Accounting for Convertible Bonds | Debt | Notes | Example

convertible bonds

Accounting for Convertible Bonds | Debt | Notes | Example – Bonds are long-term financial instruments through which a company raises capital from investors. Period of bonds, rate of interest and amount of bonds is fixed in advance. Bonds are of different types and generally tailor-made as per the needs of the issuing company.

In this article, we look at accounting for convertible bonds in detail –

Type of Bonds


Some basic types of bonds are as follows:

  • Collateral trust bonds: The investor requires collateral against the investment in the bond. Collateral can be in the form of land, building or any other property of the company.
  • Guaranteed bonds: At times, instead of collateral, issuer arranges to get guarantee of a third party. All payments associated with the bond are guaranteed by this third party.
  • Convertible debt: These type of bonds can be converted into common stock / shares of the issuer
  • Debentures: These debts do not have collateral associated with it but a fixed interest rate which is generally higher than collateral trust bonds / guarantee bonds.
  • Zero coupon bonds:As the name suggests, no coupon (in other words – interest) is paid on this type of bonds. Instead, the investors buy the bonds at discounts to their face values and at the time of redemption, they receive the entire face value. So difference is the profit that they make from zero coupon bonds.

Convertible Bonds


As mentioned earlier, these bonds entitle the bond holders to convert their bonds into a fixed number of shares of the issuing company usually at the time of their maturity. Thus, convertible bonds have features of both equity as well as liability. Convertible notes do not mandate conversion. They give an option to the bond holders at the time of conversion and it is on their discretion whether they want to convert and get equity shares or opt out and get cash against these bonds.

Company Reliant issues 500 convertible bonds. Information associated to these bonds is as follows:

Face Value of the bond $1000
Date of Issue 1st January 2016
Time to maturity 5 years
Date of maturity 31st December 2020
Coupon Rate 10% per annum
Frequency of Coupon Payment Annually
Conversion Ratio

(This means one bond is equivalent to 5 equity shares of the company at the time of maturity)

5:1
Rate of interest prevailing in the market 15% per annum

Basis of accounting for Convertible Bonds


Since, the convertible bonds have features of both liability (debt) as well as equity, it makes more sensible to account for the liability portion and equity portion separately.

This will help to give a true and fair view of the Financial Statements of the organization because of the following two reasons:

  1. As these bonds are convertible to equity in the future, they offer a lower rate of interest. Accounting the equity & debt portion separately will show the true financial cost of the organization.
  2. It is also important to show that the debt might be converted to equity and financial statements should clearly demonstrate this fact.

Accounting for Convertible Debt


Accounting will be split up into three different parts:

  1. Issue of Bonds
  2. Annual Coupon Payments
  3. Settlement of Bonds

Let us go through each one of them in detail to understand the entire flow of accounting for convertible bonds

If you are new to bonds, do have a look at Bond Pricing

#1 – Issue of Convertible Bonds


The split between equity and liability portion needs to be accounted for at the time of issue of bonds itself. The equity & liability portion for the 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 from the bonds.

a) Liability Portion:

Liability portion of the convertible bonds is the present value of the future cash flows, calculated by discounting the future cash flows of the bonds (interest and principal) at the market rate of interest with the assumption that no conversion option is available.

Using the above example, present value will be calculated as follows:

Year Date Type of Cashlow Cashflow Present Value Factor Calculation Present Value Factor Present Value
1 31-Dec-16 Coupon 50,000 (1/1.15^1) 0.869565 43,478.26
2 31-Dec-17 Coupon 50,000 (1/1.15^2) 0.756144 37,807.18
3 31-Dec-18 Coupon 50,000 (1/1.15^3) 0.657516 32,875.81
4 31-Dec-19 Coupon 50,000 (1/1.15^4) 0.571753 28,587.66
5 31-Dec-20 Coupon 50,000 (1/1.15^5) 0.497177 24,858.84
5 31-Dec-20 Principal Repayment 5,00,000 (1/1.15^5) 0.497177 248,588.40
Present Value 4,16,196.1

 

(Cash flow per year for Coupon Payments = 500 bonds * $1000 * 10% = $50,000)

b) Equity Portion:

Value of the equity portion will be the difference between the total proceeds received from the bonds and the present value (liability portion).

