Convertible Securities: Accounting Treatment

Understanding the proper accounting for complex financial instruments like convertible securities can be challenging.

This article provides a comprehensive guide to the accounting treatment of convertible debts and bonds under different standard setting bodies.

You will learn key aspects like initial recognition, bifurcation, valuation methodologies, disclosures, and more. Clear explanations of US GAAP, IFRS, and other standards provide actionable insights for proper accounting and financial reporting.

Introduction to Convertible Securities

Convertible securities are a unique type of financial instrument that have characteristics of both debt and equity. They allow companies to issue debt that can later be converted into equity shares under specified conditions. This provides flexibility in financing and deferred equity dilution for issuers.

Understanding Convertible Debt

Convertible debt begins as a loan, with the issuing company receiving cash from investors in exchange for the promise to repay the principal plus interest. However, convertible debt also comes with the option for investors to convert their loan principal into company equity shares - usually common stock. The conversion typically occurs at a discounted price compared to the share price at the time of conversion.

Some key features of convertible debt include:

Debt component - Functions as loan that must be repaid with interest if not converted
Conversion feature - Allows debt to convert into equity shares under specified conditions
Conversion ratio - The number of shares received per dollar amount converted
Conversion price - Pre-set discounted price per share for conversion from debt into equity

Convertible debt appeals to companies seeking capital without immediately diluting common shareholders. It also appeals to investors seeking the safety of debt with the potential upside of equity.

Key Features of Convertible Securities

Some key features that characterize most convertible securities:

Hybrid instruments - Convertible securities exhibit characteristics of both debt and equity instruments. The debt component provides safety while the equity component offers higher potential returns.
Conversion price - This is the pre-determined price per share at which the debt converts into equity. The conversion price is typically set at a 20-30% discount to the share fair value at time of issue. This provides upside potential to investors.
Conversion ratio - This specifies the number of shares an investor receives per dollar amount converted. For example, a $100 bond with a conversion ratio of 10:1 would convert into 1,000 shares.
Deferred equity dilution - Issuing convertible debt allows companies to obtain financing without immediately diluting common shareholders. Equity dilution only occurs later if the debt is converted.

In summary, convertible securities offer unique advantages by blending aspects of debt and equity into a hybrid security. The deferred dilution and upside potential appeal to both issuers and investors.

What is the accounting treatment for convertible notes?

The general accounting treatment of a convertible note involves initially recording it as a liability on the balance sheet. As the note accrues interest over time, the interest expense should be recognized. If and when the note converts into equity shares, the carrying value of the liability would be reclassified into equity at that time.

Some key aspects of accounting for convertible notes include:

Initial Recording: The convertible note is recorded as a liability at its face value on the date of issuance. Any related issuance costs are recognized as a discount to the liability.
Interest Accrual: Interest expense accrues based on the coupon rate of the note and is recorded in the income statement over the term of the note. The carrying value of the liability increases by the amount of accrued interest.
Conversion into Equity: If the note converts into equity shares, the carrying value of the liability at that date is reclassified into equity. Any difference between the carrying value of the liability and the fair value of shares issued is recognized as a gain/loss on extinguishment.
Embedded Derivatives: Convertible notes may contain embedded derivatives like conversion options which require bifurcation and separate accounting under complex US GAAP rules.

In summary, convertible notes start out as liabilities but may convert into equity shares later on. Accounting rules dictate how each scenario is recorded and presented in the financial statements. Proper tracking and reporting are essential.

What is convertible securities accounting?

A "convertible security" is a financial instrument, usually a bond or preferred stock, that can be converted into a specified number of shares of the company's common stock at the option of the holder.

The accounting for convertible securities can be complex depending on the specific features and terms of the security. Some key considerations in convertible securities accounting include:

Classification - Convertible securities may be classified as debt or equity on the balance sheet depending on certain criteria under accounting standards like U.S. GAAP or IFRS. The classification determines how interest or dividends and conversion features are treated.
Embedded derivatives - Certain features of convertible securities like conversion options may meet the definition of an embedded derivative. These derivatives require separate accounting and valuation.
Debt and equity components - For convertibles classified as debt, the security is split into debt and equity components. The accounting for each component differs in areas like interest or dividend payments.
Conversion - Specific accounting rules address the treatment of the book value of debt and equity when conversion occurs. Gains or losses may need to be recognized at time of conversion.
Dilution - The conversion of convertible securities impacts earnings per share and is accounted for in diluted EPS calculations.

