Definition
Accounting for Convertible Bonds refers to the process of documenting and recognizing convertible bonds in a company’s financial records. These are bonds that can be exchanged for a certain number of the company’s stock shares, as per the investor’s discretion. In the balance sheet, they are listed as a long-term liability until they are either paid off or converted into equity.
Key Takeaways
- Convertible Bonds are a type of corporate bond that can be converted into a predetermined amount of the company’s shares at certain times during its life. They offer investors the ability to change their investments from fixed income to equity.
- From the accounting perspective, Convertible Bonds are initially recorded as debt at the time of issuance. Over time, interest is accrued and added to the liability portion of the bond because companies generally agree to make periodic interest payments to the bondholders.
- When a Convertible Bond is converted into shares, the company removes the liability for the bond from its books and records it as equity. Any difference between the book value of the bond and the fair value of the shares is recorded in Paid-In Capital in Excess of Par.
Importance
Accounting for Convertible Bonds is a crucial aspect of financial management as these bonds are debt securities that can be converted into a predetermined amount of the company’s equity at certain times during their life, usually at the discretion of the bondholder.
This accounting practice is important as it provides both investors and the company with a clear understanding of the company’s financial obligations and equity potential.
By accounting for convertible bonds, companies can accurately represent their financial position, as these securities are both a debt and potential equity.
This process also impacts earnings per share calculations, which are a primary indicator of a company’s profitability.
Therefore, proper accounting for convertible bonds is essential for maintaining transparency and enhancing decision-making processes for companies and investors alike.
Explanation
Accounting for Convertible Bonds is a finance term that refers to the method by which businesses record and report the financial implications of issuing and potentially converting these securities. The main purpose of this accounting practice is to maintain accurate and up-to-date records of a company’s liability and equity positions. Convertible bonds are hybrid securities that act as bonds initially, but may be converted into shares of the issuing company’s common stock according to predetermined terms.
They are advantageous to companies seeking to raise capital, as they often carry a lower interest rate than regular bonds due to their convertibility feature. When considering their use, convertible bonds are an attractive option for investors who want the potential upside of a company’s share price appreciation while enjoying the relative safety of a bond. As for the issuing company, the conversion feature means the obligation can be cleared not with cash, rather with common stock, and the lower interest allows a cheaper way of financing.
However, if conversion takes place, it leads to dilution of the existing shareholders’ equity. For accounting purposes, any gain or loss from the bond’s conversion is refrained from being recognized immediately. Instead, the book value method is used, and the bonds converted are simply replaced with the stock issued, ensuring a smooth transition in the company’s financials.
Examples of Accounting for Convertible Bonds
**Tesla Inc.**In 2014, Tesla Inc issued convertible bonds worth $2 billion, due in 2019 and 2021 to fund its projects like Gigafactory and production of ModelThese bonds could be converted into shares of Tesla stock, giving bondholders an opportunity to benefit from any significant rise in Tesla’s share prices while also providing Tesla with lower interest rates than traditional bonds. However, on the accounting side, Tesla had to take into consideration the potential effect of these convertible bonds on its balance sheet and profit and loss account.
**Salesforce.com, Inc.**In 2013, Salesforce issued a $15 billion convertible bond due in
This financial strategy gave Salesforce an opportunity to raise funds at a relatively low cost. Convertible bonds, like this one, represented potential equity dilution, and Salesforce had to account for this in their financial statements, separating the value of the conversion feature from the debt itself.**Twitter Inc.**In 2014, Twitter issued $
8 billion of convertible bonds due 2019 and 2021, a major part of their financing strategy. This move offered investors a compromise between the safety of a bond and the potential for high returns if Twitter’s shares surged. However, when it came to accounting, Twitter had to address how the convertibility feature of these bonds could impact earnings per share.
FAQ: Accounting for Convertible Bonds
What Are Convertible Bonds?
Convertible bonds are a type of bond that the holder can convert into a specified number of shares in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt and equity-like features.
How are Convertible Bonds Accounted for?
For accounting purposes, convertible bonds are divided into the liability component (bond itself) and the equity component (conversion option). This is done to show the bond’s debt and equity portions separately in the financial statement.
What are the Benefits of Convertible Bonds from an Investor’s Perspective?
From an investor’s perspective, convertible bonds offer the potential for capital appreciation if the company’s stock price increases, and they provide a specific degree of downside protection, as they are bonds.
What are the Benefits of Convertible Bonds from a Company’s Perspective?
From the company’s perspective, convertible bonds enable it to issue debt at a lower interest rate. Companies may also prefer convertible bonds as a way to delay equity issuance, which may prevent dilution of existing shareholders.
How is the Conversion Premium Calculated?
The conversion premium refers to the amount by which the price of the convertible security exceeds the current market value of the common stock into which it may be converted. It is calculated as the difference between the total market value of the convertible bond and the conversion value.
How Does Accounting for Convertible Bonds Affect Balance Sheets?
The accounting treatment of convertible bonds affects balance sheets by showing the convertible debt in two parts: the liability component and the equity component. This shows the bond’s debt and equity aspects and how they influence the company’s financial situation.
Related Entrepreneurship Terms
- Par value
- Conversion rate
- Equity method of accounting
- Amortization of bond premiums
- Bond indenture
Sources for More Information
Sure. Here are some sources:
- Investopedia: It is a comprehensive online resource for finance-related topics, including accounting for convertible bonds.
- AccountingTools: It’s an educational platform that provides detailed, yet simple, explanations about various accounting topics, including accounting for convertible bonds.
- Corporate Finance Institute (CFI): An authoritative source for financial education. It offers many courses and guides related to finance, including topics on convertible bonds.
- The Balance: This finance-centric platform covers a wide range of topics, including accounting for convertible bonds. It offers multiple articles which explain the concept in detail.
