Convertible Security Accounting

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Convertible Security Accounting

Convertible Security Accounting - Overview

To account for a convertible security, allocate a portion of the proceeds from a convertible security to additional paid-in capital. The amount of the allocation is based on the intrinsic value of that feature on the issuance date. Intrinsic value is the difference between the conversion price and the fair value of the stock into which the security is convertible, multiplied by the number of shares into which the security is convertible.

If a convertible security includes multiple discounts at which conversion can occur, then calculate the intrinsic value using those conversion terms most beneficial to the investor.

However, if the issuing entity sells the convertible security at a price not significantly in excess of its face amount, then do not allocate any portion of the proceeds to additional paid-in capital.

Convertible Security Accounting - Example

Hephaestus Construction issues a convertible security for $900,000. The instrument is convertible three years after issuance at a conversion price of $12, which is also the fair value of the stock on the issuance date. Another provision of the agreement states that the conversion price will reset to $9 if Hephaestus does not go public and attain a per-share price of at least $15 within three years.

If there is no change in Hephaestus’ current situation, then the conversion price will be $9 (that is, the company does not go public). Therefore, the intrinsic value of the conversion option is:

Convertible debt issuance amount	$900,000
÷ Conversion price if no change in circumstances	÷ $9/share
Number of shares issuable if no change in circumstances	100,000 shares

Initial conversion price	$12/share
- Conversion price if no change in circumstances	- 9/share
= Variance	$3/share

Intrinsic value (100,000 shares x $3/share)	$300,000