Proper accounting for convertibles requires an understanding of the instrument's specific terms and intended use as well as application of the relevant accounting standards. Consultation with accounting advisors is recommended when issuing or investing in complex convertible securities.

How do you record a convertible note on a balance sheet?

A convertible note is a type of debt that converts into equity under certain conditions, usually in the next equity financing round. Here is how to record a convertible note on the balance sheet:

Classify the convertible note as a long-term liability on the balance sheet. The note represents a future obligation to repay the debt or convert it into equity shares.
Record the full face value of the note under long-term liabilities. This represents the amount that would need to be repaid in cash if the note does not convert.
Do not record any value for the conversion feature on the balance sheet initially. The conversion feature represents the option to convert the debt into equity shares in the future.
If the note converts into equity shares later on, reclassify the full carrying value of the note from long-term debt to equity at that time. Removing it from debt represents the extinguishment of the repayment obligation.
Record the equity shares issued on conversion at fair market value at that date. The difference between the carrying value of the debt and the fair value of equity shares becomes a gain/loss on extinguishment.

So in summary, convertible notes start as long-term debt on the balance sheet and convert into equity shares at a later date per the contractual terms. Follow the above steps to properly record the note over its lifetime.

How do you account for convertible bonds?

The equity and liability portion for convertible bonds can be calculated using the Residual Approach. This approach assumes that the value of the equity portion is equal to the difference between the total amount received from the proceeds of the bonds and the present value of future cash flows.

Specifically:

Calculate the present value of the future cash flows associated with the bond using an appropriate discount rate. This represents the liability component.
Subtract the present value of the future cash flows (the liability component) from the total proceeds received from issuing the convertible bond.
The remainder represents the value of the equity component.

For example, if a company issues $100 million in convertible bonds with a 6% coupon rate and the present value of the future cash flows is calculated to be $80 million, the equity component would be $20 million ($100 million total proceeds - $80 million liability component).

The liability component is accounted for similar to a standard bond issuance, while the equity component is treated as the issuance of a warrant or option. On conversion, the liability is reclassified to equity. Companies must bifurcate and account for the different components separately.

Proper accounting for convertible bonds under GAAP or IFRS standards requires determining the equity and liability elements. The residual method is an appropriate technique as it allocates value based on the difference between proceeds and discounted cash flows.

Convertible Bonds: Debt or Equity?

Convertible bonds have a unique dual nature - they are issued as debt securities but give the bondholder the option to convert into company equity at a preset price. This hybrid characteristic leads to complexity in accounting treatment and financial reporting.

Initial Recognition and Classification

When convertible bonds are issued, the issuer must determine whether they should be classified as debt or equity on the balance sheet. The key criteria are:

Mandatory redemption feature: If the bonds must be redeemed in cash at maturity, they are considered debt. Optional redemption gives more equity-like behavior.
Conversion terms: If the conversion price is out-of-the money or unlikely to occur, the bonds exhibit more debt characteristics. In-the-money conversion options appear more equity-like.
Interest payments: Required coupon payments indicate debt behavior. An equity conversion feature does not change this debt-like cash flow profile.

If convertible bonds meet the debt criteria, they are recorded as long-term liability. The issuer allocates proceeds between the debt component and equity conversion feature based on relative fair values.

Equity Conversion Features of Convertible Bonds

The equity conversion feature gives the bondholder the right to exchange each bond for a preset number of common shares. This embedded option is separated and accounted for differently than the debt host:

The debt component is measured at amortized cost, accruing interest expense over the term.
The equity component is not remeasured after initial issuance. Upon conversion, the carrying value is reclassified to equity along with any conversion premium.

In summary, careful analysis of specific terms and conditions is required to properly classify convertible bonds between debt and equity accounts. The accounting treatment impacts financial ratios and metrics.

Accounting Treatment Under U.S. GAAP

This section covers key aspects of accounting for convertible securities under U.S. GAAP.

Convertible Bonds U.S. GAAP Recognition

Convertible debt instruments are initially recorded at their issuance date fair value, which excludes the conversion feature's value. The issuer allocates the instrument's proceeds between the liability and equity components.

The liability component equals the fair value of similar non-convertible debt. The equity component represents the debt's conversion feature value.

Bifurcation of Conversion Features

U.S. GAAP requires convertible debt issuers to bifurcate conversion features and account for them separately from the liability component.

The conversion feature does not meet liability classification criteria. So its value gets recognized in equity, creating a discount on the liability.

The discount represents the conversion feature's value. It amortizes over the debt term through interest expense charges under the effective interest method.

Upon conversion, the equity component transfers to equity stockholders' interests. If never converted, it remains in equity as additional paid-in capital.

Accounting Treatment Under IFRS

IFRS has specific guidelines for accounting for convertible debt instruments. Key standards include:

Convertible Loan Notes Accounting Treatment FRS 102

Under FRS 102, convertible loan notes are accounted for as follows:

The loan note liability is measured at amortized cost using the effective interest method. This establishes a constant rate of return over the life of the loan.
The conversion feature is recognized separately as an embedded derivative at fair value if certain criteria are met related to economic characteristics and risks not being closely related to the debt host.
If the conversion feature does not require separate accounting, the entire instrument is classified as a financial liability measured at amortized cost.

In practice, FRS 102 aims to capture the substantive economic characteristics of convertible debt instruments. This involves separating out embedded conversion features that have value in their own right.

Contrasts with U.S. GAAP Accounting

There are some key differences in accounting for convertible debt under IFRS compared to U.S. GAAP:

IFRS does not require bifurcation of conversion features that are considered clearly and closely related to the debt host contract. U.S. GAAP has stricter requirements on bifurcation.
IFRS has more stringent rules for classification as debt vs. equity. Instruments with conditional obligations to deliver cash or equity are liabilities under IFRS but may be equity under U.S. GAAP.
There are some detailed calculation differences in separating conversion features and measuring them at fair value.

So in summary, IFRS aims to reflect the economics of convertible debt instruments through separation of embedded derivatives and strict debt/equity classification rules. This contrasts with U.S. GAAP which has more rigid bifurcation requirements but greater flexibility in balance sheet classification.

Valuation and Fair Value Considerations

This section examines valuation approaches and fair value measurements for convertible securities.

Determining the Fair Value of Convertible Debt

There are a few common methods used to determine the fair value of convertible debt instruments:

Discounted cash flow (DCF) analysis: Projecting expected future cash flows from the debt and discounting them back to the present using an appropriate discount rate. Key inputs include credit spread, interest rates, and timing of cash flows.
Black-Scholes option pricing model: Treating the conversion feature as an option and using an options pricing model to value. Requires estimates of stock volatility and time to maturity.
Binomial lattice model: A more complex option pricing model allowing for changing inputs over time. Can better capture early exercise and path-dependency.
Third-party pricing services: Many companies rely on outside vendors to provide periodic fair value estimates based on proprietary models.

The most appropriate approach depends on the specific instrument features and company circumstances. Assumptions should be re-evaluated each reporting period.

Fair Value Hierarchy and Convertible Securities

Under accounting standards like IFRS and U.S. GAAP, companies must categorize financial assets and liabilities based on the inputs used to measure fair value:

Level 1: Quoted prices in active markets for identical assets.
Level 2: Inputs other than quoted prices that are observable (e.g. interest rates).
Level 3: Unobservable inputs (e.g. volatility estimates).

The debt component of convertible securities often falls under Level 2 if issued in liquid markets where prices are readily observable.

The conversion feature requiring estimates of equity volatility is typically Level 3. Companies may rely on third-party estimates or use models to determine inputs.

Higher uncertainty in Level 3 estimates increases potential for errors or manipulation, so auditors scrutinize them closely. Assumptions should align to actual circumstances.

Accounting for Repurchases and Settlements

Proper accounting for repurchases, conversions, and settlement is important over the life of the convertible security to ensure accurate financial reporting.

Convertible Bond Repurchase Accounting

When a company repurchases convertible bonds prior to maturity, the transaction is accounted for as a debt extinguishment under GAAP. Any difference between the repurchase price and the net carrying amount of the debt should be recognized as a gain or loss at that time.

