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Chapter 8.4® - Characteristics of Convertible Bonds - Value of Conversions, Recognition of Convertible Debt & Associated Journal Entries & Measurement of Net Income

A key element of convertible bonds is that, in issuing the bonds, management fully expects that the conversion privileges will eventually be attractive to the investors: the investors will convert at or before the maturity date, and therefore the company will never have to repay the principal amount of the bonds.

Conversion of a bond becomes attractive when the market price of the shares into which it is convertible rises above the conversion price.

Example:

An investor has a \$1,000 bond (purchased at par) that is convertible into 25 shares of common stock (i.e., the conversion price is \$40). If the market price of the common shares is \$46, the investor can make a profit of \$6 per share (less transaction costs) by converting the bonds and then selling the shares on the open market:

 Market value of shares obtained on conversion (\$46 X 25) \$1,150 Less: Cost of Bonds (\$1,000) Profit from Conversion \$150

A convertible debenture can often be called for redemption by the company prior to maturity. The point of the redemption option is that management can force conversion before maturity if the market price is above the conversion price of the shares. By forcing, early conversion, the company removes the interest expense from the income statement, and transfers the principal amount from debt to equity on the balance sheet.

Therefore, convertible bonds usually have a provision, (called a call option) whereby management can require investors to submit their bonds for redemption. The call price is always somewhat higher than the maturity value.

If the underlying share value of a convertible bond never reaches the conversion price, it will be impossible for management to force conversion and the bonds will have to be redeemed in cash. A convertible bond that cannot be forced to convert is called a hung convertible.

The Value of Conversion

As long as the market price of the shares into which it is convertible is less than the conversion price, the bond sells principally on its merits as debt. However, once the share market price rises above the conversion price, the bond sells in the market at its equivalent share price. But even when the share market is price is lower than the conversion price, there is value to the conversion privilege. Bonds with conversion privileges will sell at a higher price (and lower interest yield) than bonds of equivalent terms and risk without a conversion privileges.

Convertible Debt, at the Investor’s Option

Convertible debt that is convertible at the option of the investor is really two things:

 1) a promise to pay interest and principal and 2) an option that gives the investors the right to use that principal to buy a certain number of common shares.

The substance of the investment is reflected if these two elements are recognized in the financial statements. Thus, accounting standards require that at issuance, if a liability includes an option on shares, the proceeds from issuance must be divided between the liability and the option and the two recorded separately.

Recognition:

Assume that Farah Corporation sells \$100,000 of 8% convertible bonds for \$106,000. The market interest rate on the day of issuance is 10%. Each \$10,000 bond is convertible into 100 common shares on any interest date after the end of second year from the date of issuance. Conversion is at the option of the investor. Also, assume that it is appropriate to assign a value of \$92,418 to the bond and \$13,582 to the conversion privilege. A discount of \$7,582 is recorded: the difference between the \$92,418 net proceeds attributable to the bond and its \$100,000 face value. The issuance will be recorded as follows:

 January 1st, 2009 Account Name Debit Credit Dr. Cash \$106,000 Dr. Discount on Bonds Payable * \$7,582 Cr. Bonds Payable \$100,000 Cr. Contributed Capital - Common Stock \$13,582 * \$100,000 - \$92,418 Journal entry to record the issuance of \$100,000 of bonds payable at a discount

Measurement:

Measurement of the two components is a major issue because there is no separate objective price provided by arm’s length market transactions.

• The incremental method, in which the stock option is valued at the difference between the total proceeds of the bond issue and the market value of an equivalent “ordinary” bond issue; or
• The proportional method, in which the proceeds of the bond issue are allocated on the basis of the relative market values of the ordinary bond and the imbedded stock option.

The incremental method was used by Farah Corporation. The present value of the cash flows of an 8%, five year, \$100,000 bond (assuming annual interest payments) is \$92,418 at an effective interest rate of 10%. Subtracting \$92,418 from the net proceeds of \$106,000 leaves \$13,582 attributable to the conversion option.

When the bonds are converted, the issuer normally will account for the shares at the sum of the carrying value of the bonds (i.e., the amortized cost value) plus the extinguished conversion right, and record no gain or loss on the conversion.

If the proportional method is used, then the is valued and an option pricing model is used to assign a value to the conversion feature. Option models are in common use by financial institutions.

Impact on Income

An interesting aspect of the allocation of the proceeds is the impact on future income. Because some of the proceeds are allocated to equity, a discount is recorded. The size of the discount varies with the pricing and allocation methods used. The discount is amortized over the life of the bond, using either the straight-line method or the effective interest method. This will decrease net income.