Convertible Securities: Structure, Accounting, and Financial Reporting

Convertible securities are hybrid financial instruments that combine features of debt or preferred equity with the option to convert into common stock at the holder’s discretion or under specified conditions. They allow companies to raise capital while offering investors potential upside participation in the issuing company’s stock.

Accounting for convertible securities involves balancing the treatment of debt/equity components, measuring conversion features, and recognizing potential dilution in earnings per share (EPS).

This article explains the structure, accounting rules, valuation, and reporting requirements for convertible securities under U.S. GAAP and IFRS, supported by examples and practical journal entries.

1. What Are Convertible Securities?

Convertible securities include:

✦ Convertible bonds – debt instruments that can be converted into a fixed number of common shares

✦ Convertible preferred stock – preferred shares that can be exchanged for common shares

They give investors the right (not obligation) to convert, usually at a pre-determined conversion price.

Advantages for issuers:

✦ Lower interest rates or dividend requirements

✦ Deferred dilution of equity

✦ Broader investor appeal

Advantages for investors:

✦ Fixed income with potential upside

✦ Downside protection if stock underperforms

2. Key Terms in Convertible Securities

✦ Conversion Ratio – number of shares each bond or preferred share can be converted into

✦ Conversion Price – price at which conversion occurs

✦ Call Provision – issuer’s right to force conversion

✦ Contingent Conversion (CoCo) – conversion triggered by specific events

3. Accounting for Convertible Debt (Before 2021 U.S. GAAP Update)

Under legacy U.S. GAAP (pre-2021 ASC 470-20 guidance):

✦ Convertible bonds were bifurcated into a debt component and an equity component

✦ Debt discount was amortized over time, increasing interest expense

✦ Conversion option was booked to additional paid-in capital (APIC)

Initial Journal Entry Example:

Company issues $1 million of 5-year convertible bonds:

✦ Fair value of bonds without conversion = $950,000

✦ Value allocated to equity = $50,000

Journal Entry:

Debit: Cash – $1,000,000

Credit: Bonds Payable – $950,000

Credit: Additional Paid-In Capital (Conversion Feature) – $50,000

4. Simplified Accounting (Post-2021 U.S. GAAP Update)

After ASU 2020-06, most convertible instruments are no longer bifurcated:

✦ Entire proceeds are allocated to liability (debt) or equity based on dominant features

✦ No separate equity component unless a derivative liability exists

✦ Reduces complexity and volatility in reported earnings

Issuers now record:

Debit: Cash – Proceeds received

Credit: Bonds Payable (or Preferred Stock) – Full amount

No APIC is recorded unless the conversion feature requires separate accounting.

5. IFRS Treatment (IAS 32 and IFRS 9)

Under IFRS, convertible bonds continue to be split between a debt component and an equity component.

The debt component equals the present value of future contractual cash flows discounted at the prevailing market interest rate for similar non-convertible debt. The equity component is the residual amount, representing the value of the holder’s option to convert.

Initial Journal Entry under IFRS:

Debit: Cash – Full proceeds

Credit: Bonds Payable (Debt portion) – PV of cash flows

Credit: Equity (Conversion Feature) – Residual amount

6. Conversion Accounting

When a holder exercises the conversion option:

• Eliminate the carrying amount of debt and/or equity components

• Issue common stock

• No gain or loss is recognized on conversion

Example – Upon Conversion:

A bond with a carrying value of $950,000 is converted into 50,000 shares.

Journal Entry:

Debit: Bonds Payable – $950,000

Credit: Common Stock – Par value of shares issued

Credit: Additional Paid-In Capital – Remainder

7. Impact on Earnings Per Share (EPS)

Convertible securities may cause dilution, affecting diluted EPS.

Under the if-converted method:

✦ Assume conversion at the beginning of the period

✦ Adjust net income for interest saved (after tax)

✦ Increase weighted-average shares outstanding

If conversion is antidilutive (i.e., it increases EPS), it is excluded from diluted EPS calculations.

8. Financial Reporting and Disclosures

Companies must disclose:

✦ Terms and conditions of convertible instruments

✦ Conversion ratios and prices

✦ Remaining principal balances and maturity dates

✦ Interest expense on convertible debt

✦ Effects on diluted earnings per share

✦ Conditions or contingencies related to conversion

Clear disclosure ensures that investors can properly assess the potential dilution and future cash outflows associated with convertible instruments.

9. Differences Between Convertible Bonds and Convertible Preferred Stock

While both convertible bonds and convertible preferred stock offer the right to convert into common shares, their structures differ significantly.

Convertible bonds are debt instruments and are reported under liabilities on the balance sheet. They typically offer periodic interest payments (coupons) and carry a maturity date at which principal must be repaid if not converted. In contrast, convertible preferred stock is classified as equity (or sometimes as a separate mezzanine equity category depending on specific features) and pays fixed preferred dividends instead of interest.

Additionally, convertible bonds represent an obligation to repay the principal, while convertible preferred shares generally do not create an obligation to repay capital — dividends are often cumulative but are discretionary to some extent.

From a dilution perspective, both instruments can increase the number of outstanding common shares if conversion occurs. However, convertible preferred stockholders might also have voting rights or preference over dividends and liquidation proceeds prior to conversion, depending on terms.