Investors can invest in various securities and instruments in the market. Usually, they prefer shares and other similar instruments as they provide higher returns. These instruments come with two types of earnings, including dividends and capital gains. However, they also come with higher risks compared to other forms of investments.
Some investors may not be willing to accept those risks. Therefore, they may prefer other securities that can lower those risks. In most cases, these securities include fixed-income instruments, which provide a guaranteed income. While the returns from these instruments may be lower, they can offer more certainty, which investors will appreciate.
When it comes to fixed-income instruments, most investors prefer bonds. These instruments are safer due to the lower risks. As mentioned, however, they come with lower returns compared to shares and other similar instruments. Nonetheless, investors may have the option to achieve both advantages through convertible bonds. However, accounting for those bonds can be highly complicated for companies.
What is a Convertible Bond?
A convertible bond is a type of financial instrument that comes with a fixed income. However, it also includes the right or an obligation to exchange the underlying security for shares. In most circumstances, the number of those shares depends on a conversion ratio. The investor and companies issuing those shares will fix this ratio at the beginning of the contract. Usually, the convertible bond mentions this ratio.
Convertible bonds provide investors with the opportunity to convert their securities into shares. Usually, these bonds come with various dates or periods on which the investor can exchange them for stock. On top of that, it also offers the same features as other bonds or most debt instruments do. For example, they come with a coupon rate based on which investors get interest payments.
Similarly, convertible bonds also come with a maturity date before which all these coupon payments apply. This maturity date also provides the expiration period for the option to convert bonds into shares. After this date, the investor may not have the right to get stuck. If the investor does not exercise their right until expiry, they will receive the bond’s face value. This process is similar to traditional bonds.
Convertible bonds also come in various variants. The most common of these include vanilla convertible bonds, which provide investors with the right to convert. However, some of these bonds may also come with mandatory conversion options, which forces the conversion at maturity. Lastly, some convertible bonds may also provide the company with the right to convert. In most cases, the accounting for all variants will be similar.
Overall, convertible bonds are debt instruments that provide investors with the right to convert to shares. However, some variants may also carry the obligation to do so or give that right to the issuer. These bonds come with the same features as traditional bonds. With the option to convert, they provide investors with an incentive to invest in a company’s debt instruments.
What is the Accounting for Issuance of Convertible Bonds?
The accounting for the issuance of convertible bonds is complex. As mentioned, convertible bonds are like other traditional bonds in essence. However, they have an element of equity, which comes from the option to convert them into shares. This option may differ from one convertible bond to another. However, most of them have the characteristics of both debt and equity.
Since convertible bonds involve both debt and equity elements, it is crucial to account for both. Through this presentation, companies can present these bonds truly and fairly in their financial statements. This presentation will also be critical for two reasons. The first involves reporting the option to convert them into shares. Therefore, the financial statements should allow investors to understand the possible dilution of equity in the future.
The second reason includes showing that these bonds are convertible to equity in the future. Due to this feature, these bonds will have a lower interest rate. Therefore, separating the debt element from the equity element will present these bonds more fairly. This accounting treatment applies under IFRS, which proposes that the issuer identify the liability and equity components separately.
In practice, calculating the liability and equity component requires complex calculations. For the liability component, a company must discount all future cash flows from the bond at a similar rate as non-convertible bonds. Since separating this component allows a different presentation, the discount rate must also follow it. The future cash flows must include both principal and interest payments.
For the equity component, the calculation is straightforward. Once companies calculate the liability component through the discount method, the residual amount will go into equity. Therefore, the accounting for the issuance of convertible bonds will impact both liabilities and equity. This method of calculation is known as the residual approach.
What are the journal entries for the issuance of Convertible Bonds?
From the above accounting for issuance of convertible bonds, it is possible to derive the journal entries. As mentioned, this process involves impacting both equity and liability. Apart from these two, companies must also recognize any proceeds from the process. Therefore, the journal entries for the issuance of convertible bonds will also impact a company’s assets.
The debit side of the journal entries for the issuance of convertible debt will include the compensation account. Usually, companies receive cash through the bank for these bonds. Therefore, it is most likely that this account will be the company’s cash at the bank account. This account will record the total compensation received for the issuance process.
The credit side will impact two accounts. The first will be the liability account which will record the present value of all future cash flows. As mentioned, the amount will include discounted cash flows based on an effective rate. The second side will be the equity account. This account will record the difference between the compensation received and the liability component.
Overall, the journal entries for the issuance of convertible bonds will be as follows.
| Date | Particulars | Dr | Cr |
| Bank | XXXX | ||
| The liability component of convertible bonds | XXXX | ||
| The equity component of convertible bonds | XXXX |
Convertible bonds will also involve other journal entries in the future. These entries will relate to the accounting for interest from convertible debts or the settlement. However, those processes don’t fall under the issuance process. Nonetheless, the above liability and equity components may get affected by future journal entries.
Example
A company, ABC Co., issues 10,000 convertible bonds at $50 each. The company receives compensation for the issuance through its bank account. For these, ABC Co. allows investors to convert at a conversion rate of 3 shares per $50 bond. The maturity period for convertible bonds is five years.
Overall, the company also estimated the liability component for these bonds to be $400,000. ABC Co. calculated this component at an effective interest rate rather than its 10% nominal rate. The company uses IFRS to record its financial instruments. Therefore, ABC Co. recorded the issuance of convertible bonds as follows.
| Date | Particulars | Dr | Cr |
| Bank | $500,000 | ||
| The liability component of convertible bonds | $400,000 | ||
| The equity component of convertible bonds | $100,000 |
Conclusion
Convertible bonds are a financial instrument that allows holders to convert them into shares in the future. These bonds come with a conversion ratio that dictates the number of shares that investors will receive. Overall, accounting for the issuance of convertible bonds requires companies to split it into liability and equity components. This treatment falls under the IFRS and is known as the residual approach.
