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Table of Contents
NATURE OF CONVERTIBLE BONDS 1
FINANCIAL ADVANTAGES AND DISADVANTAGES 2
3.1 ADVANTAGES 2
3.2 DISADVANTAGES 2
ACCOUNTING TREATMENT 3
LOGIC OF THE ACCOUNTING REQUIREMENTS 5
5 6 7
This report provides information about convertible bonds for the managers of Hamilton Manufacturing. Included is information about the nature of convertible bonds, financial advantages and disadvantages Hamilton could expect from issuing such bonds, and their accounting treatment.
A convertible bond is a debt security that carries the option of exchange for an equity security, usually common stock. The bond indenture specifies when the bonds may be converted and a conversion price or ratio. The conversion price is usually from 10 to 20 percent above the market price of the common stock at the time of issue. Both the issuer and the investor expect the market price of the stock to rise above the conversion price; therefore, bondholders are likely to convert the bond into equity.
Convertible bonds would offer Hamilton three advantages:
▪ The company could issue the bonds at a premium or at a low stated interest rate, which investors would accept because of the conversion privilege.
▪ The company could avoid another stock issue now, when the price of Hamilton’s stock is low.
▪ Management would avoid possible conflict with its major stockholder.
Management should also consider the potential disadvantages of issuing bonds:
▪ The uncertain conditions of the economy make a future increase in the market price of the company’s stock uncertain. If conversion does not occur, Hamilton may have difficulty meeting the debt requirements.
▪ Bond conversion will reduce earnings per share and operating leverage. Conversion will also increase Hamilton’s income tax liability because of the loss of interest expense.
▪ The required accounting treatment of convertible bonds, which is determined by Accounting Principles Board Opinions 14 and 15, may create an unfavourable effect on the company’s financial statements: a high level of debt may be presented alongside a lowered earnings per share.
While there are disadvantages to the issuing of bonds, they can be overcome by implementing strategies. Similarly, the expected increase in tax liability and decrease in earnings per share will be offset by the high conversion price. Therefore, it is recommended that Hamilton be proactive in considering the issuing of bonds.
FINANCIAL AND ACCOUNTING CONSIDERATIONS
The purpose of this report is to provide information for the management of Hamilton Manufacturing about an increasingly popular form of financing: convertible debt. Convertible debt is an issue of debt securities (bonds) that carry the option of exchange for equity securities (usually common stock). The primary focus of the report is the accounting requirements for convertible debt and the reasons for the requirements. Four major topics make up the report: the nature of convertible bonds, the financial advantages and disadvantages Hamilton could expect if it issues the bonds, the accounting treatment, and the logic of the accounting requirements.
2. Nature of Convertible Bonds
When convertible bonds are issued, the bond indenture specifies a period of time after issuance during which the bonds may be converted. The indenture also specifies a conversion price, “the amount of par value of principle amount of the bonds exchangeable for one share of stock” (Bogen 1968, p. 31). If a conversion ratio, rather than a conversion price, is specified, the effective price of stock to the bondholder may be determined by dividing the par value of the bond by the number of shares exchangeable for one bond.
The conversion price, which is determined when the bonds are 30%, is usually from 10 to 20 percent above the prevailing market price of the common stock at the time of issue. Both the issuing form and the investor expect that the market price of the stock will rise above the conversion price, and that the conversion privilege will then be exercised by most or all bondholders.
The indenture typically includes a call provision so that the issuing firm can force bondholders to convert. Therefore, it is evident that firms issuing convertible debt
often truly want to raise equity capital. The reasons that they choose convertible debt are discussed below.
3. Financial Advantages and Disadvantages
The use of convertible debt would offer Hamilton advantages over straight debt or stock issues. Bonds that are convertible into stock are in demand. Therefore, bond buyers are willing to accept a low stated interest rate on such bonds, to pay a premium and accept a lower yield, or to accept less restrictive covenants. Hamilton could thus obtain funds at a lower cost than would be possible if it issued bonds without the conversion privilege.
The advantages of a convertible bond issue over a common stock issue relate to timing. While Hamilton might be willing to take on more equity in the future, current economic conditions make this an unfavourable time to sell stock. One authority has explained this advantage as follows:
To sell stock now would require giving up more shares to raise a given amount of money than management thinks is necessary. However, setting the conversion price 10 to 20 percent above the recent market price of the stock will require giving up to 10 to 20 percent fewer shares when the bonds are converted than would be required if stock were sold directly (Brigham, 1978, p. 532).
Another possible advantage to Hamilton of issuing bonds is that the company could avoid creating a possible conflict with the major stockholder, who would likely want to maintain his controlling interest. The stockholder might vote against a large issue of stock. However, the bond issue could be convertible into a number of shares small enough not to injure significantly the stockholder’s interest.
Most of the disadvantages of convertible bonds are related to the uncertainty of the
conversion and its timing. If Hamilton’s stock price does not rise, conversion will not
occur, and the company will not obtain the equity financing it desired. Hamilton might then have difficulty meeting the unplanned-for-obligations of debt.
Other disadvantages arise, however, if the conversion does not occur. When the debt becomes equity earnings per share is reduced, operating leverage if reduced, and income taxes rise because interest expense is reduced.
4. Accounting Treatment
The Accounting Principles Board (APB) (1969a, p. 1) ruled that convertible bonds “which are sold at a price or have a value at issuance not significantly in excess of the face amount” must be treated in the same manner as other bonds. That is, “no portion of the proceeds from the issuance … should be accounted for as attributable to the conversion feature” (APB, 1969a, p. 10). The expectation that some or all of the bonds will be converted into stock is not recognised in the accounts.
