This course is the third course in the five-course Financial Reporting Specialization. This course begins with a discussion of current liabilities and contingencies and continues with long-term debt and bonds. The course next explores accounting model for leases, both lessees and lessors, and a discussion on deferred tax assets and liabilities. Participants will learn the latest accounting standards including the new accounting model for leases effective for public companies in 2019 and private companies in 2020.
Convertible Debt
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來自 University of Illinois at Urbana-Champaign 的課程
Accounting Analysis II: Measurement and Disclosure of Liabilities
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Module 3: Long-Term Debt Part 2
In this module, long-term debt will be discussed more in-depth. Students will learn how to account for bonds sold at a discount or premium, between interest dates, or with conversion features. Early extinguishment of debt, modifications and troubled debt restructuring are also discussed.
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John HeppClinical Assistant Professor of Accountancy
Department of Accountancy
Welcome back. In this section,
we're going to talk about convertible securities.
Convertible security, what is that?
Well, it's a security that can be converted from debt usually into something else.
It can be preferred stock or common stock, usually common stock.
A convertible security though is one in which you don't have the choice to
both purchase stock at an option price and continue to hold the debt.
It's an either or situation.
You can either collect the face value of the debt or you can
convert the instrument to shares of some sort, but not both.
The result is a complex hybrid instrument that is debt,
but continues an option to convert that debt to shares.
So, why would you do that?
Well, there's sort of something for everyone involved in there.
It can give advantages to both the issuer and the purchaser.
So, from the point of view of the issuer,
if you have convertible debt,
you will have a good chance of getting a lower interest rate than non-convertible debt.
Why? There is a possibility for the owner of
that debt to benefit from an increase in the stock price.
The purchaser obtains an option to either get the money back,
that they loan to the company in the form of the bond instrument,
or to get an equivalent amount of shares.
That's based upon the formula that's included within the conversion feature for
how many shares you can receive or for how many dollars worth of shares you can receive.
So, you have an upside.
If the fair value of the underlying common stock increases above the conversion price,
the purchaser then can benefit through appreciation,
but if the stock price goes down,
the purchaser still has the right to collect on the debt.
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.
Not you. The entry would maybe be a little bit different from that if you
have additional paid-in capital considerations, but you get the idea.
The amount is going to be at the amount of the convertible debt.
So, even though the fair value of the stock is 1,700,
I'm not going to record a gain or loss.
From the position of the company actually that would seem to be a loss.
I've just settled a debt of $1,000 with stock
worth $1,700 but because it's
an equity transaction we don't account for the gain or loss.
Well, what if the issuer adds a sweetener?
They want to get the debt off their balance sheet.
They want to convert it to equity.
Sometimes in that situation,
the issuer will offer an incentive for you to come and convert right now.
In the case that we have in the ASC they offer
an additional discount of $5 per share to exercise.
So those are bonus shares.
This gives a bond holder 50 shares instead of 40 for each bond,
converting at the market price would have given them 40 converting
at the extra $5 gives them 50 shares an additional 10 shares,
how much is that additional 10 shares worth?
It's worth 10 times fair value of the stock.
So the value of the incentive is 10 times 40 equals 400.
Not the conversion price,
we're looking at the fair value.
Well now, when I record the journal entry,
I have to account for that incentive that sweetener separately.
So my journal entry,
I'm still going to have the journal entry for the convertible debt 1,000,
but I'm going to take the fair value
of the incentive and account for that as a debt conversion expense,
and then my total amount of
convertible debt and debt conversion expense goes into capital stock.
So, there's no gain or loss on the conversion of the bond at the original terms,
but the additional shares that were issued as an incentive become an expense.
A lesson to learn from this is that conversion is often a very complex transaction,
care and professional judgment is required when a convertible bond is exercised.
So, let's add another twist to that.
What if there is a beneficial interest?
So, what is that term? What does that mean?
Well, it's again a non detachable conversion feature.
It's embedded within the debt.
It's not something I can exercise separately.
It's either or either I exercise
a conversion feature or I collect the debt, I can't do both.
But it's in the money at the commitment date.
In other words the conversion price is less than the fair value of the stock.
So, I'm going to recognize a portion of the proceeds,
that is equal to the intrinsic value of
the beneficial conversion option in additional paid-in capital on issuance.
Let's look at an example of that.
Entity A issues a million dollars of
convertible debt with a redemption date on the fifth anniversary of issuance.
The debt is convertible on the date issued.
There is a beneficial conversion feature.
The fair value of the common stock at the commitment date equals $50 per share,
but that is convertible into common stock at $40 per share.
The intrinsic value therefore is the difference between the fair value of
the stock on the date and the conversion price on the issuance date.
That's an intrinsic value,
notice that intrinsic value is not a fair value,
that it's probably worth a lot more than $10 per share
fair value because I'm holding a share,
a conversion feature that could increase in value over time over the next five years.
So intrinsic value is a different concept from fair value,
it's just the difference between
that conversion price and the fair value of the stock on the issuance date.
Now, why is there a requirement that you hold the stock for five years?
Well, because otherwise why wouldn't you just
convert it day one if somebody is just giving me $10?
On the first day if I could convert A 1,
and so there's usually,
when there's a beneficial conversion option there's a holding period,
and that's why in this problem there's
a five year holding period before it can be converted.
So what is a beneficial interest?
Again, the conversion price is less than fair value,
there's a beneficial interest.
So, I'm looking at convertible,
it's something that's convertible into 25,000 shares,
a $1,000,000 worth of debt divided by $40,
conversion price is 25,000 shares.
The fair value less
the conversion price is equal to the intrinsic value is equal to $10 per share.
So the beneficial interests will be 10 times 25,000 or 250,000.
So let's look at the journal entry to record that beneficial interest.
It's accounted for as discount and additional paid-in capital, capital stock.
So, I'm receiving $1,000,000 in cash recording that as debt.
I'm going to take the $250,000 beneficial interest,
the difference between the fair value of the stock and the conversion price,
I'm going to record that as a discount,
because I've really given away something at
that point even though I received $1,000,000 for that debt,
net I've really only gained $750,000 at the date of issuance.
Then, the other side of that discount will be additional paid-in capital.
The conversion feature for the equity will be accounted for as
discount on the issuance price and the credit goes to additional paid-in capital.
Let's look at one more situation when we're talking about conversion features.
What if the warrants are detachable?
What if, instead of it being an either or situation where I can
either convert the stock or collect on the debt, I can do both.
I could maybe have my cake and eat it too.
I can collect on the debt and I can detach the warrant and
exercise at warrant to buy shares at a conversion price.
These are two elements of the security that exist
independently and they are actually treated as separate securities.
Now in this case, this is more complicated than we're going to get into in this course.
But, in more advanced courses you'll see how
that type of derivative would have to be priced as a derivative and
you have to separate the proceeds between the debt and the
derivative which would then be accounted for fair value.
So that wraps up our discussion on conversion features,
we'll continue next with the discussion on early extinguishment of debt.
