# Accounting for Convertible Bonds ## Accounting for Convertible Bonds & Debt

Accounting for Convertibles refers to the accounting of the debt instrument that entitles or provide rights to the holder to convert its holding into a specified number of issuing company’s shares where the difference between the fair value of total securities along with other consideration that is transferred and the fair value of the securities issued is recognized an expense in the statement of income.

### Explanation

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

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.

### Step by Step Accounting for Convertible Bond (Debt)

For eg:
Source: Accounting for Convertible Bonds (wallstreetmojo.com)

An 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

#### #1 – Issue of Convertible Bonds

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

##### a) Liability Portion:

The 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, the present value will be calculated as follows:

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

##### b) Equity Portion:

The 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:

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 that 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 bondholders. As mentioned earlier, convertible bonds are issued at a lower rate of interest. For taking the actual financial cost into the 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 the 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 the year) = Value of Liability at the start of the year + Effective Interest – Actual Interest Payment

Journal Entry for Interest will be as follows:

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 the 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 may be.

#### #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 the repurchase of bonds. In this case, the bondholders are paid the maturity amount, and only the liability portion accounted for earlier will have to be de-recognized, and the maturity amount will be paid to the bondholders.

Journal entry for the same will be as follows:

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

Bondholders may exercise the conversion option, and in this case, shares will have to be issued to the bondholders 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:

##### c) Conversion of bonds before maturity

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

Journal entry for the same will be as follows:

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:

Journal entries for the above will be as follows:

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.

1. Cody Brooks says

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

• Dheeraj Vaidya says

Thank Cody! Debt financing is the best way to finance an acquisitions. Debt financing is also been called as a technique of raising capital by borrowing.

2. Brian Hoffman says

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

• Dheeraj Vaidya says

Sure. I have already sent you the templates you can check your inbox. If you didn’t receive it yet, please reply to this and I will resend you the templates