Accounting for Convertible Debt
In the previous article, we have established the fact that convertible debt is advantageous to some types of companies. We also know that this financial instrument can be quite complex. It is a known fact that investors who are not well versed in investing in bonds have a hard time understanding the functioning of convertible debt.
However, what is even harder is accounting for convertible debt. In this article, we will understand some major issues which are related to accounting for convertible debt as well as the common complications which arise during the process.
Why is Accounting for Convertible Debt Complex?
Convertible debt is unique in the sense that it has the features of both debts as well as equity. Now, the problem is that debt and equity are accounted for in very different ways in the balance sheet of a company. Hence, it is very difficult to show the accounting impact of convertible debt within a single transaction.
The net financial effect of issuing a convertible debt is the same as the impact of issuing regular debt as well as equity warrants at the same time. This is the reason that in most parts of the world, the convertible debt transaction is split into two parts and accounted for separately.
The Accounting Process
The accounting process which needs to be followed for convertible debt is different as compared to either equity or bond. The differences are pervasive and are present at every stage of the lifecycle of the bond i.e. bond issuance, coupon payments as well as redemption.
Accounting During Bond Issuance:
As mentioned above, the issuance of convertible bonds is considered to be two separate events for accounting purposes. Hence, it has two effects on the balance sheet. One effect is recorded on the liability side whereas the other request is recorded on the asset side of the balance sheet.
The dilemma is about the process which needs to be used to derive the value of this debt and equity component. Incorrect valuation could lead to incorrect reporting on the balance sheet which could have catastrophic consequences.
The value of the debt component is estimated based on the present value of the cash flow that the company would have to pay in the future. This means that the company has to quantify the number of funds that would have to be paid in interest as well as principal payments.
The assumption here would be that the bonds are regular bonds with no provision for conversion. These cash flows would have to be discounted at the cost of capital of the company. The value so derived will be listed on the debt column on the balance sheet.
Just like the bond portion, the equity portion of the issue also has to be estimated. This is done by subtracting the present value of the debt which was calculated above from the actual financial proceeds which were received from investors. The assumption is that the difference between the proceeds and the present value is equivalent to the equity component of the convertible bond issue.
Accounting During Coupon Payments:
Accounting for coupon payments can become quite confusing in the case of convertible debt. This is because the actual cash outflow which happens in the case of convertible debt is far lower as compared to the actual market rate. However, the company is actually going to pay the market rate at the end.
Hence, during the years when the company is paying a coupon rate, the amount charged to the profit and loss account is the actual market interest rate. This market interest rate is calculated using the market value of the debt and then multiplying it by the market interest rate. The actual interest paid is then subtracted from this value.
The interest paid depends upon the face value of the bonds issues as well as the coupon rate. The difference between the two values is considered to be the interest that has accrued to the company but has not been paid.
Hence, it is assumed that this interest will be paid at a later date. It is for this reason that the balance is actually posted on the balance sheet in the form of liability. It needs to be noted that the liability keeps on increasing through the years as the company makes coupon payments.
The idea behind adding some amount each year to the liability is to create a fund for the settlement of these bonds. As a result of this accounting practice, companies will have funds equal to the equity component of the convertible bonds ready to make payments in order to repay the investors if they decide not to accept equity in lieu of shares.
The reality is that accounting for convertible bonds can be quite complex. The accounting effects take place at different parts of the balance sheet and income statement. Hence, they can completely obscure the judgment of an untrained investor. It is for this reason that it is important for investors to educate themselves about the accounting effects of convertible debt. This will allow them to have a better understanding of the instrument which in turn will help them to arrive at a fair valuation.
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