CONVERTIBLE SECURITIES DEBT OR EQUITY?
LEVIS DUVAL McCULLERS
A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY
UNIVERSITY OF FLORIDA
The author wishes to express his appreciation to the members
of his supervisory committee, Dr. J. W. DaVault, Dr. C. W. Fristoe,
Dr. F. 0. Goddard, and Dr. J. H. James, for their helpful suggestions
and encouragement during the course of this study. In addition,
Dr. Fristoe and Dr. James have served as advisors to the author
from the time he entered the University of Florida and he appreciates
Special acknowledgment is given to Dr. Williard E. Stone, the
chairman of the supervisory committee. His encouragement, penetrating
insight, availability and overall supervision contributed greatly
to the successful completion of this study and made it a worthwhile
and rewarding experience for the author.
To Sharon, Theresa, Suzanne, Nora, and Marion, the women
and loves of my life, no words are adequate to express my gratitude.
TABLE OF CONTENTS
ACKNOWLEDGMENTS .............................................. i i
LIST OF TABLES................................... ............. v
1 I INT r.ODrUCT I i ...........................................
Significance ....................... ..... ................
O bj c t i.'ve s .. ... .. ................ .. ......... .......... 4
Me t hodo og,. .......................... ................... 4
Organ iza tion ............................................. 5
2. THE ROLE OF CONVERTIBLE BONDS AND
PREFERRED STOCKS IN FINANCIAL MANAGEMENT ............... 10
General Characteristics................................. 10
RP.la i'.'e Imiiportunce of Convertible Offerings ........... 15
Reasons for Issuing Convertible Securities............. 18
The Use of Convertibles When the
Firm W\1.nts DebL- or Preferred Stock................ 18
The Use of Convertibles When the
Firr. \lIar l-u. ,nimon Equity Capital .................. 24
AdJ;tional Pea'son-, for Buying Convertible
Securities........ ......................................... 37
Bonds v.s. Freferred Stock............................... 39
3. THE ACCOUNTING FERSPECTIVE ............................. 50
SeleLc-c. d Geceral Theories of Accounting ................ 54
Con'.'e rtible Securities from the Accounting
V ew i n t .............. ........ . .................. 65
Opinions of Lhc Ac .ournting Principles Board............. 70
4. DEBT \EF.SUG EQUITY ........................................ 83
Criteria for C1;a sification as Debt or Equity.......... 86
a rs ; ni ry ...... .................................. 86
Leqa! Sittus .nd Investment Character ............ 88
Di lution of F:rnings Per Share ................... 89
westor.'r, Senlor Versus Residual
Cl s if i cation ............................ .... ..... 90
TABLE OF CONTENTS (continued)
Maturity Value and Maturity Date................... 91
Legal Distinction .................................. 9 1
Value of Interest.................................. 94
Eventual Conversion or Liquidation................. .95
Some Other Factors ................................. .95
Consolidated Set of Decision Factors................... 96
5 EMPIRICAL DATA ON CONVERTIBLE SECURITIES ............... 101
Eva lua t io n ............................................. 127
Maturity Date....................................... 127
Claim on Assets.................................... 138
Claim on Income.................................... 140
Voice in Management................................ 141
Maturity Va lue ..................................... 14 1
Intent of the Parties.............................. 144
Pre-emptive Right.................................. 148
Name of Security.................................... 149
Conversion Features................................ 150
Potential Dilution of Earnings Per Share........... 150
Right to Enforce Payments ......................... 153
Good Business Reasons for Issuing.................. 154
Identity of Interest Between Creditors
and Owners.............................................. 156
6 SUMMARY AND COHCLUSIONS ................................ 160
A PPEND IX .............................................. ... 179
BIBLIOGRA PHY .................................................. 183
BIOGRAPHICAL SKETCH........................................... 187
LIST OF TABLES
2-1 OUTSTANDING CONVERTIBLES 1948-66 17
5-1 NEW BOND ISSUES 1968 102
5-2 ISSUE SIZE AND TOTAL AMOUNT OF 75 CONVERTIBLE
5-3 RISK RATING OF BOND ISSUES 105
5-4 INTEREST RATES WITH AND WITHOUT CONVERSION
