The accounting for convertible debt presents several accounting challenges, both conceptually and the journal entries required. In this article, part of our accounting tutorial series, we set out what these challenges are and work through a practical example so you can see the calculations and account transactions involved.
A convertible debt instrument is a compound financial instrument (sometimes called a hybrid), i.e. it has characteristics of both debt and equity funding for a company.
The convertible note allows the holder to convert the instrument at a specific price and time window into a particular number of a firm’s shares.
In addition to the instrument at the time of issue specifying the price and timing of conversion, it will also set out the types of shares in the company the holder will be entitled to gain control over.
These types of instruments have grown in popularity over the years, in particular for start-ups. This appears to be caused by two factors. First, for the companies issuing the instruments, a key advantage can be a lower cost of borrowing, at least initially when this is so critical. And second, investors are prepared to accept lower rates for the risk as they can gain exposure to the upside potential of future gains in share price as the company grows.
Accounting For Convertible Debt Theory
The problem that these instruments pose for accountants is how should they be recognised, measured and disclosed for financial reporting purposes. This complication is added to by the standard inclusion within the instruments of warrants, calls or puts that we must also consider.
International Financial Reporting Standard (IFRS) 9 Financial Instruments sets out how to account for these instruments in a company’s financial statements. Specifically, the standard states:
” … specifies how an entity should classify and measure financial assets, financial liabilities, and some contracts to buy or sell non-financial items.”
The motivation behind this standard and its predecessors, International Accounting Standard (IAS) 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement, was the need to ensure fair reporting. Previously it was argued that reporting entities were not fairly reporting the true financial performance and position changes these instruments brought about. The statement of financial performance understated the interest component, while the statement of financial position understated the issuance of new share capital.
So what does IFRS 9 require? The reporting entity must separate the debt and equity portions and ensure the accounts reflect the total borrowing costs.
Liability Recognition and Measurement
You measure the debt side of the instrument by calculating the discounted cash flow of the future cash outflows of principal and interest from the reporting entity to the bondholders.
Initially, we calculate the liability component by discounting the future cash flows of the bonds (interest and principal) at the rate of a similar debt instrument without the conversion option.
In the statement of financial performance, we report the effective interest cost of the bonds. This approach means that we consider the substance of the opportunity cost of the effective interest rate rather than using the nominal interest cost.
The value of the equity component is the difference between the present value of the liability component of the convertible bond and the total proceeds from the issue of bonds. This is known as the residual approach to the calculation of the equity component. Under the residual method, the value of the share option is equal to the difference between the total issue proceeds of the convertible bonds and the present value of future cash flows. The discount rate used is an interest rate of a similar debt instrument that does not have the option to convert into shares.
Subsequently, we charge the interest to the income statement (statement of financial performance) based on the effective interest rate, which is usually higher than the nominal rate, to reflect the actual opportunity cost of the financial liability.
The equity component is then the difference between the discounted cash flow as set out above and the cash flow from the convertible note issue.
If the holder exercises the conversion option or no such option exists, and the conversion is automatic, the convertible notes become share equity. This will require the company to remove both the separate debt and equity components previously recognised and, in its place, bring into account the new shares issued in their place.
On the other hand, if an option is in place and the bondholders do not exercise this, the company pays the bondholders the principal owed on the debt. The equity previously being recognised is removed from its books.
Convertible Debt Accounting Example
Now it’s time to work through an example of convertible debt and the accounting transactions you would record in the issuing and maturity of these instruments.
Carrying on with our trusty ABC Ltd; the business has been going well. However, to help the company grow further and acquire much-needed plant and equipment, it has been decided to issue $3,000,000 in convertible notes to some local private investors. The specific details are:
- 1,000 five year notes will be issued at a nominal value of $3,000 each;
- these notes provide the holder with the option to either convert them into 3,000 $1.00 shares of ABC Ltd or to receive back their initial investment;
- the notes carry an interest rate of 7.5% and similar notes without the convertibility for an issuer with a similar credit rating as ABC Ltd carry a rate of approximately 9.75%; and
- the offer to the private investors was fully subscribed for.
