# Accounting for convertible securities

A convertible security is a debt instrument that gives the holder the right to convert it into a certain number of shares of the stock of the issuing entity. This type of security has value to the investor, who can either receive interest payments on the debt or elect to acquire stock that may have increased in value. Because of this added value, the issuing company can achieve a lower interest rate on its debt than would normally be the case.

The accounting for a debt instrument that is converted into a company’s equity under an inducement offer is to recognize an expense in the amount of:

(Fair value of all securities and other consideration transferred) – (Fair value of securities issued)

The fair value in this calculation is based on the fair values of the securities when a conversion inducement offer is accepted.

If there is no inducement offer, and instead the conversion of a debt instrument into a company’s equity is based on the original conversion privileges stated in the debt instrument, do not recognize a gain or loss on the transaction.

For example, Armadillo Industries issues a \$1,000 face amount convertible bond that sells for \$1,000. The bond is convertible into Armadillo stock at a conversion price of \$20. To induce holders of the bonds to convert them into company stock, Armadillo offers to reduce the conversion price to \$10, if the conversion takes place within the next 30 days.

A number of investors accept the new conversion terms and convert their bonds into company stock. The market price of Armadillo’s stock on the conversion date is \$30. Based on this information, the calculation of the incremental consideration paid by Armadillo to effect the conversion is:

 Value of securities issued to debt holders (using inducement): Face amount \$1,000 ÷ New conversion price ÷ \$10 Per share = Number of shares issued upon conversion = 100 Shares × Market price per common share × \$30 Per share = Value of securities issued \$3,000

 Value of securities issued to debt holders (prior to inducement): Face amount \$1,000 ÷ Old conversion price ÷ \$20 Per share = Number of shares issued upon conversion = 50 Shares × Market price per common share × \$30 Per share = Value of securities issued \$1,500

By subtracting the value of the equity securities prior to the inducement price from the value of the securities including the inducement price, we arrive at the following fair value of the incremental consideration:

\$3,000 Value of securities with inducement - \$1,500 Value of securities prior to inducement
= \$1,500 Fair value of incremental consideration

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