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Chapter 8.6® - Issuing Convertible Debt at Issuer's Option & Terms - Stock Options & Warrants, Accounting for Stock Rights, Generating Cash Flow Statements of Debt Activities

Lets suppose that Tahir Ltd. issues a $100,000, 8%, four-year debenture at par, repayable at maturity in common shares at Tahir’s option. Interest is payable annually, in cash. The present value of the debenture can be disaggregated as follows:

Principal [$100,000 X (P/F, 8%, 4)] $73,503
Interest [$8,000 X (P/A, 8%, 4)] $26,497
Total $100,000

When the bond is issued, the entry will be:

January 1st, 2009

Account Name

Dr. Cash   $100,000  
Cr. Interest liability on debenture   $26,497
  Cr. Share equity – debenture   $73,503
Journal entry to record the issue of $100,000, 8%, four-year debenture at par, repayable at maturity in common shares.

The journal entry to record interest expense would be:

December 31st, 2009

Account Name

Dr. Interest Expense*   $2,120  
Dr. Interest Liability on Debenture
  Cr. Interest liability on debenture   $2,120
Cr. Cash   $8,000
* ($26,497 X 8%)
Journal entry to record interest payable on 4 year debenture issued at par (see above).

Stock Options:

Stock options are financial instruments that give the holder the right to buy shares at a fixed price. If the exercise price of the option is above the value of the shares, the option has no value. When options are first issued, they almost always have an exercise price that is equal to or higher than the current market price of the shares. Only when the share price rises above the exercise price does the option itself have intrinsic value.

Stock Rights and Warrants:

Corporations often issue stock rights that provide the holder with an option to acquire a specified number of shares in the corporation under prescribed conditions and within a stated future time period. Stock rights that are issued as an attachment to other securities (usually to bonds) are sometimes called stock warrants. A common distinction between stock rights and stock warrants is that stock rights often have a short life while warrants are valid for longer period of time and often have no expiry date.

Accounting for Stock Rights:

The issuance of stock rights raises accounting issues for both the recipients and the issuing corporation. For the recipient, stock rights received on existing shares held an investment have no additional cost, so the current carrying value of the shares already owned is allocated between the original shares and the rights received, based on the current market values of each.

Commodity-Linked Debt:

Some companies issue what are called commodity loans, where, at maturity, a specific quantity of a commodity is delivered instead of cash.

In the case of commodity-linked debt, however, standard-setters have agreed that there is financial liability. The term of this loan will allow the investor the option of receiving , at maturity, either the principal amount of the loan, in cash, or a specific amount of a given commodity, such as oil or a precious metal.

Cash Flow Statement:

The cash flows relating to complex financial instruments must be reported in the cash flow statement in manner that is consistent with their substance. The net proceeds from the issuance of any financial instrument will be reported as a financing activity, with the nature of the instrument disclosed in the notes to the financial statements. If an instrument is a hybrid that consists of both equity and liability components, then the individual components should be reported together on the CFS. Since conversions do not involve cash flow, they are not reported on the CFS.

Cash flows for interest and dividend must be reported in a manner that is consistent with their substance. For example, all payments that are related to debt in substance should be included in cash flow from operations even if the form of payments is that they are dividends.

  2009 2008
Retractable preferred shares - $3,000,000
Convertible bonds payable $8,000,000 -
Discount on bonds payable $245,000 -
Common Stock conversion rights $457,000 -
Stock rights outstanding - $55,000
Common Shares $13,800,000 $13,645,000

Convertible bonds were issued in 2009. Discount amortization in 2009 was $15,000. The retractable preferred shares were redeemed during the year, at par. Stock rights were issued to a law firm for legal services performed in 2008 and were exercised in 2009. There were no other common share transactions.

As a result of these transactions, the cash flow statement would report:

1) In financing, as source of funds, proceeds on issuance of convertible bonds, $8,197,000. The bonds were originally allocated $7,740,000 of the original proceeds. (That is $8,000,000 less $260,000; the original discount before this year’s amortization). In addition, proceeds of $457,000 were allocated to the equity account, $7,740,000 + $457,000 = $8,197,000.

2) In financing, as a use of funds, redemption of preferred shares, $3,000,000.

3) In financing, as a source of funds, sale of common shares, $1,000,000. The common shares account has actually increased by $155,000 (or, $13,800,000 - $13,645,000). However, this represents not only the cash received on the sale of shares, but also the rights account, $55,000, that was transferred to common shares. Only the cash portion is shown on the cash flow statement.

4) In operations, add-back of the non-cash interest expense caused by discount amortization, $15,000.


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