The other reason for issuing convertible bonds is to raise debt financing at lower rates. In many cases, the debt financing could be obtained only at high interest costs unless the company attaches a conversion privilege to the debt security. The conversion covenant attached to debt entices investors to accept a lower rate than would normally be the case on a straight debt issue. In one case, the note’s terms may say that the investor gets paid back per their liquidation preference, which is usually up to three times the original amount they loaned. In others, they can convert the note into common stock priced per the valuation cap, then sell those shares to the acquiring company.
- However, convertible debt also comes with the option for investors to convert their loan principal into company equity shares – usually common stock.
- The specific terms of the note, including any conversion discounts or valuation caps, may affect the journal entries.
- Convertible securities are a unique type of financial instrument that have characteristics of both debt and equity.
- Convertible debt begins as a loan, with the issuing company receiving cash from investors in exchange for the promise to repay the principal plus interest.
- However, some convertible notes also have a cash settlement feature which protects the investor from any downside losses where the option conversion feature is ‘out of the money’.
Accounting Entries on Issuing of the Convertible Notes
At this time, let us assume that the company is valued at $6M at the price of $6 per share. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance. We also see issuers adding enhancements to conversion features in order to attract investors. So in summary, convertible notes start as long-term debt on the balance sheet and convert into equity shares at a later date per the contractual terms.
Compound financial instrument
Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The required effective dates, as detailed below, follow the FASB’s two bucket approach that staggers the effective dates between larger public companies and other entities. What if your company gets acquired rather than going through an official fundraising the best way to start saving for college round or going public? Maturity dates should be taken seriously, but you should also know that very few founders find themselves coughing up lump sums if they reach that date without a conversion event. Most startups wouldn’t be able to pay back the conversion note, and investors know they would likely be forcing a bankruptcy — and consequently forfeiting that money — if they tried to require repayment.
Simplified Accounting for Convertible Instruments
Basically, convertible notes carry a unique characteristic among investments. And since convertible notes are technically debt, if the note is held to maturity, the note holder can demand a payback. In fact, only during a preferred round can the convertible notes convert into equity.
Summary of Financial Liability
Since the convertible bonds have features of both liability (debt) and equity, it makes more sense to account for the liability and equity portions separately. Among other requirements, this guidance requires specific criteria to be met in order to qualify for equity classification. The new standard removes certain of these specific criteria and clarifies another criterion. However, the new standard does not amend the scope of specific guidance which requires certain freestanding instruments to be reported as liabilities and mark-to-market accounting for certain instruments (ASC 480). If the holder exercises the conversion option or no such option exists, and the conversion is automatic, the convertible notes become share equity.
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This journal entry converts the debt into the ABC shares and creates the share premium account. This is the one of the most common ways to have the conversion triggered. It is normally a set amount negotiated in the convertible note that sets a limit within the next equity financing round. The main idea is to first protect the investor and next to allow the company to gain a significant amount of cash in their equity round without having to deal with the complication of issuing additional shares.
On the other hand, if an option is in place and the bondholders do not exercise this, the company pays the bondholders the principal owed on the debt. Convertible debt was initially used as a bridge between two funding rounds in a company. However, it has recently become highly popular as a seed round funding instrument.
By maintaining accurate accounting of your convertible notes, you’re not only complying with accounting standards but also giving potential investors a transparent view of your company’s financial health. Remember, the balance sheet is trying to balance the assets against the liabilities + equity. So the cash coming in from your convertible note will generally equate to the liability that you add to the balance sheet. And, if your accounting is doing a good job, the accrued interest is a non-cash expense that flows through your income statement and impacts your accumulated net income in the equity section. Continuing down the right hand side of the above flow chart, we then consider whether the instrument has any characteristics that are similar to equity. The answer is ‘yes’ because the instrument contains an option to be converted into equity instruments, but the question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately in Step four below.
We can see that when the conversion feature is classified as equity, it is not remeasured. Also, even if the conversion option is not exercised, the amount recorded in equity is not reclassified (or ‘recycled’), although it could be transferred from one equity reserve to another. The only item that affects profit or loss is the recognition of interest expense at the effective interest rate for the liability component.
Instead, what accrues converts into more equity for the investor at the triggering event. This month we work through a more detailed example of a convertible note classified as a compound financial instrument (i.e. part debt and part equity). We review the process for classification (using a flowchart), as well as measurement issues and the relevant journal entries.