Question

Some financial instruments such as convertible bonds, preferred stocks, warrants, and options can have both debt and equity features. They can be converted into common stock, or into preferred stocks by investors. Please discuss whether these securities should be reported as: a. Issuers should account for an instrument with both liability and equity characteristics entirely as a liability, or entirely as an equity instrument, depending on which characteristic governs: or, b. Issuers should account for an instrument as consisting of a liability component and an equity component that should be accounted for separately. Which of the two options do you favor and why? Develop and explain your argument. In considering this question, you should disregard the current position of the FASB on the issue. Instead, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by US GAAP and IFRS. Also, focus your deliberations on convertible bonds as the instrument with both liability and equity characteristics.

Answer 1

Let us suppose there is a convertible bond which has got both the Liability and Equity instrument.

In this case, we should choose Option b, i.e. Issuers should account for an instrument as consisting of liability component and an equity component that should be accounted for separately.

This can be explained with the help of the following example

A 10 years, 8% convertible bond is issued for $200 having yield of 12% which is convertible into equity after 10 years

Particulars	$ Mn	$ Mn
Proceeds from issue of bond		200.00
Present Value of bond at the end of 10 years @ 12%	64.39
Present Value of interest (16 mn paid annually) @ 12%	90.40
Total Financial Liability component		154.80
Residual Equity Component		45.20

Journal entry on issue shall be
Particulars	Dr/Cr.	Dr ($)	Cr ($)
Bank A/c	Dr	200.00
To 8% Convertible Coupon Bond	Cr		154.80
To Equity	Cr		45.20
(Being financial liability and equity component of bond recorded as per IFRS 32)