Convertible debt is a type of loan that can be converted back to stock after some specified future date. When making an investment in convertible debt, both the issuer and investor are clear that there is a possibility of debt being converted into stock in the future. International Account Standard 32 deals with accounting for convertible debt.
A convertible debt instrument is an alternative financing solution, normally used by companies to finance their operation or working capital. The peculiar thing about this arrangement is that both parties can be on the same page regarding an eventual conversion of convertible debt into common stocks of the company. In other words, both the issuer and the holder can convert the debt into equity at a future date. However, the former (i.e. the forced conversion) is rare, while the latter (conversion by the holder) is more common.
Sometimes, it is not easy for the company to issue convertible debt because the shareholder may oppose this management decision. This is due to the fact that upon conversion of the debt to equity, the shareholders’ stock values will decline because of the share dilution. Therefore management needs to pursue by performing a cost-benefit analysis as to why the issuance of convertible debt is beneficial to the company and its shareholders at the same time.
An example of a convertible debt
Normally, the company issues the bond at par, but sometimes it can offer a discount to investors in convertible debts as an incentive. For example, Mr. A purchased a convertible bond on January 01, 2020, for $500,000 at $500 each, whereas the par value of the bond is $550. Why has the company offered a discount on the issuance of the bond? It is because investors will be likely to convert their debts into equities.
Why offering a discount?
Debt is senior to equity in terms of payback at times of liquidation. So if an investor is willing to forgo his debt right for equity, then obviously the company has to offer some incentive in order to keep its investment.
Moving forward in the above-mentioned example, if the maturity of the bond is December 31, 2024, this means that after 5 years, the investor can convert and the company can reduce its debt leverage and issue its stocks in place.
Why is issuing a convertible bond good for the company?
A company at times is in need of financing, but they don’t want to increase their debt leverage, therefore they offer a discount to investors for investing in their convertible debt instruments. Once the investment has been made, the company can save itself from a debt burden.
Why is purchasing a convertible bond good for investors?
Often times it is worthwhile to invest in a company’s stock but for some reason, the investor does not want to invest in equity immediately. Therefore a better way is to go for convertible debt and then convert it into equity at a future date. This way, the investor will be in the position of a shareholder. In addition, as discussed above, the investor can be offered a discount as an incentive for investing in convertible debt.
How to account for the convertible debt
As both the company and investors have the same understanding that after a defined period of time they can convert the debt into common stocks, therefore as per IAS 32, when accounting for the convertible debt, the company has to recognize the issuance of convertible debts as a compound instrument.
A compound financial instrument is an instrument that includes two components. These are equity and liability components. Liability includes all contractual arrangements to deliver cash. On the other hand, equity includes the call option, allowing the debtholder to exercise their right to receive shares. Therefore, the debtholder can convert their liability into debt.
Convertible debt, as mentioned, meets the requirements for a compound financial instrument. For that purpose, the accounting standards specify that companies must split compound instruments into equity and liability components and record both separately. However, there are some conditions that may obligate the company to classify convertible debt as equity or debt.
The classification for a single component is complex. IAS 32 requires companies to put their convertible debts through a series of tests to determine whether they should use the equity, debt, or compound financial instrument treatment.
The test starts with establishing whether the company has a contractual obligation to pay cash that it cannot avoid. If such an obligation exists, the company must determine whether the exemptions defined in IAS 32.16A-D apply. If that is the case, the treatment will be equity.
Similarly, if it does not meet the test, then the company must determine whether it has an obligation to issue a variable number of shares. If that is not the case, they must move to the next test. The next test requires companies to establish whether there is an obligation to issue a fixed number of shares to settle an instrument whose book value is variable. If the convertible debt also fails this test, then the treatment will be of equity.
If it passes any of the two above tests, or if the exemptions in IAS 32.16A-D do not apply after passing the first test, then there is one final test. This test requires companies to determine whether the instrument has any characteristics that are similar to equity. If it fails the test, then the company must treat it as a liability. If it passes the test, then the treatment will be of a compound financial instrument.
Treatment as Equity
When treating convertible debt as equity, the accounting entry is straightforward. The company must record the full amount of the debt as equity. It can do so in the following way.
Cr Equity (Convertible Debt)
Treatment as Liability
For the liability treatment, the method will be the same. The company will recognize any increase in the asset in exchange for an increase in liabilities. The treatment is as follows.
Cr Liability (Convertible Debt)
Treatment as Compound Financial Instrument
The compound financial instrument treatment for convertible debt isn’t as straightforward. With this method, the company must split the convertible debt into its equity and liability components. The company can split both components by finding the present value of future cash flows from the debt. This amount will constitute the liability portion of the debt. The equity portion will be the difference between the liability component and the amount received for the debt.
In the case of the compound financial instrument treatment, the accounting entries will be as follows.
Cr Liability (Convertible Debt)
Cr Equity (Convertible Debt)
Every year the interests accrued on the debt portion of the convertible debt shall be recognized in the profit and loss statement. These payments are similar to other debts and calculated using the coupon rate on the convertible debt. Once the issuing company calculates the amount, it can use the following double entry to record it.
Dr Interest Expense
At the maturity of a convertible debt, the company must convert any recognized debt or equity into equity. In some cases, the conversion will be mandatory. In others, the investor will have the choice to convert or skip it. If they choose to convert, the accounting treatment will be as follows.
Dr Equity (Convertible Debt)
Dr Liability (Convertible Debt)
Cr Share Capital
Cr Share Premium
The above treatment is for compound financial instruments only. For the other methods, the company can remove the equity or liability part of the above entry.
A company, Green Co., issues convertible debt of $100,000 to investors. Green Co. goes through the tests necessary to classify the debt and reaches the conclusion that it should be treated as a compound financial instrument. Based on Green Co.’s calculations, the present value of future cash flows from the convertible debt will be $80,000. Therefore, the company will record the issuance as follows.
Dr Cash $100,000
Cr Convertible Debt Liability $80,000
Cr Convertible Debt Equity $20,000
Green Co. also pays 10% annual interest on the debt. Therefore, the company will record an interest payment of $1,000 ($10,000 x 10%) each year. The accounting entry is as follows.
Dr Interest Expense $1,000
Cr Cash $1,000
At maturity, investors choose to convert their debt into shares. Therefore, Green Co. must transfer the debt into its equity accounts. According to the conversion ratio for the debt, Green Co. will issue 7,500 shares to investors, which have a par value of $10. Therefore, the accounting treatment for the conversion will be as follows.
Dr Convertible Debt Liability $80,000
Dr Convertible Debt Equity $20,000
Cr Share Capital (7,500 shares x $10 per share) $75,000
Cr Share Premium ($100,000 – $75,000) $25,000
How to price a convertible debt
A convertible debt is a hybrid security, part debt and part equity. Its valuation is derived from both the level of interest rates and the price of the underlying equity. Several convertible bond pricing approaches are available to value these complex hybrid securities such as Binomial Tree, Partial Differential Equation and Monte Carlo simulation. One of the earliest approaches was the Binomial Tree model originally developed by Goldman Sachs and this model allows for an efficient implementation with high accuracy. The Binomial Tree model is flexible enough to support the implementation of bespoke exotic features such as redemption and conversion by the issuer, lockout periods, conversion and retraction by the shareowner.
The Binomial Tree approach for valuing a convertible debt can be implemented in Excel or Python.