Convertible securities are the securities that can be converted by the holder of the security in the equity of the business entity from which the security is purchased. Convertible security is mostly treated as a debt instrument. When conducting accounting for the convertible security a few of the following steps are taken that can be explained as under:-
- In the first step the Additional Paid In Capital Account is credited with the proceeds from the convertible securities
- The proceeds amount depends upon the amount of intrinsic value that the date of issuance.
- The difference of the conversion price and the fair value of the stock is termed as the intrinsic value of the stock and the difference is multiplied by the number of shares into which we can convert the security.
- If the convertible security contains discounts at which the conversion can occur then the investor must choose that discount which is more profitable for the investor
An example of convertible security can be presented as under:-
Say a company XYZ has a convertible security of $900,000. The date of conversion is three years after the issuance of the security at the price of $ 12 that is the conversion price of the security. The fair value on the issuance of the security and the price of the security are the same that is $12. The conversion agreement shows that the conversion price will decline to $9 if the company doesn’t go public and the share price reaches 15 dollars within three years. Now calculation shows
Number of issuable shares = debt issuance amount / conversion price
= 100,000 shares
Variance = Initial conversion price – declined conversion price
Intrinsic Value = 3x 100,000 = $300,000
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