Book Value Method
The financial accounting term book value method refers to one of two approaches to valuing a transaction involving the conversion of bonds to common stock. The book value method uses the current book value of the company’s bonds when recording the transaction.
Companies will issue convertible securities for a number of reasons. For example, convertible bonds and preferred stock may include this feature to attract investors, since the ability to convert these securities to common stock lowers their perceived risk.
When a company issues convertible debt securities, they need to assign a value to the transaction when the holders of these securities convert them into shares of common stock. There are two accepted ways to value this transaction, the market and the book method.
The book method uses the carrying value of the bonds to record the transaction. While this approach is helpful when the market price of the company’s common stock or bonds is not readily available, proponents believe it should be the only method used. It’s argued that when the convertible securities were first issued, the value of the securities were equal to the face value of the bond or the shares of common stock, if converted.
For this reason, strict theorists believe the company should not record a gain or loss when converted. Typically, investors would not convert these securities unless the value of the company’s stock received was significantly higher than the face value of the bond. If the market value method is used, this transaction would result in a loss that flows to the income statement. For all of the above reasons, the book method is a popular approach to recording transactions involving convertible securities.
Company A’s convertible bonds have a face value of $1,000 and a book value of $1,025. Bondholders have the right to convert this security to fifty shares of Company A’s common stock, which is currently selling for $22.00 per share. The par value of Company A’s stock is $1.00 per share.
The book method does not recognize a gain or loss on the conversion of securities; therefore, the following journal entry would be used to record this transaction:
|Premium on Bonds Payable||$25|
|Paid-In Capital in Excess of Par||$975|
Even though the market value of the common stock provided to the investor is $1,100 (50 shares x $22.00 per share), the book value of the bonds is used to value the transaction.