Chapter 8.5® - Conversion of Bond Debt using Book Value & Market Value Methods & Examples to Illustrate - Repayment of Bonds & Credit to Contributed Capital - Common Shares

• Part 8.1 - Complex Debt & Equity Instruments - the Debt-To-Equity Continuum, Convertible Debt, Income Bonds & Redeemable Preferred Shares
• Part 8.2 - Financial Assets & Liabilities - Debt & Equity Problem - Examples of Financial Instrument Classification & Retractable Preferred Shares
• Part 8.3 - Reasons for Issuance of Retractable Preferred Shares - Perpetual & Convertible Debt
• Part 8.4 - Characteristics of Convertible Bonds - Value of Conversions, Recognition of Convertible Debt & Associated Journal Entries & Measurement of Net Income
• Part 8.5 - Conversion of Bond Debt using Book Value & Market Value Methods & Examples to Illustrate - Repayment of Bonds & Credit to Contributed Capital - Common Shares
• Part 8.6 - Issuing Convertible Debt at Issuer's Option & Terms - Stock Options & Warrants, Accounting for Stock Rights, Generating Cash Flow Statements of Debt Activities

When convertible bonds are submitted for conversion, the first task is to update any accounts relating to bond premium or discount, accrued interest, and foreign exchange gains and losses on foreign currency denominated debt.

Book Value Method:

The conversion can be recorded using the book value method. For example, return to the Farah bonds. All the $100,000 Farah bonds payable are converted to 1,000 common shares on an interest date. Assume that on this date, the stock price is $140 per share, and calculations show that $4,550 of discount remains unamortized after updating the discount account. The entry to record the conversion is:

The common shares are recorded at the book value of the debt.

Market Value Method:

An alternative approach is the market value method. Under the market value method, the conversion is recorded at the value of the shares that are issued on conversion. This approach is supported by the various provincial and federal corporations acts, which generally stipulate that shares should be recorded at their cash equivalent value, which is the amount that would be received if the company issued the shares for cash rather than through conversion.

Example:

The shares are assumed to have a value of $140 each. The cash equivalent value of the 1,000 shares issued on conversion is $140,000 which will be recorded as follows:

An argument in favour of the market value method is that the transaction is not simply a trade – the exchange of debt for equity represents a change of risk for both the issuer and the holder and therefore is a substantive exchange. Substantive exchange (such as barter transactions) are normally accounted for at market values in order to reflect the economic consequences of the exchange.

Repayment:

If the market value of underlying shares is less than face value, investors will request and the conversion rights will expire. If this happens at maturity, all discount or premium accounts will be zero. The entries for the Farah: