Communication Case 14-3 ls convertible debt a liability or is it shareholders\'

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Communication Case 14-3 ls convertible debt a liability or is it shareholders' equity? Group Interaction 014-5 2 Some financial instruments can be considered compound instruments in that they have features of both debt and shareholders' equity. The most common example encountered in practice is convertible debt-bonds or notes convertible by the investor into common stock. A topic of debate for several years has been whether: View 1: Issuers should account for an instrument with both liability and equity characteristics entirely as a liability or entirely as an equity instrument depending on which characteristic governs .View 2: Issuers should account for an instrument as consisting of a liability component and an equity component that should be accounted for separately In considering this question, you should disregard what you know about the current position of the FASB on the Page 82-5 issue. Instead, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by GAAP. Also, focus your deliberations on convertible bonds as the instrument with both liability and equity characteristics Required 1. Which view do you favor? Develop a list of arguments in support of your view prior to the class session for which the 2. In class, your instructor will pair you (and everyone else) with a classmate (who also has independently developed an a. You will be given three minutes to argue your view to your partner. Your partner likewise will be given three case is assigned argument) minutes to argue his or her view to you. During these three-minute presentations, the listening partner is not permitted to speak. b. After each person has had a turn attempting to convince his or her partner, the two partners will have a three-minute discussion in which they will decide which view is more convincing. Arguments will be merged into a single vievw for each pair 3. After the allotted time, a spokesperson for each of the two views will be selected by the instructor. Each spokesperson will field arguments from the class in support of that view's position and list the arguments on the board. The class then will discuss the merits of the two lists of arguments and attempt to reach a consensus view, though a consensus is not necessary

Explanation / Answer

View 2 --- to account for the issue with both liability & equity component-- will be more appropriate Conversion feature is added to the bond issue for the purpose of selling the bonds faster So, from the outset,the issuing company is aware that these Convertible debts are going to cost (interest costs) lesser than debts issued without any conversion feature. Regular interest expenses are going to be lesser, for the entire duration of the bond--hence yearly profits are going to be higher adding to retained earnings ,for the existing shareholders   Ownership is ensured for the buyer of the bond In the event of the buyer choosing the conversion option,no.of common shares outstanding will go up , thus, Earnings per share(EPS) will go down. All the above being the case, it is only proper that difference between the present values of the bond without the conversion feature & with the conversion feature should be treated as that due to the equity assurance ,in future. So, a fair representation would be to include both the liability component & the equity component.

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