Category: Accounting News

According to EY, the convertible debt market saw whipsaw action in issuances. Between 2015 and 2019, average issuance varied between $40 billion and $45 billion. However, it dropped to $22 billion in 2022 but re-accelerated to $52 billion in 2023. While the levels of issuance varied, the way this type of debt is accounted for has remained much calmer.

Defining a Convertible Bond

A convertible bond is a type of debt security that gives the investor the right to exchange the bond, at certain milestones, for a pre-determined percentage of equity in the issuing company. This investment vehicle has both equity and debt features.

Since this type of investment gives investors the potential for equity conversion into a company, the debt/bond side of it may present investors with a nominal coupon remittance or a potentially zero-coupon payment. However, there are important accounting considerations for this type of investment vehicle via generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).

IFRS

When it comes to IFRS, convertible bonds are considered blended securities because they are partially debt and partially equity. The debt piece is accounted for by discounting the principal and interest paid out to the bondholder at the company’s cost of straight debt. The following example illustrates how it’s calculated:

The business presents a 10-year, $250 million convertible bond, providing investors with a 2.5 percent coupon rate and a 9.5 percent straight cost of debt. Based on discounting these variables, the present value of the principal and coupon payments is: $182,805,096 (assuming end-of-year, annual coupons). To determine the equity proportion, we must take $250 million and subtract $182,805,096, which equals $67,194,904.

Looking at the journal entry, we have the following breakdown:

Cash: Debit $250,000,000

Convertible Debt Component – Liability = $182,805,096

Equity Component – Shareholder’s Equity = $67,194,904

Looking at the interest expense this is calculated as follows:

The 9.5 percent (straight debt cost) is multiplied by the net present value of the beginning debt liability balance of the first year ($182,805,096), which is $17,366,484.12. Since there’s a coupon payment of (2.5 percent X $250,000,000 = $6,250,000), the difference between $17,366,484.12 and $6,250,000 = $11,116,484.12 should be “accreted” to the debt liability or the debt balance.

The journal entry would be as follows:

Debit: Interest Expense $17,366,484.12

Credit: Cash $6,250,000

Credit: Accretion of Debt Discount – Liability = $11,116,484.12

Now, if at the bond’s maturity, the investor is unable to convert the bond to equity according to the terms of the convertible note, the entire $250 million bond will be paid back to the investor. The journal entry will be as follows:

Debit: Convertible Debt $250,000,000

Credit: Cash $250,000,000

If, however, the investor of the convertible bond is favorable to it being exchanged, the journal entry will be as follows:

Debit: Convertible Debt $250,000,000

Credit: Share Capital – Shareholder’s Equity = $250,000,000

This explanation assumes that convertible bonds are only able to be converted into company equity. However, if the bond is cash-settled, there are alternate considerations. It’s also assumed that the bond is issued at year’s end and makes its coupon payments once a year.

GAAP

Under generally accepted accounting principles (GAAP), present standards treat it as straight debt. This accounting practice changed from GAAP’s previous treatment of bifurcating it, similar to IFRS’ current treatment.

At issuance, the journal entries are as follows:

Debit: Cash $250,000,000

Credit: Convertible Debt $250,000,000

With this accounting treatment, it’s recognized as an interest expense. Since this contrasts with IFRS, no accretion is required under GAAP. This assumes there are no additional debt issuance costs when calculating interest expenses. Therefore, assuming the same initial debt amount at par and the coupon rate for year one, it’s the rate for the debt issuance multiplied by the full debt amount ($250,000,000).

The journal entry is as follows:

Debit: Interest Expense $6,250,000

Credit: Cash $6,250,000

If the convertible debt doesn’t present a good opportunity for the investor, they’ll receive the principal back. The journal entry is as follows:

Debit: Convertible Debt $250,000,000

Credit: Cash $250,000,000

If, however, the convertible debt presents the investor with an opportunity to convert to equity, and it’s exercised, the journal entry is presented as follows:

 Debit: Convertible Debt $250,000,000

 Credit: Share Capital – Shareholder’s Equity $250,000,000

Conclusion

While these examples do not explore all the potential scenarios when accounting for convertible debt, they show what considerations accountants must keep in mind when analyzing a transaction.

Comprehensive income (CI), which is defined as the sum of net income (NI) and other comprehensive income (OCI), gives both the internal and external audiences a 30,000-foot perspective of a company’s valuation. Understanding how it’s broken down, how it’s accounted for, and how it’s interpreted by different audiences is essential to making favorable impressions.

In the banking industry, the Government Accountability Office (GAO) found 2,705 material restatements occurred between the beginning of January 1997 and the first half of 2006. Businesses that fail to report financial information accurately the first time are not uncommon – but this can have harmful effects on their bottom line.

