ABC Corporation, a growing tech company, decides to raise capital by issuing convertible debt securities. Convertible debt allows bondholders the option to convert their debt into a predetermined number of common shares. This case study explores the accounting treatment of convertible debt, emphasizing the impact on financial statements and the complexities involved.

Step 1: Issuance of Convertible Debt

Convertible Debt Terms: ABC issues $10 million in convertible debt with a 5% interest rate and a conversion option allowing bondholders to convert each $1,000 of debt into 50 common shares.

Step 2: Initial Accounting and Financial Reporting

Classification as Liability and Equity: The convertible debt is bifurcated into liability and equity components. The liability component represents the present value of future interest and principal payments. The residual, representing the conversion option, is classified as equity.

Recognition in Financial Statements: The liability component is recorded on the balance sheet at fair value, and the equity component is recorded as a direct increase to shareholders' equity.

Step 3: Ongoing Reporting and Conversion Events

Interest Expense Recognition: ABC records interest expense on the liability component over the life of the convertible debt at the stated interest rate.

Conversion Events: When bondholders exercise the conversion option, ABC adjusts the liability and equity components based on the fair value of the common shares issued.

Step 4: Dilution and Impact on Earnings per Share (EPS)

Dilution Considerations: The conversion option introduces potential dilution to existing shareholders when bondholders convert debt to equity.

Impact on EPS: ABC calculates diluted EPS, considering the potential impact of converted shares on earnings per share. This calculation reflects the hypothetical conversion of all convertible debt.

Case Study Question: How is the equity component of convertible debt classified in the financial statements?