What are convertible bonds and convertible preferred stock and how does U.S. GAAP and IFRS account for their issuance? Describe the accounting for conversion of convertible bonds and convertible preferred
Convertible Bonds or Preferred Stock
Convertible bonds and convertible preferred stock permit the owner either to hold the security as a bond or preferred stock or to convert the security into shares of common stock. The owner cannot detach and transfer, or separately exercise, the conversion option as the owner can for a bond or preferred stock issued with a separable stock warrant. The issue price of a convertible bond or convertible preferred stock is payment for both debt or preferred stock and for the conversion option, but no one can observe the fair value of these separate components.
In most cases U.S. GAAP requires firms to allocate the full issue price of convertible bonds or preferred stock to the bonds or preferred stock and none of the price to the conversion feature.
IFRS requires firms to allocate a portion of the issue price to the conversion feature. The calculation of this amount requires knowing the proceeds of an issue of nonconvertible bonds that otherwise resemble the convertible bonds. In this case,
Conversion of Convertible Bonds and Convertible Preferred Stock
Accounting for the conversion of bonds or preferred stock into common stock uses either carrying values or fair values to record the conversion, although practice is evolving.
The usual entry to record the conversion of convertible bonds or preferred stock into common shares ignores current market prices and shows the swap of common shares for bonds or preferred stock at their carrying value.
An allowable alternative treatment recognizes that market prices provide information useful
in quantifying the market value of the shares issued. Relative to the usual entry, the alternative entry results in a loss on the income statement and the same total shareholders' equity, with smaller retained earnings but larger contributed capital.
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