So we now have all the information we need to calculate the value of the debt and equity portions and make the appropriate accounting entries in ABC’s books.
Accounting Entries on Issuing of the Convertible Notes
We know we will have to bring to account three types of transactions to issue these convertible notes. For simplicity, we ignore transaction costs, legal fees, etc., involved in these transactions. We are just going to focus on the instruments themselves and what accounting entries are required.
We know that the debit to Bank will be $3,000,000, but at this stage, we don’t know what the credits will be for the liability and equity entries:
As we mentioned above, the debt and equity part of the transactions require calculating the net present value (NPV) of the associated cash flow over the five-year life of the notes. So in ABC’s case, you would make the following calculation:
Each year the interest payment is:
principle x convertible debt interest rate
$3,000,000 x 7.5% = $225,000
The net present value (NPV) calculation for each year is:
$292,500 x (1 / (1+0.0975) ^ n)
|Year||Principle Repayment||Interest Payment||NPV|
We now have the NPV of the cash flow over the five-year term of the notes; so we can complete our initial accounting entry with the new figures to bring the new convertible notes to account:
Accounting Entries Over the Life of the Notes
Each year we will have to consider the interest charge and the subsequent change in liability position for ABC Ltd. To do this, we will now be using the equivalent interest rate for non-convertible notes of 9.75%, rather than the actual interest rate on the notes of 7.5%.
We do this to disclose fairly the cost of borrowings where they are in effect being “subsidised” by the equity component.
Net Present Value Calculations
So to start with we need to calculate the interest charge to bring to account and we do this by the following formula:
NPV of borrowings x equivalent interest rate for non-convertible notes
|Year||NPV of Debt (1)||Equivalent Interest (2)||NPV of Debt (3)||Interest (4)||Total of Debt (5)|
Notes to Table 2:
- this initial figure is obtained from Table 1 above. Then each year this opening figure is obtained from the previous year’s closing balance (see note 5).
- the equivalent interest rate from equivalent non-convertible debt is used. Again, this is used to bring to account a fairer reflection of the actual borrowing costs incurred by the firm.
- the NPV of debt in effect double-counts interest by having included the nominal interest charge we used in Table 1 above.
- we must remove the double counting by deducting the nominal interest expense already included in the figure we are using in column 1.
- this is the liability we bring to account at the end of the for the balance of notes on issue.
For example, for year three, we would make the following accounting entry:
|10 May||Interest Expense||$276,061|||
This entry brings the interest expense into the statement of financial performance and increases the convertible debt liability figure in the statement of financial position.
Interest Payment to Bond Holders
We mustn’t forget the bondholders. One of them reached out to me (see comment below from Ian) wondering why ABC wasn’t paying their annual interest payment (Ian, thanks for reaching out and pointing out the missing bit from our original version of this tutorial). Under the ABC example, they pay bondholders each year their interest earnings in cash, and so the entry would be:
|10 May||Convertible Debt||$225,000|||
The debit to the convertible debt liability reflects our table 2 (Note 4) comment where we don’t want to double count the interest expense. So we have to bring a debit to the liability account. At the same time, the credit reflects the cash payment to the bondholders.
Accounting Entries on Maturity of Convertible Debt
So, we are now five years down the road for ABC Ltd, and the convertible notes are maturing, and the noteholders will have their compound instruments converted into equity. You will be glad to know there is just one more journal entry. This journal entry converts the debt into the ABC shares and creates the share premium account.
|10 May||Convertible Debtentry||$3,000,000|||
|Share Premium Reserve||$257,521|
The creation of the share equity capital position closes the convertible debt liability position. We also need to close the share options position through the share premium reserve.
And that is it: convertible debt and the accounting issues you need to consider in bringing it to account. As always, we welcome your comments, feedback and questions. You can use the form below this post, head over to our questions and answer section, use our ask a question section or drop us a note using our Contact Us form.