Question

Some financial instruments can have both debt and equity features. The most common example is convertible debt—bonds or notes convertible by the investor into common stock.

A topic of debate for several years has been whether:

issuers should account for an instrument with both liability and equity characteristics entirely as a liability or entirely as an equity instrument depending on which characteristic governs; or

issuers should account for an instrument as consisting of a liability component and an equity component that should be accounted for separately.

Which of the two options do you favor and why? Develop and explain your argument. In considering this question, you should disregard the current position of the FASB on the issue. Instead, focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by GAAP. Also, focus your deliberations on convertible bonds as the instrument with both liability and equity characteristics.

Answer 1

Answer:

Arguments brought out in the FASB DM include the following:

Arguments supporting view 1:

The individuals who support representing convertible obligation as completely a risk until the point that it is either changed over or reimbursed contend that a convertible bond offers the holder two totally unrelated decisions. The holder can't both reclaim the bond for money at development and change over it into basic stock. They battle that the bookkeeping before transformation or other settlement ought to reflect just the guarantor's present position as a borrower and the holder's present current position as a loan boss. Until the point when the change alternative is excercised , the bondholder is qualified for get, and the endeavor is committed to pay, just the occasional intrigue installments. In the event that the choice has not been excercised at the date the bonds develop, the guarantor is committed to pay the face sum, not to issue stock to the holder. Promoters of representing convertible obligation as per its administering characteristics contend that a convertible bond is a solitary instrument, not two. To represent it as two instruments would not be illustratively faithful.(par.295)  

Arguments supporting perspective 2:

The individuals who support isolate acknowledgment of the obligation and value parts of convertible obligation contend that to disregard the existence of the risk of the change highlight in perceiving the issuance of the bond brings about exaggerating the obligation and comprehension the interest expense. The impact of the transformation include is to bring down the rate for generally practically identical straight debt.(par 333)