Basics of accounting for convertible bonds

A conversion feature can add a lot of value for potential bondholders because the investor could take advantage of future company growth. In this article, well discuss the basics of recording an issuance of convertible bonds and transferring the bond liability to equity accounts when the bonds are converted.

1. Bond issuance

Under US GAAP, a convertible bond can be surrendered for a specific number of shares of common stock, usually at the option of the bondholder. The value of a conversion feature is not recorded separately when such bonds are issued, which means the journal entry for the issuance is the same as the entry for a standard bond, including any discount or premium.

Note that under international accounting standards (IFRS), the fair value of the conversion feature is recorded separately from the bond liability.

2. Bond conversion

There are two methods for recording the conversion from liability to equity. The first is the book value method, which results in no gain or loss. The full carrying amount of the bond is split up between common stock and additional paid-in capital. As a quick example, lets say that 100 bonds with a carrying value of $120,000 are exchanged for 1,000 shares of $1 par value stock. In the journal entry, the bond liability and premium would be removed. Common stock would be credited for the par value of the stock ($1,000), and additional paid-in capital would be credited for the remainder ($119,000).

The second method is the market value method, and its a bit more complicated because it can result in a gain or loss on conversion. Under this method, additional paid-in capital is credited for the difference between the fair value and the par value of the stock. A gain or loss is used to balance the journal entry. In the above example, if the shares currently traded for $150 per share, the fair market value of the 1,000 shares issued would be $150,000, resulting in a loss of $30,000 on conversion (the difference between the fair value of $150,000 and the bond carrying amount of $120,000).

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