Key things to consider:

The repurchase price often exceeds the carrying value to entice conversion, resulting in a loss
Any unamortized debt issuance costs should be written off immediately
Companies may repurchase bonds to force conversion or reduce potential dilution

Overall, repurchases can impact earnings but may strategically limit shareholder dilution from conversions.

Conversion and Equity Settlement Processes

Upon conversion according to the terms, the carrying amount of the converted debt transfers to equity. The number of shares issued depends on the conversion ratio.

Key things to consider:

Premiums paid over market value upon conversion are recognized immediately per FASB and IFRS
Partially settled bonds must bifurcate the liability and equity components
Settlement procedures should be established upfront to smoothly facilitate conversions

Careful tracking and accounting for conversions is critical to ensure the debt and equity accounts reflect the ongoing settlements.

PwC Convertible Debt Guide: An Overview

Convertible debt can be a complex area of accounting. PwC's guide provides helpful insights into the key considerations.

Insights from PwC's Guidance

PwC explains several key points on accounting for convertible debt under IFRS:

Assess whether the convertible debt should be classified as a financial liability or an equity instrument based on the specific terms and conditions. Key factors include whether the issuer has an unconditional right to avoid delivering cash or shares.
Determine if any embedded derivatives (like conversion options) need separate accounting treatment. These may need to be valued separately if their economic characteristics aren't closely related to the debt host.
Recognize the liability component first, measured at fair value. Then the equity component reflects the residual amount after deducting the liability component from the total proceeds.
Subsequent measurement of the liability follows amortized cost accounting using the effective interest method. The equity component isn't remeasured.
Conversion, early redemption, or maturity is treated as an extinguishment of debt. Gain/loss on extinguishment is recognized accordingly.

Comparative Analysis with Other Standards

PwC also contrasts some key differences in convertible debt accounting between IFRS and U.S. GAAP:

IFRS has more guidance on separating embedded derivatives. U.S. GAAP focuses more on assessing the equity or liability classification as a whole.
IFRS allows more components into which consideration can be allocated. U.S. GAAP only separates convertible debt into liability and equity components.

So while core principles are similar, some specific requirements differ. Understanding these subtleties is vital for accurate accounting and financial reporting.

Disclosure and Presentation Requirements

Proper disclosure and presentation of convertible securities in financial statements provides transparency for users. This enables stakeholders to understand the company's capital structure and obligations.

Balance Sheet and Income Statement Presentation

Convertible debt is classified as a liability on the balance sheet until conversion. It is presented as either current or noncurrent debt depending on the conversion terms. Interest expense on the convertible debt should be presented separately on the income statement.

Upon conversion to equity, the carrying value of the debt is reclassified to equity. No gain or loss is recorded. The company's share capital and additional paid-in capital accounts are increased.

Notes and Supplementary Information

Extensive disclosures in the footnotes help users analyze convertible debt. These include:

Key terms of the convertible securities
Accounting policies
Interest rates and interest expense
Due dates and repayment terms
Conversion features and terms
Balance sheet presentation and carrying amounts
Fair value estimates

Supplementary information further aids analysis. For example, presentation of diluted EPS helps users evaluate the dilutive impact of the convertible securities.

Robust disclosure and presentation facilitates transparency into the financial obligations and effects of complex convertible instruments. This allows stakeholders to make informed decisions.

Conclusion and Key Takeaways

Convertible securities involve complex accounting considerations due to their unique hybrid nature between debt and equity. Key takeaways include:

Summarizing Convertible Debt Accounting Complexities

Proper classification as debt or equity is essential under accounting standards like U.S. GAAP and IFRS. This impacts the balance sheet and income statement.
Discounts, derivatives, and fair value measurements further complicate accounting and reporting.
Tax and audit implications should also be evaluated.

Final Thoughts on Convertible Securities Accounting

Finance, accounting, legal, tax and other functions should coordinate to fully address impacts of using convertibles.
Understanding nuances around standards, structure, valuations, and more is crucial.
With proper planning and accounting treatment, convertibles can still be an attractive financing option.

In summary, while convertible securities offer unique benefits, their accounting is complex. Stakeholders should work cross-functionally to ensure proper classification, measurement, disclosure and overall compliance.