Calculating the equity portion for the above example:

Total Proceeds = $1000 * 500 bonds = $5,00,000

Present Value of Bond = $4,16,196.12

Equity Portion = Total Proceeds – Present Value of Bond = $5,00,000 – $4,16,196.12 = $83,803.88

So the very first Journal Entry in the books for issue of Convertible Bonds will be as follows:

01-Jan-2016 Bank A/c Dr 5,00,000
10% Convertible Bonds Series I A/c Cr 4,16,196.12
Share Premium – Equity Conversion A/c Cr 83,803.88
(Being 500 convertible bonds issued at 10% coupon rate and maturity 5 years)

Here, 10% Convertible Bonds Series I A/c is the liability account specifically created to represent this particular issue of bonds.

Share Premium – Equity Conversion A/c is the equity portion which will be reported under the Equity Section in the balance sheet.

#2 – Annual Coupon Payments

On a yearly basis, coupon payments will be made to the bond holders. As mentioned earlier, convertible bonds are issued at a lower rate of interest. To take the actual financial cost into picture, interest will be charged to the Profit & Loss Account on the effective rate of interest which will be higher than the nominal interest. The difference between the effective interest and nominal interest will be added to the value of liability at the time of interest payment.

The calculation of the same will be as follows:

Effective Interest = Present Value of Liability * Market Rate of Interest

Actual Interest Payment = Face Value of Bond * No. of Bonds Issued * Coupon Rate

Value of Liability (end of year) = Value of Liability at the start of the year + Effective Interest – Actual Interest Payment

Year Date Present value of liability Interest Calculation Effective Interest Actual Interest Payment Value of Liability at end of Year
1 31-Dec-16 4,16,196.12 4,16,196.12 * 15% 62,429.42 50,000.00 4,28,625.54
2 31-Dec-17 4,28,625.54 4,28,625.54 * 15% 64,293.83 50,000.00 4,42,919.37
3 31-Dec-18 4,42,919.37 4,42,919.37 * 15% 66,437.91 50,000.00 4,59,357.28
4 31-Dec-19 4,59,357.28 4,59,357.28 * 15% 68,903.59 50,000.00 4,78,260.87
5 31-Dec-20 4,78,260.87 4,78,260.87 * 15% 71,739.13 50,000.00 5,00,000.00

Journal Entry for Interest will be as follows:

31-Dec-2016 Interest Expense A/c Dr 62,429.42
10% Convertible Bonds Series I A/c Cr 12,429.42
Bank A/c Cr 50,000.00
(Being coupon payments made for year 1 and interest expense accounted for)
31-Dec-2017 Interest Expense A/c Dr 64,293.83
10% Convertible Bonds Series I A/c Cr 14,293.83
Bank A/c Cr 50,000.00
(Being coupon payments made for year 2 and interest expense accounted for)
31-Dec-2018 Interest Expense A/c Dr 66,437.91
10% Convertible Bonds Series I A/c Cr 16,437.91
Bank A/c Cr 50,000.00
(Being coupon payments made for year 3 and interest expense accounted for)
31-Dec-2019 Interest Expense A/c Dr 68,903.59
10% Convertible Bonds Series I A/c Cr 18,903.59
Bank A/c Cr 50,000.00
(Being coupon payments made for year 4 and interest expense accounted for)
31-Dec-2019 Interest Expense A/c Dr 71,739.13
10% Convertible Bonds Series I A/c Cr 21,739.13
Bank A/c Cr 50,000.00
(Being coupon payments made for year 5 and interest expense accounted for)

Food for thought: As you must have noticed, the liability value keeps increasing year after year and at the end of year 5 it is equal to the face value of the bond. The total amount added up to the Liability each year will be equal to the Equity Options amount we have arrived at the time of issue of these Convertible Bonds.

Total Amount added to liability= 12,429.42 + 14,293.83 + 16,437.91 + 18,903.59 + 21,739.13 = 83,808.88

Also note, the equity section of the Convertible Bonds will not change during the life of the bonds. This will change only at the time of conversion or payout, as the case maybe.