Comprehensive Income Components Defined

Net income, which is the first component of comprehensive income, is the difference between a company’s total revenue and the taxes, interest, and expenses. This shows how profitable a company is during a certain accounting time frame. It’s important to keep in mind that net income, along with all of the deductions taken from the total revenue, are reflected on the income statement because this financial document recognizes only incurred expenses and earned income during a set accounting period. 

Other comprehensive income (OCI), the second half of CI, is a way to account for and analyze unrealized or not yet booked gains or losses. This can include investing ventures, cash flow hedges, debt securities, foreign currency exchange rate adjustments, pension obligations, etc. It’s important to keep in mind that along with being reported on the company’s balance sheet, it may also be reported on a separate statement of comprehensive financial statement.  

Further Financial Statement Reporting Considerations

On June 17, 2011, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) 2011-05, Comprehensive Income – Topic 220: Presentation of Comprehensive Income.

One of the original three ways that was in effect but has been repealed with this modification from FASB was to report elements of other comprehensive income (OCI) as a portion of the statement of changes in stockholders’ equity. However, many professionals argued that this change simplified the reading and analysis of how OCI impacts a business’ total operations.

Based on FASB’s Accounting Standards Codification (ASC) 220-10-45-1, comprehensive income can be presented in either one statement or two discrete, successive statements.  

#1: Single, Successive Statement Option

Based on ASC 220-10-45-1A, the following figures are required to be reported:

Components of net income

Total net income

Components of other comprehensive income

Total for other comprehensive income

Total for comprehensive income

#2: Two Discrete, Successive Statements

Based on ASC 220-10-45-1B, the following two figures are required:

1. Statement of net income

2. Statement of other comprehensive income

The following data for each respective successive financial statement should be included:

1a. Components of net income

b. Total net income

2a. Components of other comprehensive income

b. Total for other comprehensive income

c. Total for comprehensive income

Conclusion

While each business has its own challenges and opportunities, when it comes to preparing financial statements it’s essential to prepare financial statements that are transparent and follow FASB reporting requirements to maintain attractiveness to internal and external stakeholders.

When a business is looking for a valuation, it needs to decide whether to use the calculation of value approach versus the conclusion of value option.

The conclusion of value calculation is a more rigorous and resource-intensive calculation of value. Both approaches are similarly dependable, and despite the calculation of value’s less in-depth approach, business owners can still benefit from this knowledge for their short- and long-term projection needs. However, there are some distinctions between the two approaches. 

Calculation of Value

This method can be conducted annually or once every 24 months. It’s often applied for internal needs, such as the owner looking to retire, selling the business or for critical strategy development. Calculation of value also can be used for planning purposes, such as the settlement stage of a divorce. However, since it’s not an opinion of value, it’s not seen during litigation. 

Calculation of value aims to get the company’s fair market value via comparable companies. It is an approximate value, calculated through either a single figure or a range.

Conclusion of Value

This is more comprehensive and has stricter standards that can meet those required by the IRS, lawsuits, the Department of Labor, potential business buyers, M&A activity, etc. Conclusion of value can take as long as six weeks to complete due to stricter reporting standards.  

It’s up to the discretion of the analyst, and the results can be a single figure or a range. There are three accepted forms of valuation: market, income and asset-based, necessitating additional time. These three approaches are defined further below.

Market-Based Valuation

This looks at charted data of transaction values to calculate a business’ financial worth. This works similar to how those in the real estate industry determine comparable business’ worth, which is based on substantially similar conditions.

Regardless of the type of business, it looks at financial metrics such as the client service model, business location, profitability, percentage of periodic revenue projections, overall revenue, growth rates, mean account sizes, etc.  

Income-Based Valuation

This type of analysis establishes fair value by looking at historical, present and projected future cash flows. It also looks at reasonable projected returns on future investments.  

Valuing investments via the discounted cash flow method (DCF) involves looking at after-tax, discretionary, and/or operating cash flow types. This approach is often utilized with businesses that have no to limited earning growth projections.

The Capitalization of Earnings/Cash Flow Method

This begins with determining the cash flow for a discrete period. Then, the cash flow is divided by the capitalization rate over the same period. The capitalization rate is determined by taking a property’s net operating income and dividing it by the present market value. Looking through a real estate lens, it’s interpreted as the percentage of return an investor is likely to obtain from an investment. It’s often calculated for mature/established businesses that grow at a reasonable/predictable rate.

Excess Earnings Valuation Methodology

This can be defined as looking at how much tangible and intangible assets earn for a company over a discrete period of time. 

Asset-Based Valuation

This values a company by looking at the net value of assets within a company or the post-liability deduction of the fair market value of the company’s total assets. It’s one way to determine how much a company would cost to re-create. 

While each business has its own needs for valuation, be it for internal or external audiences, understanding how to accomplish them and when to use each type is extremely helpful for overall operations.