- 1 Definition
- 2 Overview
- 3 The Accounting Around Convertible Debt
- 4 Accounting Treatment
- 5 Convertible Debt Accounting Example
- 6 Conclusion
The accounting for convertible debt presents a number of 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 type of compound financial instrument (also sometimes referred as a hybrid), ie 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 specific 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, for investors they are prepared to accept lower rates for the risk as they are able to gain exposure to the up-side potential of future gains in share price as the company grows.
The Accounting Around Convertible Debt
The problem that these instruments pose for accountants is how should they be recognized, measured and disclosed for financial reporting purposes. This complication is added to by the common inclusion within the instruments of warrants, calls and / or puts that must also be considered in how these are brought to account.
International Financial Reporting Standard (IFRS) 9 Financial Instruments sets out how these types of instruments are to be accounted for in company’s financial statements. Specifically, the standard
” … 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 is 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 bearing costs, while the statement of financial position understated that in substance new share capital was being issued.
So what does IFRS 9 require? In order to achieve the fair reporting of these hybrid instruments the reporting entity must separate out the debt and equity portions and ensure the full borrowing costs are reflected in the accounts.
Liability Recognition and Measurement
The debt side of the instrument is measured by calculating the discounted cashflow of the future cash out flows of principle and interest from the reporting entity to the bond holders.
Initially, the liability component is calculated by discounting the future cash flows of the bonds (interest and principle) at the rate of a similar debt instrument without the conversion option.
In the statement of financial performance the effective interest cost of the bonds is disclosed. This approach means rather than the nominal interest cost being used the substance of the opportunity cost of the effective interest rate is brought to account.
The value of the equity component is the difference between the present value of the liability component of the convertible bond (as mentioned above) and the total proceeds from the issue of bonds. This is known as the residual approach to calculation of the equity component, which assumes that 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 – using the interest rate of a similar debt instrument without the option to convert into shares.
Subsequently, interest is charged 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 true opportunity cost of the financial liability.
The equity component calculated as the difference between the discounted cash flow as set out above and the cash flow from the convertible note issue.
If the conversion option is exercised or no such option exists and the conversion is automatic, the convertible notes are replaced by share equity. This will require the company to remove both the separate debt and equity components it was previously recognizing and in its place bring to account the new shares issued in their place.
On the other hand, if an option is in place and this is not exercised by the bond holders the company simply pays the bond holders the principle owed on the debt and the equity previously being recognized 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 that would be recorded in the issuing and maturity of these instruments.
Carrying on with our trusty ABC Ltd; business has been going well, however to help the business grow further and acquire much needed plant and equipment it has been decided to issue $3,000,000 in convertible notes to a number of 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 to 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 for the issuing of these convertible notes. For simplicity we are ignoring transaction costs, legal fees, etc that are 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 the calculation of the net present value (NPV) of the associated cash flow over the five year life of the notes. So in ABC’s case the following calculation would be made:
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 cashflow 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 bring to account 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%.
The reason we do this is to fairly disclose the cost of borrowings where they are in effect being “subsidized” by the equity component, which does not reflect a borrowing cost but is in effect a borrowing by the firm until it is converted into equity at maturity.
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:
- Note 1: 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).
- Note 2: 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.
- Note 3: the NPV of debt in effect double-counts interest by having included the nominal interest charge we used in Table 1 above.
- Note 4: we must remove the double counting by deducting the nominal interest expense already included in the figure we are using in column 1.
- Note 5: this is the liability we bring to account at the end of the for the balance of notes on issue.
For example, for year 3 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.
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 note holders will have their compound instruments converted into equity in the firm. You will be glad no more calculations are required, just one set of accounting entries:
|10 May||Convertible Debt||$3,000,000|||
|Share Premium Reserve||$257,521|
This closes the convertible debt liability position through the creation of the share equity capital position. We also need to close the share options position, and this is brought across into a 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 note by using our Contact Us form.