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Chapter 8.5® - Conversion of Bond Debt using Book Value & Market Value Methods & Examples to Illustrate - Repayment of Bonds & Credit to Contributed Capital - Common Shares

When convertible bonds are submitted for conversion, the first task is to update any accounts relating to bond premium or discount, accrued interest, and foreign exchange gains and losses on foreign currency denominated debt.

Book Value Method:

The conversion can be recorded using the book value method. For example, return to the Farah bonds. All the \$100,000 Farah bonds payable are converted to 1,000 common shares on an interest date. Assume that on this date, the stock price is \$140 per share, and calculations show that \$4,550 of discount remains unamortized after updating the discount account. The entry to record the conversion is:

 January 1st, 2009 Account Name Debit Credit Dr. Bonds Payable \$100,000 Dr. Contributed Capital - Common Stock \$13,582 Cr. Discount on Bond Payable \$4,550 Cr. Common Shares \$109,032 Journal entry to record the conversion of \$100,000 worth of bonds to Common shares and delete the unamortized discount on bonds payable of \$4,550 by debiting Contributed Capital - Common stock.

The common shares are recorded at the book value of the debt.

Market Value Method:

An alternative approach is the market value method. Under the market value method, the conversion is recorded at the value of the shares that are issued on conversion. This approach is supported by the various provincial and federal corporations acts, which generally stipulate that shares should be recorded at their cash equivalent value, which is the amount that would be received if the company issued the shares for cash rather than through conversion.

Example:

The shares are assumed to have a value of \$140 each. The cash equivalent value of the 1,000 shares issued on conversion is \$140,000 which will be recorded as follows:

 January 1st, 2009 Account Name Debit Credit Dr. Bonds Payable \$100,000 Dr. Contributed Capital - Common Stock \$13,582 Dr. Loss on Conversion of Bonds \$30,968 Cr. Discount on Bonds Payable \$4,550 Cr. Common Shares \$140,000 Journal entry to record the conversion of \$100,000 worth of bonds to common shares @ \$140 per share and to delete unamortized discount on bonds payable of \$4,550 and record a loss on conversion of bonds.

An argument in favour of the market value method is that the transaction is not simply a trade – the exchange of debt for equity represents a change of risk for both the issuer and the holder and therefore is a substantive exchange. Substantive exchange (such as barter transactions) are normally accounted for at market values in order to reflect the economic consequences of the exchange.

Repayment:

If the market value of underlying shares is less than face value, investors will request and the conversion rights will expire. If this happens at maturity, all discount or premium accounts will be zero. The entries for the Farah:

 December 31st, 2009 Account Name Debit Credit Dr. Bonds Payable \$100,000 Dr. Contributed Capital - Common Stock \$13,582 Cr. Cash \$100,000 Cr. Contributed Capital - Lapse of Right \$13,582 Journal entry to pay back bonds payable issued on January 1st, 2009 worth \$100,000 and delete Contributed Capital since bonds are no longer converted to common shares at a discount or premium.