Convertible bonds and stock options are two financial instruments that companies use to raise capital or compensate employees. Both can be converted into equity, which means they impact a company’s financial statements, including the balance sheet, income statement, and earnings per share (EPS).
A convertible bond is a type of debt instrument that allows bondholders to convert their bonds into a specified number of shares of common stock. These bonds provide investors with fixed interest payments while giving them the opportunity to benefit from potential stock price appreciation.
📌 Key Features of Convertible Bonds:
✔ Can be converted into shares at a predetermined price
✔ Carry a lower interest rate than regular bonds, since investors get potential upside from conversion
✔ Dilute existing shareholders when converted into equity
When issued, convertible bonds are recorded as a liability (like regular bonds). However, under IFRS, part of the bond is classified as equity since it includes an option to convert.
📌 Example: Issuing a Convertible Bond for $100,000
Cash $100,000
Convertible Bonds Payable $90,000
Equity – Conversion Option $10,000
If the bondholder decides to convert the bond into shares, the company removes the bond liability and increases equity.
📌 Conversion Example (Bondholders Convert to Stock):
Convertible Bonds Payable $90,000
Common Stock $90,000
This conversion removes debt and increases equity, improving the company's leverage ratios.
Stock options give employees or executives the right to purchase company stock at a predetermined price (exercise price). They are used as an incentive for employees to stay with the company and contribute to its growth.
📌 Key Features of Stock Options:
✔ Employees must wait for a vesting period before exercising options
✔ If the stock price rises, employees benefit from purchasing at a lower price
✔ When exercised, options increase the number of shares outstanding, leading to potential dilution
Under accounting standards like IFRS and US GAAP, companies recognize compensation expense for stock options over the vesting period.
📌 Example: Issuing Stock Options Worth $20,000 (Over 4 Years)
Each year, the company records:
Stock Compensation Expense $5,000
Additional Paid-in Capital (APIC) $5,000
When employees exercise the options, the company receives cash and issues new shares:
Cash $50,000 (e.g., 1,000 shares at $50 per share)
Additional Paid-in Capital $5,000
Common Stock $55,000
📌 Balance Sheet:
✔ Convertible bonds appear as long-term liabilities until converted into equity
✔ Stock options do not appear as liabilities, but they increase equity (APIC) when exercised
📌 Income Statement:
✔ Stock option compensation expense reduces net income
✔ Convertible bonds may lead to interest expense, affecting profitability
📌 Earnings Per Share (EPS):
✔ If convertible bonds are converted into shares, the number of outstanding shares increases, reducing EPS (dilution effect)
✔ Stock options also increase outstanding shares when exercised, impacting diluted EPS
✔ Convertible bonds start as debt but can turn into equity, reducing liabilities and increasing shares outstanding.
✔ Stock options create compensation expenses and can dilute ownership when exercised.
✔ Both instruments affect EPS, making financial analysis more complex.
✔ Companies use convertible bonds to raise funds at a lower interest rate and stock options to attract and retain employees.
Understanding these financial instruments helps investors and analysts evaluate a company's future financial health and potential risks related to dilution and debt management.