Accounting for Convertible Bonds Illustration - Example

ABC LTD issues 1 million convertible bonds of $1 each carrying nominal interest of 10%. Bondholders are entitled to convert their bonds into $1 ordinary shares of the company on the date of their maturity in three years time instead of receiving principle repayment.

Interest rate of a similar bond without the conversion option is 15%.

How must ABC LTD account for the convertible bonds upon initial recognition, subsequent measurement and maturity assuming all bonds are converted after three years?

Initial Recognition

Following accounting entries must be recorded upon initial recognition:

Dr - Cash/Bank		$1,000,000 (Total Proceeds)

Cr - Liability	$885,839 (Note 1)
Cr - Share Options (Equity)	$114,161 (Balancing Figure)

Note 1:

Present value of future interest payments and principal using 15%:

Year1:	$100,000 (interest)	x	[1/1.15]	=	$ 86,956.5
Year2:	$100,000 (interest)	x	[1/1.15^2]	=	$ 75,614.4
Year3:	$100,000 (interest)	x	[1/1.15^3]	=	$ 65,751.6
Year3:	$1,000,000 (principal)	x	[1/1.15^3]	=	$ 657,516.0
Total					$ 885,839.0

Subsequent Measurement

Interest expense will be charged using 15%. The difference between interest paid and interest charged will be added to the liability component as follows:

	Interest Expense		Liability
		$		$
Year1:	[885,839 x 15%]	132,876	[885,839 + 132,876 - 100,000*]	918,715
Year2:	[918,715x 15%]	137,807	[918,715+ 137,807 - 100,000]	956,522
Year3:	[956,522x 15%]	143,478	[956,522+ 143,478 - 100,000]	1,000,000