Convertible bonds

By: Rashid Javed | Updated on: July 24th, 2022

Definition and explanation

A convertible bond is a corporate issued debt instrument that entitles its holder to exchange it for common shares or other corporate securities at holder’s option during a specified time after its issuance. In other words, we can say that convertible bonds combine a conversion option with the security of bond holding i.e., guaranteed interest and principle.

There are two main reasons for issuing convertible bonds. One reason is to attract investors while avoiding unnecessary giving up of ownership control. For example, assume ABC company’s common stock is selling at $45 a share and it needs to raise $1,000,000. If we ignore the issue cost, it would need to sell 22,222 shares. On other side, if the company sells 1,000 bonds at $1,000 par, each convertible into 20 common shares, it could raise $1,000,000 by committing only 20,000 shares of common stock.

The other reason for issuing convertible bonds is to raise debt financing at lower rates. In many cases, the debt financing could be obtained only at high interest costs unless company attaches a conversion privilege to the debt security. The conversion covenant attached to debt entices investors to accept a lower rate than would normally be the case on a straight debt issue.

Journal entry for conversion of bonds to common stock

Convertible bonds are initially recorded like a straight debt. No part of the proceeds received is recorded as equity at the time of their issuance because it is difficult to predict when, if at all, the actual conversion will occur. If a premium or discount arises from the issuance of convertible bonds, it is amortized to their maturity date.

Companies mostly use book value method to record the conversion of bonds to other securities like common stock etc. Under book value method, the common stock or other security that is exchanged for convertible bonds is recorded at the book value or carrying amount of bonds. For example, assume, Delta Inc. has a $1,000 convertible bond that the holder can convert into 10 common shares of $10 par value each. The unamortized premium is $50 at the time of conversion. Using the book value method, Delta would record this conversion as follows:

Induced conversion

Sometimes the issuing company wants to encourage an early conversion. The purpose of a prompt conversion is usually to lower the interest costs or to improve the debt to equity ratio of the entity. Companies try to achieve this by offering to holders some additional consideration known as sweetener. The sweetener is generally given in the form of cash, additional shares of common stock or both. The fair value of securities or other consideration given as sweetener is reported as expense of the current period. The account name used to record this expense is “debt conversion expense”.

Albania Company has outstanding $500,000 par value bonds convertible into 50,000 shares of $1 par value common stock. In order to reduce its interest cost, Albania offers its bondholders an additional cash amounting to $40,000 if they agree to convert their bonds to common shares. Assuming the bond holders agree and conversion occurs successfully, Albania records the following journal entry:

Example

Galaxy Corporation had outstanding 3,000 $1,000 bonds, each convertible into 40 shares of $10 par value common stock. The bonds were converted on December 31, 2022, when the total unamortized discount was $40,000 and the market price of the stock was $18 per share. Record the above conversion using the book value method.

Solution

More from Dilutive securities and EPS (explanations):

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