How to Report Convertible Debt
A company issues convertible debt, such as bonds, because it is cheaper than straight debt. The owner of convertible debt can turn it into equity, or shares of stock, in the company. The company reports convertible debt as a long-term liability on its balance sheet, with footnotes explaining the conversion features. Interest expense is reported on the income statement with an accompanying footnote explaining the effect of the conversion feature on the interest rate. The conversion feature will induce investors to accept a lower interest rate.
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Instructions
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Account for the convertible debt in the long-term liability section of the general ledger. This convertible debt account will be credited and the cash account will be debited for the amount of the convertible debt (bond principal amount) when the debt is incurred. For example, ABC Company sells $1 million of convertible bonds at 6 percent interest. Cash is debited for $1 million and the convertible bonds liability account is credited for $1 million.
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Account for the interest expense of the convertible debt in the expense section of the general ledger and the interest payable in the short-term liability section of the balance sheet. A debit is made each month to interest expense for $60,000 and a credit is made to interest payable each month for $60,000 to accrue the interest payable. When the interest payment is made a debit to interest payable is made for $60,000 and a credit to cash is made for $60,000.
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Debit the convertible debt liability account as investors exchange the bonds for shares of stock in the company. Credit the stockholders equity account and stockholders equity in excess of par account for the applicable amount of convertible debt converted into equity. For example, if half the bonds are converted to stock at $10 per share and the stock has a par value of $1 per share debit the convertible debt liability account for $500,000 and credit the stockholder equity account for $50,000 and the stockholder equity in excess of par account $450,000.
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Close the books and produce financial statements for the reporting period. Set up balance sheet and income statement footnotes explaining the conversion features of the convertible debt as part of the financial statements. Interested parties should be able to understand from the footnote the covenants and conversion features of the convertible debt, as well as the resulting interest rate exposure and potential dilution of current stock holders.
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References
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