Discuss the factors that might motivate corporate management to decides to issue convertible debt. how is the issuance of convertible debt accounted for at the time of issuance under U.S GAAPs?
What arguments can be made for the recognition of the equity feature in convertible debt at the time of issuance of the securities?
What Is Convertible Debt:
Convertible Debt is the most common form of hybrid debt instruments issued by companies. Convertible Debt is similar to a regular note or bond payable, only that the holders of the debt securities have the option to convert their balance into shares of the company.
Answer and Explanation:
Management often elects to issue convertible debt for one of the following reasons:
- They want to keep earnings per share high in the short-run.
- They want to lower their borrowing rate.
- They want to secure more capital from investors.
Management has the choice on how to account for convertible debt under US GAAP:
- They can measure the liability portion by computing the fair market value of the debt. The residual proceeds are deemed to be the equity portion.
- They can simply elect to recognize the entire amount as debt (i.e. No equity recorded).
The main arguments for the recognition of the equity feature are:
- Doing so improves the company's financial leverage (i.e. since debt would be lower).
- Doing so provides more transparent information to users of the financial statements (i.e. since there is a value for the option of the debt holder to convert their debt into shares).
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from Financial Accounting: Help and ReviewChapter 8 / Lesson 7