Simplified Accounting for Convertible Bonds

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Convertible bonds are complex financial instruments. However, the accounting treatment for convertible bonds has been simplified.

The Financial Accounting Standards Board (FASB) released new guidance last month on accounting for convertible instruments and contracts in an entity’s own equity…

Convertible instruments are debt or equity instruments (or features) that either require or permit the investor to convert the instrument into equity securities of the issuer. The accounting treatment for such instruments depends on the underlying terms and conditions, including the manner in which the instrument is settled upon conversion. Some convertible instruments are settled upon conversion entirely in shares, some in a combination of cash and shares, and less commonly, entirely in cash. The terms and conditions may mandate a settlement method, or the reporting entity may have its option.

In addition, many convertible instruments contain a number of provisions, such as put and call options, or contingent interest features, which should be assessed to determine whether the features should be bifurcated and accounted for separately. Read more

How to price a convertible bond

A convertible bond is a hybrid security, part debt and part equity. Its valuation is derived from both the level of interest rates and the price of the underlying equity. Several convertible bond pricing approaches are available to value these complex hybrid securities such as Binomial Tree, Partial Differential Equation and Monte Carlo simulation. One of the earliest approaches was the Binomial Tree model originally developed by Goldman Sachs and this model allows for an efficient implementation with high accuracy. The Binomial Tree model is flexible enough to support the implementation of bespoke exotic features such as redemption and conversion by the issuer, lockout periods, conversion and retraction by the share owner.

Binomial Tree approach for valuing a convertible debt can be implemented in Excel or Python.

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