 | 1,845,300 | 147,624 | 100,000 | 1,892,924 |
| 2 | 1,892,924 | 151,434 | 100,000 | 1,944,358 |
| 3 | 1,944,358 | 155,549 | 100,000 | 2,000,000*** |
*** Note: rounding error of $ 93
Accounting record on the initial recognition: Company ABC need to make journal entry by debiting cash $ 2,00,000, credit financial liabilities $ 1,845,300 and other equity $ 154,700. Cash 2 million is the amount receive from bonds issue while the finanncial liabilities $ 1,845,300 is the present value of bonds. The different $ 154,700 is recorded to equity.
| Accounts | Debit | Credit |
|---|---|---|
| Cash | 2,000,000 | |
| Financial Liability | 1,845,300 | |
| Other Component Equity | 154,700 |
At the end of year one.
Company will pay interest on bonds holder $ 100,000 ($ 2,000,000 * 5%), however, the interest expense must be calculated by using the effective interest rate.
Interest expense = $ 147,624 ($ 1,845,300 * 8%)
Different = $ 147,624 – $ 100,000 = $ 47,624 (record as financial liabilities)
Accounting record: Company record debit interest expense $ 147,624 which base on FL present value and effective interest rate. They need to credit cash $ 100,000 which is based on bonds par value and coupon rate, while the different $ 47,624 is recorded as additional financial liabilities.
| Accounts | Debit | Credit |
|---|---|---|
| Interest Expense | 147,624 | |
| Financial Liability | 47,624 | |
| Cash | 100,000 |
At the end of Year 2: Company record debit interest expense $ 151,434, it is higher than last year as the financial liabilities increase. Cash paid to holder remains the same as it depends on the same par value and coupon rate. The different between these two balances record as financial liability.
| Accounts | Debit | Credit |
|---|---|---|
| Interest Expense | 151,434 | |
| Financial Liability | 51,434 | |
| Cash | 100,000 |
At the end of Year 3: The treatement and calculation is similar to prior year.
| Accounts | Debit | Credit |
|---|---|---|
| Interest Expense | 155,549 | |
| Financial Liability | 55,549 | |
| Cash | 100,000 |
Settlement of Convertible Bonds
- Bonds do not convert on the maturity date
Holder does not convert to equity at the maturity date, company must pay cash to settle and the transactions should be:
| Accounts | Debit | Credit |
|---|---|---|
| Financial Liability | 2,000,000 | |
| Cash | 2,000,000 |
For the Other component Equity, the company may decide to keep it or reclass it to Share Premium Account which also under the equity section.
- Bond Convert at the maturity date
Bondholder may decide to convert bonds to equity share at the maturity date when the share price increase. However, the share price is not effect to our recording, only the share face value is taking into account.
Assume the par value of share is $ 50 per share.
No of share = 20 share per bond * 2,000 bonds = 40,000 shares
Common Share = 40,000 shares * $ 50 par value = $ 2,000,000
Journal entry: The company makes journal entry by debiting financial liability $ 2,000,000, other equity components $ 154,700 and credit common share $ 2,000,000, additional paid in capital $ 154,700.
| Accounts | Debit | Credit |
|---|---|---|
| Financial Liability | 2,000,000 | |
| Other equity components | 154,700 | |
| Common Share | 2,000,000 | |
| Additional Paid In Capital | 154,700 |
- Bond convert before the maturity date
Assume the holder agree to convert the bond at the end of year 2. Based on the table above, financial liability balance is $ 1,944,358 which need to reverse from balance sheet, so it will impact the additional paid-in capital which is the balancing figure.
Journal Entry: The company can make journal entry by debit financial liability $ 1,944,358, other equity components $ 154,700 and credit common share $ 2,000,000 and additional paid in capital $ 99,058.
| Accounts | Debit | Credit |
|---|---|---|
| Financial Liability | 1,944,358 | |
| Other equity components | 154,700 | |
| Common Share | 2,000,000 | |
| Additional Paid in Capital | 99,058 |
Types of Convertible Bonds
Vanilla convertible bonds
It is the most common type of convertible bond, the company grant right to the holder to convert the bonds to common share base the conversion rate which is calculated in advance. Moreover, the holders will receive interest base on the coupon rate and it comes with the fixed maturity date when holders can receive the nominal value.
Mandatory convertibles
It is the convertible bonds that require the holder to convert to a common share on the maturity date. The holders cannot receive the cash on the maturity date but must convert the bonds to share. The mandatory bonds have two rates, the first one give the holder with share value equal to bonds. While the second rate will limit the value that investors will receive above the par value. This is the method which company uses to forward sell the share equity at a premium.
Reverse convertibles
Reverse convertible bonds allow the company to buyback the bonds or allow it to be converted to share at the maturity date. The issuer can use cash to buyback bonds otherwise they will be converted to equity share base on the conversion rate which is predetermined.
Convertible Bonds Advantages
- Low-interest rate
The convertible bonds will allow the company to raise a fund with a lower interest rate as the investors saw the convertible options as the other benefit. As a result, the company can save huge money on interest payments.
- Reduce the number of share equity
In the short term, company will be able to raise funds without issuing share equity. The current shareholders will have the same voting power. In the future, even the bonds are converted, it will increase the stock price which will benefit the current shareholders as well.
- Interest rate
The company require to pay annual interest to investors, these are the deductible expense and will save on tax at the end of the year.
Convertible Bonds Disadvantages
- Loss control
The company may face a loss of control when majority of holders decide to convert the bonds on any date. It will happen when the share price is higher than the bonds nominal value.
- Decrease share price
When huge investors decide to convert in the same time, it will impact to market share, the share pirce will decrease. It means the supply increase leads to a lower price.