#3 – Settlement of Convertible Bonds

There can be four different situations for settlement of bonds depending on conversion / non-conversion and the time on which this takes place i.e. before or at the time of maturity:

a) Bonds are not converted at the time of maturity

This is also known as repurchase of bonds. In this case, the bond holders are paid the maturity amount and only the liability portion accounted earlier will have to be de-recognized and the maturity amount will be paid to the bond holders.

Journal entry for the same will be as follows:

31-Dec-2020 10% Convertible Bonds Series I A/c Dr 5,00,000.00
Bank A/c Cr 5,00,000.00
(Being maturity proceeds paid to convertible bond holders at the time of maturity)

Now, the equity portion which we had accounted for under Share Premium – Equity Conversion A/c can remain as it is or the company can transfer it to normal Share Premium A/c, if any.

b) Conversion of bonds at the time of maturity

Bond holders may exercise the conversion option and in this case shares will have to be issued to the bond holders as per the conversion ratio. In this case, both the equity and liability portion accounted will be de-recognized and equity share capital & reserves will have to be accounted for.

No. of shares issued = 5 shares per bond * 500 bonds = 2500 shares of face value $20 each

Journal entry for the same will be as follows:

31-Dec-2020 10% Convertible Bonds Series I A/c Dr 5,00,000.00
Share Premium – Equity Conversion A/c Dr 83,803.88
Equity Share Capital A/c Cr 5,00,000.00
Share Premium A/c Cr 83,803.88
(Being 2500 shares of face value $20 issued against convertible bonds)

c) Conversion of bonds before maturity

Let us say that the conversion takes place on 31st December 2018. At value of liability on this date is $4,59,357.28. Further, the Share Premium – Equity Conversion A/c will be also need to be reversed.

Journal entry for the same will be as follows:

31-Dec-2018 10% Convertible Bonds Series I A/c Dr 4,59,357.28
Share Premium – Equity Conversion A/c Dr 83,803.88
Equity Share Capital A/c Cr 5,00,000.00
Share Premium A/c Cr 43,161.16
(Being 2500 shares of face value Rs. 20 issued against convertible bonds)

Here, Share Premium A/c will be the balancing figure arrived as follows: 4,59,357.28 + 83,803.88 – 5,00,000.00 = 43,161.16

d) Repurchase of bonds before maturity

An organization may decide to repurchase its bonds before maturity. In the given example, let us say that the bonds are repurchased on 31st December 2018.

On this date, different values which need to be considered are as follows:

Carrying Value of Liability Calculated earlier (Refer section annual coupon payments) $4,59,357.28
Market Value of Bonds Assumed value – Selling Price $5,25,000.00
Fair Value of Liability This amount needs to be calculated as the present value of the non-convertible bond with a three-year maturity (which basically corresponds to the shortened time to maturity of the repurchased bonds – Refer next table for calculation) $4,42,919.37
Gain on repurchase Fair Value of Liability – Carrying Value of Liability $16,437.91
Equity Adjustment Fair Value of equity component

= Market Value of Bonds – Fair Value of Liability

$82,080.63

Journal entries for the above will be as follows:

31-Dec-2018 10% Convertible Bonds Series I A/c Dr 4,59,357.28
Share Premium – Equity Conversion A/c Dr 82,080.63
Gain on Repurchase of Bonds A/c Cr 16,437.91
Bank A/c Cr 5,25,000.00
(Being 2500 shares of face value $20 issued against convertible bonds)

There will be a balance of $1,723.25 (83,803.88 – $82,080.63) in Share Premium – Equity Conversion A/c. This can remain as it is or the company can transfer it to normal Share Premium A/c, if any.

Comments

  1. By Cody Brooks on

    Thank you for explaining Convertible Bonds in a clear way, I got to know what actually Convertible bonds are but I want to know a bit about Debt financing if you can explain me about this in two three sentence I would appreciate more. Thank you

    Reply

  2. By Brian Hoffman on

    Nice article Very informative notes. I would like you to send me the templates for financial statement analysis?

    Reply

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