March 21th, 2011

Under GAAP, issuers of convertible bonds can account for inducements to convert them into stock as an expense. But the IRS calls them a nondeductible dividend.

Issuers of convertible debt that has fallen “out of the money” (the conversion price is more than the applicable stock price) sometimes want to encourage conversion of the debt into its equity securities anyhow. To do that, they can provide an incentive, lasting for a brief period, for holders of the debt to exercise their conversion privilege.

Frequently, this inducement will take the form of a temporary lessening of the conversion price (and consequent increase in the “conversion ratio,” which determines how many shares can be converted from each bond). Less often, the issuer may transfer cash or other property to those holders who can be persuaded to exercise the conversion privilege.

The financial-accounting and federal income-tax consequences of these arrangements differ quite significantly. Statement of Financial Accounting Standards No. 84, Induced Conversions of Convertible Debt, addresses the financial-accounting ramifications of such arrangements.