Accounting For The Issuance Of Convertible Securities
By Joel Steinberg, CPA, American Express Tax and Business Services of New York, Inc.
Convertible preferred stock and bonds are convertible into common stock of the issuer at specified rates. These securities are attractive to the investor because they provide stated dividend or interest payments and have preference in liquidation, while also allowing the investor to benefit from increases in the value of the issuer's common stock. Issuers of convertible securities should be aware, however, that the issuance of these securities can result in charges for dividends and interest in addition to the stated amounts, resulting in an unexpected reduction in earnings or a reduction in earnings available to common stockholders. This occurs when the conversion feature is beneficial at the date of issuance.
Emerging Issues Task Force (EITF) Topic No. D-60, Accounting for the Issuance of Convertible Preferred Stock and Debt Securities with a Nondetachable Conversion Feature, provides guidance on accounting for the issuance of convertible securities where the conversion feature is beneficial at the time of issuance. A conversion feature is beneficial, or "in the money," when the conversion rate is such that by converting the security, the investor obtains the underlying common stock at below market price.
If securities are issued with a beneficial conversion feature, the intrinsic value of the conversion feature should be computed and a portion of the proceeds equal to the intrinsic value allocated to additional paid-in capital. The allocation will result in a reduction of the initial carrying amount of the preferred stock or debt. The intrinsic value is the difference between the conversion price and the market price of the underlying common stock, multiplied by the number of shares into which the security is convertible. If the security provides more than one method of determining the conversion rate, the computation should be made using the conversion terms that are most beneficial to the investor. If the common stock is publicly traded, the quoted market price should not be adjusted for transferability restrictions, large block factors, avoided underwriters' fees, or time value discounts.
Accounting for Convertible Preferred Stock
For convertible preferred stock, the discount resulting from the allocation of proceeds to the beneficial conversion feature should be treated as analogous to a dividend and should be recognized over the minimum period during which the preferred shareholders can realize that return. This is done by amortizing the discount from the date of issuance through the date the security is first convertible, using the effective interest method. Applying the guidance in SEC Staff Accounting Bulletin No. 68 (Topic 5Q), Accounting for Increasing Rate Preferred Stock, the discount is amortized by recording a dividend and recording a corresponding increase to the carrying amount of the preferred stock. The recording of the dividend will have no impact on cash, net income, or total stockholder's equity. However, the imputed dividend will reduce income available to common shareholders or increase any loss for the purpose of computing earnings-per-share.
Accounting for Convertible Debt
APB No. 14, Accounting for Conver-
tible Debt and Debt Issued with Stock Purchase Warrants, covers the accounting for convertible debt. However, the terms of the securities covered by that statement generally include an initial conversion price that is greater than the market value of the underlying common stock at the time of issuance. APB No. 14 states that securities not explicitly discussed should be dealt with in accordance with the substance of the transaction. For example, when convertible debt is issued at a substantial premium, there is a presumption that such premium represents additional paid-in capital.
When convertible debt is issued with a beneficial conversion feature, a portion of the proceeds should be allocated to the intrinsic value of the conversion feature, and the resulting discount should be amortized as additional interest expense. Rather than using the stated term of the debt, the discount should be amortized from the date the security is issued to the date it first becomes convertible. The stated maturity date is presumed to be not substantive, because the debt has been issued with beneficial conversion terms. The recording of additional interest expense will impact net income; however, it will have no impact on cash or total stockholder equity.
Under EITF Topic No. D-60, the discount on issuance of convertible securities is based on the intrinsic value of the beneficial conversion feature rather than the fair value of the feature. In EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, the EITF reconsidered this conclusion. The task force tentatively concluded that embedded (nondetachable) beneficial conversion features should be valued separately at fair value at the time of issuance. However, the task force did not reach a consensus, and, accordingly, the guidance in Topic No. D-60 should still be applied. The task force also discussed, but did not reach a consensus on, situations where the conversion price is variable based on future events. *
Douglas R. Carmichael, PhD, CFE, CPA
Stan Ross Department of Accountancy,
Zicklin School of Business,
John F. Burke, CPA
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