So, an ordinary conversion feature.
We're going to call it non beneficial.
You'll see what beneficial means in a little bit.
An ordinary conversion feature has both of the following characteristics.
That debt is convertible into common stock at
a specified price at the option of the holder.
It's not mandatorily convertible,
that would be accounted for differently.
The debt instrument is sold at a price or has a value addition issuance.
It's not significantly in excess of the face amount.
So, the option is not what we would say is in the money,
that would be a beneficial conversion feature which we'll talk about separately.
So, it's convertible at a specified price at the option of the holder.
It's not significantly in the money.
The conversion price does not exceed the fair value of the stock at the date of issuance.
So, if you have those two conditions,
there's no special accounting on issuance.
You don't attribute any portion of the proceeds from
ordinary convertible instruments to the conversion feature.
You're not allocating the amount of debt proceeds you receive when you borrow
the money and saying "Some of this belongs with
the conversion feature and some of it belongs to the debt. "
You are accounting for it strictly as debt.
So, if you don't account for the option separately,
then it's just the same accounting as you would have for non-convertible debt,
except that you would expect to have a premium on those bonds because
of the value of that option that's embedded
within the bonds or a lower discount if depending on what the stated rate is,
but you would expect overall a lower interest rate on the debt,
because of the value to the holder of having that option to convert.
So, the effective interest rate will be lower.
You'll get higher proceeds.
Again, understanding the mathematics of
discounting is a really a key skill for accountants and auditors,
as you should've picked up by now between these two sections.
You really need to understand this math and how the change
in the discount rate affects the value of either debt or an asset.
Well, what about on conversion?
Well, the carrying amount of the debt including any on
amortize premium or discount and issuance cost,
shall be credited to the capital accounts upon conversion.
This is important. No gain or loss is recognized by the issuer of the debt.
So, let's take an example.
This is straight out of the accounting standards codification. It is adapted.
I've modified it to fit the needs of this course
but you can find it in
the ASC at that reference is down there at the bottom of the slide.
January 1st 19X4, Entity A issues a $1,000 face amount,
10 percent convertible bond maturing December 31st 20X3.
The carrying amount now is $1,000 and it is
convertible into common shares at a conversion price of $25 per share.
So now, notice there's no discount or premium on this.
On January 1st 19X6,
a convertible bond has a fair value of $1,700.
So, the face amount,
the carrying amount of the debt is 1,000.
The fair value of the common stock is 1,700.
What happens if they convert?
Well, on conversion I'm going to show that debt going from,
being reclassified from convertible debt to being classified as capitalist stock.