Firms that borrow by issuing bonds frequently include a conversion privilege in thebond contract. Convertible bonds allow the bondholder to exchange the bonds for a specified number of shares of stock. As an example, let’s assume that in 2001 the Aloha Company’s long-term debt included $150 million principal in convertible bonds payable, exchangeable for common stock at $15 per share at any time before the year 2002. If all the bondholders elected to convert to common stock, Aloha would then issue 10 million shares of common stock ($150 million bond principal $15 conversion price). Aloha’s bonds payable would be reduced, and paid-in capital would be increased by $150 million:
Note that the conversion of debt to common stock reduces the firm’s liabilities and increases shareholders’ equity. The number of common shares outstanding is increased, and the periodic interest expense is eliminated.
Convertible bonds such as those issued by Aloha are hybrid securities. A hybrid security is neither clearly debt nor clearly equity. Instead, it combines certain features of both types of securities. In the case of convertible bonds, the bondholder is in one sense a lender and owns the firm’s promise to make future interest and principal payments. In another sense, the holder of a convertible bond holds an option to acquire a specified number of common shares at a fixed price at any time over the life of the bond issue. In fact, investors in convertible bonds are willing to pay for this combination of debt and equity features. Convertible bonds generally are issued at higher prices (in other words, at lower interest rates) than nonconvertible debt.
The proper way to account for hybrid securities is a matter of debate. Present accounting standards reflect the view that convertible debt is to be reported as debt until it is actually converted and as equity thereafter. No recognition is given in the financial statements to the likelihood that conversion will actually occur, or to the relative values to investors of the hybrid security’s debt and equity features.
Opponents of present practice argue that it is misleading to ignore the hybrid nature of convertible securities. In the case of debt, they argue that the issue price should be apportioned between the amount the investor is paying for the debt features and the additional amount being paid for the conversion privilege. Ignoring these separate elements, they contend, causes the financial statements to overvalue the firm’s reported liabilities, undervalue its shareholders’ equity, and understate periodic interest expense. To address these and related issues, the FASB is pursuing a comprehensive financial instruments project. The project aims to identify the component claims that are bundled in hybrid financial assets and liabilities and to develop appropriate methods of valuation for these components.