Question

Explain the meaning of each of the following terms as they relate to a bond issue: (a) convertible, and (b) callable. Also, provide an example of each and the journal entries involved in each transaction.

Answer 1

(a)Convertible Bonds

          Convertible bonds are types of bonds that the bond holders can convert the bond into specific number of shares of the common stock of the company or it can be redeemed for cash in future. It is hybrid instrument with debt and equity feature. Conversion of bonds into equity can be done on the life of the of shares bond the discretion of the of the holder. The rate which tells about the number of shares are issued for bond is known as conversion ratio.

Example: Company issues shares bonds of face value $1000 and converts to share of commons stock. Conversion ration 10 shares for a bond. Bonds are issued at 2% discount. Par value of the shares issued is $10.

Accounting entries as follows,

          On issuance of Bond

          Cash A/c Dr                                                            980

        Discount on Bond Payable A/c Dr                20

                           To Bond Payable A/c                      1000

         

          Conversion on future Date

          Bonds Payable A/c Dr                              1000

                   To Common Stock Account A/c                       100

                   To Securities Premium A/c                      900

(b) Callable Bonds

Callable bonds are type of bonds in which the issuer has the right to redeem the bond at any point of time before the bond reaches the maturity. Issuer of the bond is provided with certain embedded right not the obligation. When a bond is called by the issuer, he pays to holder with the call money along with the accrued interest on the bonds. Issuer may prefer to call a bond when current market rate falls below the bond interest rate

There three type of call options:

· Optional Redemption

· Sinking Fund Redemption

· Extraordinary Redemption

Example: Company issues shares bonds of face value $1000. Bonds are issued at 2% discount. Maturity of the Bond 5 years at the end of the second-year   bonds are called.

         

          Accounting entries as follows,

          On issuance of Bond

          Cash A/c Dr                                                            980

        Discount on Bond Payable A/c Dr                20

                           To Bond Payable A/c                      1000

At the time of Calling of bonds

Bonds Payable A/c Dr                              1000

    To Cash A/c                                                    1000

Note: The bonds are required to pay periodic interest at specified rates at the time.