Accounting For Convertible Bonds: An Alternative Approach

Abstract

Accounting for convertible bonds (CBs) has been a source of controversy for more than two decades. The main question relates to the nature of CBs. Should they be defined as: 1) debt; 2) equity; or 3) hybrid securities having both debt and equity characteristics? The disagreements revolve around the definition of several financial statement elements and fundamental concepts of accounting measurement. We believe that current procedures in accounting for CBs are flawed and alternative measures of reporting and recognizing CBs are required in order to provide useful information to external users of financial statements. After a review of alternative methods of accounting for CBs, we conclude that a CB is a partially executed contract which has equity characteristics. The purchaser has committed to buy stock at a fixed price in a future time period. The seller is committed to issue stock in the future and is committed to provide a cash dividend at a fixed rate (i.e. interest) until the stock is issued. The issuance allows the buyer to receive a return of the subscription price in the future if he fails to exercise his right or if the issue is called by the seller. Our approach of accounting for CBs emphasizes the economics reality of the situation rather than accounting by recording a liability which is replaced by equity when the issue is converted.