Convertible Debt and Debt Issued with Stock Warrants
(Pronouncements affecting: APB Opinion Nos. 10, 12, 14)
Convertible Debt--Debt securities that can be converted into common stock of the issuer at a specified price at the option of the holder and which are sold at a price or have a value at issuance not significantly in excess of the face amount.

Terms generally include (1) an interest rate which is lower than the issuer could establish for nonconvertible debt, (2)  an initial conversion price that is greater than the market value of the common stock at time of issuance, and (3) a conversion price that does not decrease....

When an entity issues convertible debt, the normal expectation is that the bonds will not be repaid but rather will be extinguished by conversion into common stock of the company.  Convertible bonds generally have a callable feature, which allows the issuing company to call the bonds.  When the market price of the common stock is greater than the call price of the bonds, then a call on the bonds will lead to the holder converting into common stock instead of letting the bonds be called in.

Two views of how to treat convertible debt at issuance:

View 1.  Convertible debt possesses the characteristics of both debt and equity and the proceeds from the sale of the securities should be allocated to the debt and the equity features.

Example:

CyberCorp issues 100, $1,000, 6%  convertible bonds.  Each bond is convertible into 20 shares of CyberCorp common stock. The bonds are issued at 101.

If the bonds were not convertible, they would have been sold at 98.

As a convertible security, the bonds are sold for $101,000.
Without the conversion feature the bonds would have been sold for $98,000.

From the above data, the conversion feature of the bonds appears to have a value of $3,000 ($101,000-$ 98,000).  The bonds, without the conversion feature, would sell at a discount of $ 2,000. (par, $100,000, less amount that would have been received for the bonds without the conversion feature, $98,000)

Journal entry to record the sale of bonds, if an allocation is to be made to the conversion feature:


 
Cash $101,000  
Discount on bonds payable         2,000   
        Bonds payable    $100,000
        Contributed capital--Conversion feature of debt            3,000

 


Arguments for allocation of a portion of the proceeds between the debt and equity features:
  • Conversion feature has economic value separate from the debt
  • Measurement of interest expense should be based on the debt characteristics only
  • Amounts paid for the right to become a common stockholder at some future time should be treated similarly to  the sale of an option or warrant for the purchase of common stock in the future.
  • Valuation of the debt portion should reflect the market yield for similar debt at the time of issuing the debt securities.


View 2.  Convertible debt should be treated solely as debt with no allocation of the proceeds to an conversion feature.
Using the data from the example above, the journal entry to record the sale of bonds, if no allocation is to be made to the conversion feature:

 
Cash $101,000  
        Bonds payable    $100,000
        Premium on bonds payable             1,000


Arguments for Treating the Proceeds only as Debt:
  • Debt and conversion privilege are inseparable
  • Difficult to measure the conversion privilege--determinations are subjective


APB Opinion No. 10 required that the proceeds be allocated between the debt and conversion privilege.

APB Opinion No. 12 reported that practitioners were having difficulty implementing the requirements of APB Opinion No. 10. Indicated that there would be a comprehensive study conducted on the matter.

APB Opinion No. 14 concluded that all proceeds from the issuance of convertible debt be treated as debt only; no allocation was to be made to the conversion feature. Conclusion based primarily on inseparability of the debt and the conversion feature.
 

Bonds issued with stock purchase warrants--Stock purchase warrants are often issued with Bonds as a "sweeter;" that is, as an enhancement that makes the bond issue a more attractive investment for the purchaser.  The interest rate on the bonds is often lower as a result of the inclusion of the warrants.

When bonds with detachable stock warrants are issued, the purchaser is essentially purchasing two investments--the bonds, which represent a liability to the issuer, and the warrants, which represent an equity component.

APB Opinion No. 10 (1966) required that the proceeds from the sale of a bond issue with detachable stock purchase warrants be allocated between the debt (bonds) and the equity (warrants) feature.

APB Opinion No 14 (1969) re-affirmed the position taken in Opinion No. 10.  The Board's position was based on the separability of the warrants from the bond.

The allocation of the proceeds should be based on the relative market values of the bonds and the warrants.  Since there are two separate financial instruments (bonds and warrants), market values should exist for each. 

However, if a market value cannot be determined for one of the securities, the residual approach may be used.  The market value of one of one of he securities is deducted from the total proceeds to determine the value to be assigned to the other security.

Example

  • Dutch Corp issues 100, $1,000, 6%  bonds with detachable stock warrants to buy 10 shares of $20 par value capital stock at $60 per share.  Each unit of bond plus warrants is sold for $1,040.
  • After the bonds were issued, the bonds were trading at $990 and the warrants were trading at  $6.
Allocation for one bond and warrants:


  Market value Percentage Proceeds Allocated-Per Unit
Bonds $ 990 94% $1,040 $ 977.60
Warrants(10) 60 6% $1,040 $62.40
  Total $1,050 100%   $1,040

Journal entry to issue bonds and warrants:


Cash $104,000  
Discount on Bonds Payable 2,240  
                 Bonds Payable   $10,000
                 Stock Warrants Outstanding   6,240

Return to topical outline