Accounting for Convertible Bonds : Current Practices and Proposed Changes

Convertible bonds are financial instruments used by corporations to raise funds. Investors buy them for both their return and potential equity feature. To make the bonds more attractive to investors and to lower the bond interest rate, the corporations give investors the opportunity to receive equity shares at a time of their choosing during the life of the bonds. According to the generally accepted accounting standards issued by the Financial Accounting Standards Board, convertible bonds in the U.S. are accounted for as bonds, ignoring the equity option imbedded in these instruments. In the rest of the world, convertible bonds are accounted for according to the international financial reporting standards of the International Accounting Standards Board. Under international financial reporting standards, convertible bonds are bifurcated into liability and equity components. Should the U.S. standards change? Will such a change result in financial statements that are more transparent and representationally faithful? This paper aims to answer these questions and propose recognition, measurement, and reporting procedures that will implement the answers