In Chapter 9 we outline the accounting for convertible securities under U.S. GAAP, showing that the accounting is deficient by creating an off-balance liability for the potential loss to shareholders from the conversion into common equity. Indeed, on page 263 we give examples in the Vignette of convertible bond issues with zero coupon where it looks like a firm is getting financing without interest. The effective borrowing cost to shareholders is in the loss on conversion from issuing stock at less than market price, but that is not reported.
We were remiss in not explaining why there is no apparent interest cost for the zero coupon convertible bonds mentioned in the Vignette. In normal times when interest rates are above zero, such coupon bonds are issued at a discount. Under both US GAAP and IFRS, when bonds are issued at a discount, the discount is amortized over the life of the bond at the effective interest rate. Hence an interest expense is recognized each year for zero coupon bonds when they are issued at a discount.
For bonds issued at a discount under both US GAAP and IFRS, the book value of the bond is transferred to equity at the conversion date But there is no additional recognition of the loss incurred from issuing shares at less than the market price. Further, since the book value of the bond when it is converted depends on the amount of interest amortized in previous years, the accounting credits equity with the interest expense recognized in previous years, effectively eliminating the cumulative interest cost from the book value of equity: Again, borrowing without affecting shareholders’ equity.
The Vignette refers to bonds issued in an unusual year, 2021, when interest rates were close to zero and at times even negative. Hence, the bonds were issued at (close to) par with no discount. Therefore, under both the US GAAP and IFRS accounting described above, no interest expense would be recorded for zero coupon bonds issued at par (the effective interest rate is zero).
Technically, IFRS is a little different from US GAAP in its general treatment of the convertible component of a convertible bond. IFRS requires the separation of an equity component representing the conversion option. (In rare cases US GAAP also requires the recognition of an equity component. This happens when there is a so-called beneficial conversion feature – or BCF – when the conversion price is less than the equity market price at issuance.) However, the equity component is only defined as the residual obtained after subtracting the liability (straight bond) component from the issue proceeds. When interest rates are zero, e.g., in 2021, the liability equals the proceeds and there is no residual to be recognized in equity due to the conversion option. Therefore, there would still be an off-balance sheet liability with no interest cost.