Overview
Companies regularly borrow cash for assistance towards advancement and covering their bills. To spare the interest cost, the issuer can facilitate the obligation by providing an alternative to buy common stock at an expected reduction.
It encourages additional demand for the bonds, which would then be able to sell at a lower cost. It permits the holder to pick from accepting the ensured interest on bonds or convert to the organization’s offer to receive the dividend and exchange the shares in the capital market.
Definition
A convertible bond is a sort of bond that authorizes the holder to change over to share or common equity. Per the acknowledged bookkeeping guidelines given by the Financial Accounting Standards Board, convertible bonds are accounted as bonds in the U.S., disregarding the equity choice surrounding these tools.
Conversion can be possible whenever before the maturity date, along with relying upon the bondholder’s tact.
What are convertible bonds?
A convertible bond is a conventional one with an additional conversion alternative, which permits a shareholder to trade the bond for an established number of common stock shares. A convertible bond comprises both the components of a valuable instrument and a debt instrument.
The holder can either convert it to the organization’s share or acquire money at the time of maturity. This choice permits the organization to issue bonds at a decreased interest rate with no concession.
It is essential in accounting to perceive the two components in the financial report. The financial liability will at first be measured by utilizing limited income of interest installment and bonds’ supposed value.
Accordingly, the additional balance needs to be recorded, which emerges from the distinction between interest paid and interest cost.
The interest expense relies upon the successful interest rate while the interest paid to bondholders relies upon the coupon rate.
The conversion possibly bodes well when share costs rise sufficiently to make a profitable conversion. For instance, if a shareholder pays $1,000 for a bond, which converts to 10 shares of stock, the share cost must surpass $100 to create an appealing conversion.
The conversion alternative permits the enterprise to issue the one with a lesser yield, as conversion is an important element that grows the demand for a bond.
Why does the Company Issue Convertible Bonds?
There are several reasons why a company may choose to issue convertible bonds.
Here are some of the main reasons:
- Lower interest rates: A company may issue convertible bonds to take advantage of lower interest rates. Convertible bonds typically offer a lower interest rate than traditional bonds because they also offer the option to convert the bond into equity, which provides investors with the potential for greater returns.
- Attracting investors: A company can attract a wider range of investors seeking income and potential capital appreciation by offering convertible bonds. This can include investors interested in the company’s growth potential but also looking for a certain level of income.
- Raising capital: Companies may issue convertible bonds to raise capital without diluting the ownership of existing shareholders. Because convertible bonds can be converted into equity at a pre-determined price, the company can raise capital without issuing additional shares of common stock.
- Flexibility: Convertible bonds offer companies greater flexibility than traditional bonds. If the company’s stock price rises significantly, investors may choose to convert their bonds into equity, reducing the company’s debt load and improving its financial position.
- Timing: Companies may issue convertible bonds if they believe their stock price is undervalued and likely to rise. By offering convertible bonds, the company can benefit from the potential appreciation in its stock price while also providing investors with a fixed income stream.
Types of Convertible Bonds
- Mandatory convertibles
These convertible bonds need the holder to convert to a common share on its maturity date. The bondholders cannot get the money on its maturity date however should convert the bonds to shares.
The required bonds come under two rates; the first provides the shareholder with a share value equivalent to its bonds.
While the second one will restrict the worth that investors will get more than its par value. The organization’s strategy is to advance and sell the share equity at a higher cost.
- Vanilla Convertible bonds
This one is a well-known type. The organization awards the right to the shareholder to convert the bonds over to common shares based on the conversion rate determined ahead of time.
In addition, the bondholders will get revenue based on the coupon rate, which accompanies the fixed maturity date when bondholders may get the nominal rates.
- Reverse convertibles
Reverse convertible bonds permit the organization to reacquire the bonds or permit them to be converted over to shares at the time of their maturity.
The issuer may utilize the money to reacquire bonds otherwise; they will be transformed into equity shares based on the conversion rate, which is fixed.
Accounting for Convertible Bonds
Measurement:
Convertible bonds are measured at fair value at the time of issuance, and any associated fees or transaction costs are deducted from the bond issuance proceeds. Subsequently, the liability component of the convertible bond is measured at amortized cost using the effective interest method.
The equity component of the convertible bond is measured as the difference between the fair value of the bond and the fair value of a comparable debt instrument that does not have a conversion option.
Recognition:
A convertible bond’s liability and equity components are recognized separately in the financial statements. The liability component is recorded as a long-term liability on the balance sheet, while the equity component is recorded in the stockholders’ equity section of the balance sheet.
Disclosure:
The company must disclose the details of the convertible bond in the notes to the financial statements. This includes the terms of the bond, such as the conversion ratio and conversion price, as well as any associated fees or transaction costs.
Additionally, the company must disclose the impact of the convertible bond on its financial statements, such as the impact on earnings per share if the bond were to be converted into equity.
Journal Entry:
The journal entry to record the issuance of a convertible bond includes a debit to cash or other applicable asset accounts for the bond issuance proceeds. The liability component of the bond is then recorded as a credit to the bond liability account. Finally, the equity component of the bond is recorded as a credit to the equity account.
The effective interest method calculates the interest expense as the bond is amortized over its life. The journal entry to record the interest expense includes a debit to the bond liability account and a credit to the interest expense account.
