## Wednesday, October 12, 2011

### Reporting The Retirement Or Conversion of Bonds

CFA Level 1 - Liabilities

A company that retires its bond at maturity will issue to bondholders the last interest payments, if any, and the face value of the bond. At that time the book value of the bond will equal the face value.

Journal entry

Retiring Bonds Prior to Maturity

Sometimes bonds can be retired before they mature. They can be retired, or if they are convertible bonds, they can be converted to another form of securities such as common stock.

If a company retires a bond prior to maturity, the stated book value (or carry value for a discount or premium bond) will most likely be the same as market value for which the company repurchased the bond. This difference creates an extraordinary gain or loss for the repurchasing company. This gain or loss is classified as extraordinary because it is non-recurring in nature. Extraordinary gains and losses are reported on the income statement below the operating line net of taxes.

Remember: carrying value is computed as:

Formula 9.5

Bonds Payable at par         Bonds Payable at par
- Unamortized Discount    +  Unamortized Premium
Carrying Value                 Carrying Value

To compute the gain or loss, compare the carrying value of the bonds with the amount we pay to redeem the bonds.

Formula 9.6

Carrying Value - cash paid to retire bonds = gain or loss on bond retirement

Look Out!

If the carrying value is greater than the cash paid, there is a gain on the bond retirement.

If the carrying value is less than the cash paid, there is a loss on the bond retirement.

Journal entry:
A company retires a bond with a \$1m face value early for \$1.2m and creates a loss of \$200,000.

Converting Bonds Into Common Stock
Some bonds can be converted or exchanged into common stock. Under SFAS 14 the convertible feature of a bond is completely ignored when the bond is issued, and it is considered only when it is converted into equity. The effect of a conversion of a bond into common stock is a decrease in liabilities for the carrying value of the bond and an increase in stockholders' equity for an amount equal to the bond carrying value. Gains or losses on bond conversion are not recognized. Any difference between the carrying value of the bond converted and the par value of the new shares issued is recorded in the account called "contributed capital in excess of par value". The market value of the common stock is ignored.

Example: Bondholders converted \$20,000 worth of convertible bonds into the issuer's \$5-par common stock. Each \$1,000 bond is can be converted into 10 shares of common stock. The carrying value of the bonds at the time of conversion is \$21,500.

First we need to compute the carrying value of the bonds converted
Carrying value = bonds payable + bond premium = \$20,000 + \$1,500 = \$21,500

Then we calculate the number of bonds converted
Number of bonds converted = \$20,000/\$1000 = 20 bonds

Then we calculate the number common shares to be issued?
Number of common shares = 20 bonds * 10 shares = 200 common shares

Then we calculate the contributed capital in excess of par value
Contributed capital in excess of par value = carrying value of the bond - par value of the new shares = 21,500 - (200*\$5) = \$20,500

Journal entry

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