Wiley GAAP 2008

Convertible Debt

Bonds are frequently issued with the right to convert into common stock of the company at the holder's option. Convertible debt is typically used for two reasons. First, when a specific amount of funds is needed, convertible debt often allows a lesser number of shares to be issued (assuming conversion) than if the funds were raised by directly issuing the shares. Thus, less dilution occurs. Second, the conversion feature allows debt to be issued at a lower interest rate and with fewer restrictive covenants than if the debt was issued without it.

This dual nature of debt and equity, however, creates a question as to whether the equity element should receive separate recognition. Support for separate treatment is based on the assumption that this equity element has economic value. Since the convertible feature tends to lower the rate of interest, a portion of the proceeds should be allocated to this equity feature. FASB concurred, and it issued proposed standards that would, among other things, require convertible debt to be divided into its liability components and equity components. Those components would be separately presented in the balance sheet. If issued (the draft remains outstanding as of mid‐2007), those standards would replace that under APB 14, which require that the instrument be reported as either all debt or all equity. (FASB is now expected to issue another preliminary views document on this project in late 2007.) For more details, see the discussion ...