Since convertible bonds are normally sold at the premium, the amount of the cash proceeds from the issue is greater than the face value of the bonds. The difference between the debit to Cash and the credit to Bonds Payable is credited to a Premium on Bonds account.
The premium is amortised, using the effective interest method, over the life of the bonds. The effect of the amortisation is that the interest expense recorded by Hamilton each period would not equal the amount of the interest payment, but would reflect the effective yield to the bondholders.
When the bonds are converted, Hamilton will remove from the accounts the balances associated with those bonds: Bonds Payable will be debited for the par value of the bonds converted, and the premium account will be debited for the portion of the unamortized premium which is attributable to the bonds converted. Two methods can
be used to record the common stock issued in exchange for the bonds. If this value
differs from the book value of the bonds (the balances associated with the bonds, mentioned above), then a gain or a loss is recorded. Under the other methods, which
are more widely used, the value assigned to the stock equals the book value of the bonds, and no gain or loss is recognised or recorded (Kieso and Weygandt, 1989).
If Hamilton decides to retire its convertible bonds for cash before their maturity date, the transaction will be recorded in the same way as the early retirement of any other debt. The difference between the book value of the bonds and the cash paid to retire them will be a gain or a loss. If the gain or loss is material, it will be shown as an extraordinary item on the income statement.
While the convertibles are accounted for solely as debt, Hamilton must also consider the equity characteristics of such issues in computing earning per share (EPS). APB Opinion No. 15 (APB, 1969b) requires that corporations which have issued securities that are potentially dilutive of EPS must present, in their financial statements, two EPS figures. If a convertible security meets the requirements of certain tests, as outlined in Financial Accounting Standard No.55 (Financial Accounting Standards Board, 1982), it is considered a common stock equivalent and enters the calculation of primary EPS; otherwise, it enters only the calculation of fully diluted EFS (Kieso and Weygandt, 1989).
Both EPS figures represent FPS as if the bonds had been converted into stock. If they had been converted, the removal of the bonds would have raised a reduction of interest expense, which would have increased earnings; therefore, Hamilton would have to revise the number of shares upward (Kieso and Weygandt, 1986). However, the positive effect of the earnings adjustment may not offset the negative effect of the shares adjustment. The result is that convertibles reduce reported EPS.
5. Logic of the Accounting Requirements
In requiring that convertible debt be accounted for solely as debt, the APB (1969a) reasoned that the debt and the conversion feature are inseparable. That is, at any given
time, a security is either all debt or all equity. Therefore, since at the time of issuance the security is all debt, its issuance should be recorded as debt.
The Board argued further that practical problems exist in the attempt to value the debt and conversion features separately. The conversion feature is difficult to value because of the uncertainty of the timing of conversion, and because of the uncertain future market value of stock. The debt part of the security is difficult to value independently of the conversion option, because the conversion option affects the terms of the bond. An attempt to value the bonds as if they were not convertible would require the assumption of higher terms – an unrealistic assumption, because the issuing firm would not have wanted to issue bonds with those terms (APB, 1969a).
The accounting requirements concerning presentation of EPS are intended to meet investors’ reporting needs. In Opinion No. 15, the APB explains that the value of a convertible security “is derived in large part from the value of the common stock to which it is related.” and that the holder of such a security is essentially a participator in “the earnings and earnings potential of the issuing corporation” (APB, 1969b, p. 25). Therefore, the determination of EPS based only on understanding shares of common stock “would place form over substance” (APB 1969b, p. 261), and would mislead the investor.
This report has presented Hamilton Manufacturing with information about convertible bonds. The issuing of bonds now will appeal to investors because the alternative, Hamilton stock, is currently at a low price. Despite this, there are disadvantages
surrounding the conversion of bonds to stock. If conversion does not occur, Hamilton
may struggle to meet debt requirements; equally, if conversion does occur, it can reduce earnings per share and increase Hamilton’s tax liability. However, the high conversion price will offset these increases. Accordingly, the following recommendations are made.
While there are disadvantages to the issuing of bonds, they can be overcome by implementing strategies. Similarly, the expected increase in tax liability and decrease in earnings per share will be offset by the high conversion price. Therefore, it is recommended that Hamilton be proactive in considering the issuing of bonds. Specifically, it is recommended that:
7.1 Management should take advantage of issuing convertible bonds at the present premium, or at a low stated interest rate;
7.2 Due to the possibility that conversion of bonds may not occur as expected, management is advised to have in place an alternative strategy for meeting debt requirements;
7.3 Because the required accounting treatment of convertible bonds may present an unfavourable picture of high debt and low earnings per share in financial statements, management should ensure that investors are fully informed.
Accounting Principles Board (APB) (1969a) Accounts for Convertible Debt and Debt Issued with Stock Purchase Warrants, Opinion No. 14.
Accounting Principles Board (APB), (1969b) Earnings per Share, Opinion No. 15.
Bogen, J.I. (1968) Financial Handbook, 4th Edn, Ronald Press, New York.
Booker, J.A. and Jarnagin, B.D. (1979) Financial Accounting Standards: Explanation and Analysis, Commerce Clearing House, Chicago.
Brigham, E.F. (1978) Fundamentals of Financial Management, Dryden Press, Hinsdale.
Financial Accounting Standards Board, (1982) Determining Whether a Convertible Security is a Common Stock Equivalent, Statement of Financial Accounting Standards, No. 55, Stamford, Connecticut.
Kieso, D.E. and Weygandt, J.J. (1989) Intermediate Accounting, 6th Edn, Wiley, New York.
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