If the bond is converted into equity, the liability component is removed from the balance sheet, and the equity component is reclassified as common stock or another applicable equity account. The journal entry to record the conversion includes:
- A debit to the bond liability account.
- A credit to the equity component of the bond.
- A credit to the common stock or another equity account.
Example:
Measurement:
On January 1, 2023, XYZ Company issued $10 million in convertible bonds with a coupon rate of 5% and a conversion ratio of 50 shares per $1,000 bond. The bond’s fair value is $9.5 million, with a fair value of $500,000 for the equity component.
Recognition:
The liability component of the bond is recorded as a long-term liability on the balance sheet for $10 million. In contrast, the equity component is recorded in the stockholders’ equity section of the balance sheet for $500,000.
Disclosure:
In the notes to the financial statements, XYZ Company discloses the terms of the convertible bond, including the conversion ratio and conversion price, as well as the impact of the bond on its financial statements, such as the impact on earnings per share if the bond were to be converted into equity.
Journal Entry:
To record the issuance of the convertible bond, the following journal entry is made:
Debit: Cash $10,000,000 Credit: Convertible Bond Liability $10,000,000 Credit: Additional Paid-In Capital $500,000
Over the bond’s life, the effective interest method calculates the interest expense. For example, if the bond has a term of 5 years, the annual interest expense would be $500,000 ($10 million x 5%), and the amortization of the liability component would be $1 million per year.
If the bond is converted into equity, the liability component is removed from the balance sheet, and the equity component is reclassified as common stock or another applicable equity account. For example, if the bond is converted on January 1, 2025, when the company’s stock price is $25 per share, the following journal entry is made:
Debit: Convertible Bond Liability $10,000,000 Credit: Convertible Bond Equity $500,000 Credit: Common Stock $9,500,000
In summary, accounting for convertible bonds requires careful measurement, recognition, disclosure, and journal entries to accurately represent the impact of the bonds on the company’s financial statements.
Convertible Bonds Advantages
Convertible bonds are a type of debt security that can be converted into shares of the issuing company’s common stock at a predetermined conversion price. These bonds offer several advantages to both issuers and investors, including:
- Lower Interest Rates: Convertible bonds typically offer lower interest rates than non-convertible bonds because they allow investors to benefit from an increase in the issuer’s stock price.
- Access to Capital: Convertible bonds give companies access to a broader pool of investors who may be more willing to invest in a company with the potential for capital appreciation through stock price increases.
- Flexibility: Convertible bonds offer greater flexibility to both issuers and investors. Issuers can tailor the conversion terms to suit their needs, while investors can choose to convert their bonds into stock or hold them to maturity.
- Reduced Dilution: Convertible bonds can help reduce dilution for existing shareholders because they offer a way for companies to raise capital without issuing additional shares of common stock.
- Potential for Capital Appreciation: Convertible bondholders can benefit from capital appreciation if the issuer’s stock price increases, allowing them to convert their bonds into shares at a lower price and sell them at a higher price.
- Attractive Yield: Convertible bonds can offer an attractive yield to investors as they typically pay a fixed interest rate and offer the potential for capital appreciation through conversion into equity.
In conclusion, convertible bonds offer several advantages to issuers and investors, including lower interest rates, access to capital, flexibility, reduced dilution, the potential for capital appreciation, and attractive yields. As a result, convertible bonds can be an attractive option for companies looking to raise capital and investors seeking a balance between fixed income and equity exposure.
Convertible Bonds Disadvantages
While convertible bonds offer several advantages, they also have some potential drawbacks that issuers and investors should consider before investing. These disadvantages include the following:
- Lower Interest Rates: Lower interest rates are an advantage for issuers but can be a disadvantage for investors seeking higher returns. Convertible bonds typically offer lower yields than non-convertible bonds with similar credit ratings and maturities.
- Dilution: If convertible bonds are converted into shares of common stock, it can dilute the ownership of existing shareholders. This dilution can hurt the company’s stock price and earnings per share.
- Complex Structure: Convertible bonds are more complex than traditional bonds, and their conversion terms can be difficult to understand. This complexity can make it challenging for investors to evaluate the potential risks and rewards of investing in these securities.
- Higher Issuance Costs: Convertible bonds may have higher issuance costs than traditional bonds because of the additional legal and administrative expenses of creating a convertible security.
- Interest Rate Risk: Like all fixed-income securities, convertible bonds are subject to interest rate risk. If interest rates rise, the value of these bonds may decline, resulting in capital losses for investors.
- Limited Upside Potential: While convertible bonds offer the potential for capital appreciation through conversion into equity, this potential is limited by the predetermined conversion price. Bondholders will not benefit from any capital appreciation if the stock price does not rise above the conversion price.
Convertible bonds offer several potential disadvantages to investors, including lower interest rates, dilution, complex structure, higher issuance costs, interest rate risk, and limited upside potential. Investors should carefully consider these factors before investing in convertible bonds.
Conclusion:
In short, convertible bonds are monetary instruments utilized by organizations to increase resources. Bondholders get them for their probable equity as well as return.
To create more appealing bonds for bondholders and to bring down the bond interest rate, the companies offer them the chance to get equity shares all at once based on their personal preferences throughout the lifetime of the bonds.
