THE LIABILITY OR EQUITY CASE (PART I) 

 

"It's a debt! It's an equity! It's, it's...!" 

 

Kids & Co., a medium-sized toy manufacturer, issued convertible bonds with a face value of $50 million. Each of the 50,000 bonds was issued at its face value of $1,000. The coupon interest rate, payable semiannually, is 7.8 percent. Except for the interest rate and the conversion feature, all of the terms of the convertible bond are the same as the terms of outstanding issues of otherwise comparable nonconvertible debt. The market interest rate for otherwise comparable nonconvertible debt is 10 percent; in that interest rate environment, similar debt with the same face value could have been issued for approximately $40 million. 

 

The controller, Barb E. Dahl, asked her new staff accountant, Ted E. Baer, to prepare the entries to record the issuance of the convertible bonds. Two days later, she was surprised to discover that Ted was struggling to prepare the entries. When asked what the problem was, Ted responded that he could not decide whether a portion of the $50 million issuance proceeds should be attributed to the conversion feature.

 

QUESTION: Should Kids & Co. account for the convertible bonds as a straight debt instrument, or should it account separately for the debt and conversion feature components?