Convertible debt comes with a conversion feature for investors to buy stocks of the issuer. The investors can enjoy the benefits of fixed-income instruments and later can subscribe to shares of the issuing company.
Issuers can attract investors by attaching the stock warrants to the convertible debt as well. The feature further acts as a beneficial conversion feature for investors.
Let us discuss how convertible debt with stock warrants work.
Convertible Debt – Definition
Convertible debt is issued in the form of securities that can be converted to common stock at a specified date and price.
Common examples of convertible debt are bonds and preferred shares. Companies issue these instruments to attract investors primarily. Investors can redeem their initial investment in cash at maturity.
The conversion feature provides investors an additional option of purchasing common stocks of the issuer (or a subsidiary company of the issuer). This helps issuers of convertible debt to raise capital easily.
Another common reason to issue convertible debt is to lower the cost of capital. These debt instruments offer flexible options to investors as well. Investors can receive coupon payments (in case of a bond) and convert the investment into common stocks later as well.
Convertible Debt with Stock Warrants
A special type of convertible debt comes with stock warrants. These debt instruments offer dual benefits to investors.
These instruments are convertible. It means the debt (bonds or preferred shares) can be later converted into common stocks. The issuer may embed the conversion for its own stocks or another company of the same group.
These instruments come with stock warrants. It means the investors have an additional option to convert warrants into stocks with specified terms. The issuer would specify the conversion period and prices accordingly.
Convertible debt that comes with stock warrants is a special type of beneficial debt plan for issuers. Both embedded features in the debt instrument act as a “sweetener” for investors. These features help issuers attract more investment and lower the total cost of borrowings.
Accounting for Convertible Debt with Stock Warrants
ASC 470-20 guides on the accounting treatment for convertible debt with detachable warrants. It states that the issuer should first allocate the fair value to both instruments.
Once the issuer determines the proceeds for the fair value of the debt and the detachable warrants, it can then adjust to evaluate the intrinsic values later.
Let us consider a simple example to understand the accounting treatment as below:
Suppose ABC Company issues $ 1 million of convertible debt (bonds). The debt also comes with 100,000 stock warrants.
ABC company’s stock at par is $ 10 and a current price of $ 50. On issuance day, the common stock of ABC is trading at $ 46.
Suppose the bond is trading at 85 nominal and warrants at $ 2.
Under ASC 470-20 guidance, ABC company will apportion the $ 1 million proceeds into debt and equity as below:
1.Debt Proportion= $850,000/ ($850,000 + $200,000) × $1,000,000 = $809,524
2. Warrants= $200,000/ ($850,000 + $200,000) × $1,000,000 = $190,476
The second step is to evaluate the intrinsic value of the conversion feature for ABC company. It can be calculated as:
1. $1,000,000/$50 per share = 20,000 shares to be issued upon conversion
2. The effective conversion price is the bond’s allocated proceeds of $809,524
divided by 20,000 shares or $40.48
3. ($46 current fair value of the stock – $40.48 effective conversion price) ×
20,000 shares = $110,476, which is the implied discount granted on the
bonds in connection with the conversion feature.
Thus, ABC company can record the following journal entries:
| Account | Debit | Credit |
| Cash | $1,000,000 | |
| Debt Payable | $809,524 | |
| Stock Warrants – Paid-in capital | $190,476 | |
| Discount on Debt (Bonds) | $110,476 | |
| Additional Paid-in Capital | $110,476 |
Convertible debt with or without stock warrants can come with several scenarios.
Beneficial Conversion
Issuers of convertible debt often attach further beneficial conversion features. For instance, an issuer may offer a discount on convertible debt to be converted at or before a specific date.
The issuer may offer a single percentage discount or multiple discounts for several conversion periods. The issuer will also specify terms such as conversion price and relevant discount on the conversion date.
ASC 470-20 guides on the accounting treatment of convertible debt with a beneficial conversion feature. The embedded additional beneficial feature with convertible debt is accounted for separately from the debt instrument.
The value of the additional conversion benefit is computed as the intrinsic value of the conversion. The method is given below.
- Calculate the difference between the fair value and the conversion price of the common stock (into which the investor can convert the bond).
- Multiply it by the number of common stocks that are received as a result of the conversion.
An issuer can offer multiple discounts or conversion features to investors as well. In such cases, the company would record the higher amount that is more beneficial to the investors.
For example, if an issuer of convertible bond offers a 10% discount on its conversion feature for a conversion period of one year and a 25% discount for the same for a conversion period after two years, the company will use the 25% value for the computation of fair value of the conversion feature.
Contingent Conversion
In some cases, a convertible debt may be converted upon the fulfillment of certain conditions or events that are outside the control of investors. Thus, convertible debt is classified as the debt with a contingent conversion feature.
The issuer would measure the value of the contingent conversion on the commitment date. However, the issuer will not record the value unless the contingent conversion takes place. In other words, until the conditions or events take place that makes the conversion contingent.
ASC 470-20 states that convertible debt with contingent conversion feature can be accounted for as an additional beneficial conversion feature as well. However, the issuer would recognize the conversion at commitment and record when the contingent event takes place.
Debt convertible into Stock of a Subsidiary
A special case of convertible debt with stock warrants is when the issuer attaches stocks of one of its subsidiary companies. That is, the investors have the option to convert the debt as well as use the warrants to buy stocks of another company.
ASC 470-2-25 provides guidelines on the accounting treatment for the consolidated financial statements of the issuer company. The guidance states that no portion of the conversion proceeds should be recorded as attributable to the conversion feature.
Other Conditions with Convertible Debt
There are other important considerations with the convertible debt instruments.
An issuer may not be able to calculate the number of shares with a contingent conversion feature. The issuer would not record the conversion value immediately in that case.
ASC 470-20-35-1 guides that the issuer would wait until the contingent conversion condition is met. Then, the issuer would compute the number of received shares as if there was no contingent conversion. The difference between both values is the additional shares received.
The excess shares multiplied by the common stock price on the contingent conversion date is the value that should be recorded.
Some important points include:
- If a convertible debt instrument is redeemed before the maturity date and it had no intrinsic value at the issuance date, no portion of the reacquisition price should be allocated to the conversion option.
- If a company issued a convertible debt instrument with stock warrants attached, the date for the recording of intrinsic value of the conversion feature will be the commitment date of warrants and not the exercise date.
- The deemed proceeds for determining whether a beneficial conversion option exists are equal to the sum of the proceeds received for the warrant and the exercise price of the warrant.
- A conversion feature may allow the investors to receive both common stocks and warrants to acquire common stocks. It means from both the conversion feature as well as stock warrants attached. In that case, the intrinsic value of the conversion can be measured as the difference between:
- The proceeds proportioned to the common stock of the conversion feature, and
- The fair value of the commitment date of the common stock that the investor would receive upon conversion.
Derecognition of Convertible Debt
ASC 470-50 provides guidelines on the accounting treatment for the derecognition of the convertible debt.
The proceeds can be received fully or partially in cash. The proceeds should first be allocated to the extinguishment of the liability component of the fair value of the liability component.
Difference between the amount allocated to the liability component and the sum of:
- the net carrying amount of the liability component, and
- any unamortized debt issuance costs
These should be recorded as a gain or loss on the financial statement.
