KALEVOR: Accounting treatment of Convertible Debt and Bonds with detachable stock warrants – a conceptual evaluation

                                           Source of image: Investopedia.com

Behavior of the Price of the conversion option of a Convertible Bond

When I was at Simon, my Corporate finance professor, Cliff Smith had a fascinating way of using humor to engage us in an otherwise technical, often boring subject. During one of his classes on capital structure, he once joked that “on Wall Street, when debt is not straight, we don’t call it gay - we call it convertible.” I was like, what? I couldn’t stop laughing but neither could I stop paying attention. With that said, let’s get a little technical.

The accounting treatment for convertible debt has always attracted a great deal of controversy. The bearer of a convertible bond has the option to convert the bond to equity within some specified time after issuance. The hybrid nature of convertible debt affords the investor the security of holding a bond (guaranteed interest income plus principal at maturity) as well as the flexibility of the added option of conversion if the value of the issuer’s stock appreciates considerably. For the issuer it offers two main advantages – to raise quasi-equity (or mezzanine capital) without necessarily diluting EPS and secondly to raise debt at a cheaper rate. If Google needed to raise $2 billion for instance and the current stock price was $500, it would have to issue 4 million new shares which would have a major dilutive effect. On the other hand it could issue 2 million convertible bonds at $1,000 par each convertible into 1 share of common stock. This way Google is able to raise the $2 billion it needs but only commits 2 million shares instead of 4 million. In addition, issuers are able to raise convertible debt at rates much lower than current market yield to maturity on similar rated straight debt. For instance, Google could issue its convertible debt at a yield to maturity of say 4.5% when the effective yield on similar rated straight debt would be say 6.5%. By foregoing this 2% spread, investors acquire the right to convert their bonds to common stock at a specified time period after issuance.

The conceptual dilemma lies in the accounting treatment of convertible debt at the time of issuance. At the date of issue the method for recording convertible debt follows that of straight debt – all proceeds are recorded as debt, none as equity. The reasons are that at the time of issuance, it is difficult to predict when, if at all, conversion will kick in. At the time of conversion, the debt ceases to exist and is converted to equity. So for instance in the Google example, at issuance the following journal entries would occur:

Cash	$2 billion
Bonds payable		$2 billion

If all the investors converted their debt into equity and Google common stock had a par value of $10:

Bonds payable	$2 billion
Common Stock (2 million * $10)		$0.02 billion
Paid in Capital in excess of Par		$1.98 billion

While this current treatment is logical as the debt ceases to exist after conversion, merely ignoring the equity component of a hybrid security misrepresents its economic reality. The reason is that at issuance investors receive a lower yield on convertible debt compared to similar straight debt. This lower yield represents the opportunity cost of acquiring the conversion option. Secondly, by converting to equity, investors actually lose future interest income till maturity and the principal itself. So why then are we not separately accounting for the equity component at issuance, if the opportunity costs (which are real and quantifiable economic costs) of the conversion option and the equity itself are so significant?

To better understand this argument, let’s compare convertible bonds to a straight bond issued with a detachable stock warrant. As the name suggests a detachable stock warrant can be separated and traded as a separate security from the underlying security (in our example a plain vanilla bond). The warrant is essentially a long term option to buy common stock at a fixed price. The FASB treatment for such securities is to separately account for the debt and the equity component.

For instance, let’s assume that Amazon issues 10,000 bonds with 5-year detachable warrants to buy one share of common stock (par value $10) at $28. These warrants would enable Amazon to price its bond offering below market yield of similar debt that didn’t have such warrants. So for example Amazon’s bonds would normally sell for say 95 cents on the dollar without the warrants based on Amazon’s bond rating. However, because the bonds were issued with detachable warrants they would sell for say par (100 cents on the dollar). Assume further that Amazon’s investment bank estimates the market value of each of the 10,000 warrants to be $30 and that the price for the 10,000, $1,000 par value bonds (with the warrants) was $10,000,000. With these facts, the allocation between debt and equity would be as follows:

Fair market value of bonds without warrants ($10,000,000*0.95)	$9,500,000
Fair market value of warrants ($30*10,000)	300,000
Aggregate fair market value	$9,800,000

So the allocation would be as follows:

Allocated to bonds: (9,500,000/9,800,000)*10,000,000

$9,693,878

Allocated to stock warrants: (300,000/9,800,000)*10,000,000
       306,122

$10,000,000

So here, the investor is buying both a bond and a possible future claim on equity (detachable stock warrant) for which he pays $306,122. The bonds (without the warrants) would have cost $9,693,878 but investors pay $10,000,000. The difference of $306,122 is the price of the stock warrant.

If all 10,000 warrants were exercised the following journal entries would be recorded:

Cash (10,000*$28)	$280,000
Paid-in-Capital – Stock warrants	$306,122
Common Stock (10,000*$10)		$100,000
Paid-in-capital in excess of par		$486,122

So the difference between this and a convertible bond is that the underlying bond continues to exist after the warrants are exercised but a convertible bond no longer exists after conversion. Arguably, the conversion feature of a convertible bond is not significantly different in nature from the call represented by a warrant. The litmus test is whether sufficient similarities exist to require the same accounting treatment regardless of the different legal forms.

In its current exposure draft on this issue, the Financial Accounting Standards Board (FASB) suggests that companies should separate the debt and equity components of securities such as convertible bonds. This seems like a reasonable assertion and I’m personally leaning towards it. The fact of the matter is, in either case (a convertible bond and a bond with a detachable stock warrant) the investor makes a payment to the issuer for an equity feature – the option to acquire common stock at some future date. In both cases the payment for the equity option is in the form of a lower yield to maturity compared to the market yield on similar traded straight debt.

The only real distinction between them is the additional payment made when the equity is actually acquired – for a stock warrant, the holder pays additional cash to the company ($28 * 10,000 = $280,000 in the Amazon example); and for a convertible bond, the holder forfeits the present value of future interest income till maturity plus the principal. Clearly, the only real difference between these two hybrid securities lies in the method of paying for the equity component if/when it is exercised; but the economic substance remains the same, regardless of legal form. Based on this, I think it’s fair to expect these two to receive the same accounting treatment at issuance. However, until the accounting rules are amended to reflect this similarity, convertible bonds will continue to remain a controversial issue.