CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term de

Question

CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate. Instructions (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock. (2) Discuss the underlying rationale for the differences described in (a)(1) above. (3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants

Explanation / Answer

Warrants are also long-term securities but are generally shorter-term than convertibles. They grant investors the right to purchase shares at a fixed for a predetermined amount of time, often several years.

Warrants are often tied to bonds or preferred stock, but can also be issued independently.

The exercise price is usually higher than the price at which the shares for the company are currently trading, but if those shares then increase in value, the investor will still be able to purchase at the exercise price.

Warrants are more valuable in volatile markets when chances of the price swinging above the exercise price are good. They become less valuable as the warrant expiration date approaches because the chances of a favourable price swing are greatly reduced.

Convertible are long-term securities which can be changed into another type of security, such as common stock. Convertibles include bonds and preferred shares, but most commonly take the form of bonds.

Convertibles are attractive to investors who are looking for an investment with greater growth potential than that offered by a traditional bond. By purchasing a convertible bond, the investor can still receive returns as if it were a traditional bond, but has the additional option of converting that bond into shares if the share price increases enough to make it worthwhile.

When warrants are traded independently of their accompanying bonds, they can rise in price as the underlying stock price rises. The exercise price of a warrant on its day of issue is usually higher than the price of the stock on the same day. Nevertheless, the price of the stock may rise during the period of validity for the warrant, which can be as long as five years. When this happens, the price of the warrant rises as well. The bondholder who received the warrants can either purchase the stock at a lower price or sell the warrants at an advantageous price.

When the debt instrument and the option to acquire common stock are inseparable, as in the case of convertible bonds, the entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts. When the debt and the warrants are separable, the proceeds of their sale should be allocated between them. The basis of allocation is their relative fair values. As a practical matter, these relative values are usually determined by reference to the price at which the respective instruments are traded in the open market. Thus, if the debt alone would bring six times as much as would the stock warrants if sold separately, one-seventh of the total proceeds should be apportioned to the warrants and six sevenths to the debt securities. That portion of the proceeds assigned to the warrants should be accounted for as paid-in capital. The result may be that the debt is issued at a reduced premium or at a discount. 2. In the case of convertible debt there are two principal reasons why all the proceeds should be ascribed to the debt. First, the option is inseparable from the debt. The investor in such securities has two mutually exclusive choices: be a creditor and later receive cash for the security; or give up all rights as a creditor and become a stockholder. There is no way to retain one right while selling the other. Second, the valuation of the conversion option or the debt security without the conversion option presents practical problems. For example, in the absence of separate transferability, no separate market values are established and the only values which could be assigned to each would be subjective. Separability of the debt and the warrants and the establishment of a market value for each results in an objective basis for allocating proceeds to the two different equities—creditors’ and stockholders’—involved. 3. Arguments have been advanced that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants. Convertible debt has features of debt and stockholders’ equity, and separate recognition should be given to those characteristics at the time of issuance. Difficulties encountered in separating the relative values of the features are not insurmountable and, in any case, should not result in a solution which ignores the problem. In effect, the company is selling a debt instrument and a call on its stock. Coexistence of the two features in one instrument is no reason why each cannot receive its proper accounting recognition. The practical difficulties of estimation of the relative values may be overcome with reliable professional advice. Allocation is a well-recognized accounting technique and could be applied in this case once reliable estimates of the relative values are known. If the convertible feature was added in order to sell the security at an acceptable price, the value of the convertible option is obviously material and recognition is essential. The question of whether or not the purchaser will exercise the option is not relevant to reflecting the separate elements at the time of issuance.

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