5-5 CUtIULATIVE PROVISION OF CONVERTIBLE PREFERRED
5-6 PURPOSE OF CONVERTIBLE PREFERRED STOCKS 109
5-7 AVERAGE YIELD OF CONVERTIBLES VS. COMMON 110
5-3 STRAIGHT DEBT VALUE OF CONVERTIBLES 112
5-9 tIARKET V,\LUE OF CONVERTIBLE BONDS
DECEIIBER 13, 1968 113
5-10 COr1VERSI ON PREMIUM 115
5-11 IrCREASE IN COMMON STOCK UPON FULL
COr!VERS ION 117
5-12 CAIL PROVISION OF CONVERTIBLE SECURITIES 119
5-13 CALLED CONVERTIBLE BONDS 1968 120
5-14 TlllING OF CONVERSION BONDS 122
5-15 TIIIING OF CONVERSION PREFERRED STOCKS 123
5-16 COTlMENTS ABOUT CONVERTIBLE ISSUES 124
5-17 SI Il:IHG FUND PROVISION 126
5-18 RIGHTS OFFERING 126
5-19 1MATUR'ITi' DATES 137
LIST OF TABLES (continued)
5-20 PRIMARY MOTIVATION FOR ISSUANCE OF
A CONVERTIBLE SECURITY 145
Si f i chance
The significance of this study is based primarily upon the
croml-onl accounri.gl convention of classification. The usual statement
of financial psi tion shows accounts placed in major categories
of thie follr,, inr g pattern: on the left-hand side assets, with sub-
cla.S,1ifc icti ons of current assets, investments, intangible assets,
and fix.-d a;.ss t ; on the right-hand side, equities, divided into two
iiajor cate-ories, liabilities and owner's equity, with the liabilities
further classified into current and long-term. Despite some widespread
dis.ao-reeient aoin::gn accountants as to where a particular item should
be sho',.n on iLh. stLdcement of financial position, any system of
cla.jssificctior inrJicates that the data to be classified has certain
discernible characteristics which support the selected classification.
Theref-ore, it is important that accountants be able to point to the
sii lar r o.- Jis.imilar characteristics of other accounting data
iih;'-l result in i..Kjrticular classification and to the factors which
(.d Liii guish one classification from another. For example, current
iiabili ies. are .. isLinguished from long-term liabilities on the basis
of tii -c. CurrenL liabilities are those which are payable within one
year o- o.er.'.ing btisiness cycle of the firm. Therefore, an account
uliich is. du-. in '0 cays, for example, is classified as a current
l;ab i li i L,.
While many accounting transactions are not nearly so easily
classified as the above illustration, most of the grey areas have been
sufficiently discussed and debated that a general, though far from
unanimous, consensus has been reached as to the controlling characteris-
tics for classification purposes. However, convertible securities
represent an area which appears to have almost complete agreement
among accountants as to classification but which has had little
discussion about its characteristics. Thus, convertible securities
seem to have been traditionally classified according to the following
rationale. If a convertible security is a convertible bond then the
word "bond" is the clue that this is a liability because bonds
generally are liabilities. Likewise, if the convertible security is
convertible preferred stock then the word "stock" indicates that this
is a part of owner's equity because stock is normally classified as
owner's equity. The name, not the characteristics, is the controlling
This study also has significance for the more basic question of
the appropriateness or necessity of distinguishing between liabilities
and owner's equity, and, assuming that a distinction is necessary,
the factors which should be evaluated in making that distinction.
Accounting journals and textbooks contain frequent reference to the
entity concept, which is expressed as the need to account for the
activities of the business apart from the activities of the owners.
This is considered to be a basic concept or postulate of accounting.
Yet, the common classification patterns, with the major breakdown
between liabilities and owner's equity, are a rather clear manifes-
tation of the proprietary concept.
It is not intended, nor is it within the scope of this study,
to make any normative judgment concerning the merits of these basic
concepts of accounting. Nevertheless, it will be useful to show
how convertible securities, and for that matter all accounts on the
equity side of the statement of financial position, are directly
influenced by the choice of which concept to follow and the particu-
lar interpretation of the selected concept.
The study will proceed on the assumption, which will be treated
later, that the proprietary concept is the concept generally followed
by accountants. According to that concept creditors and owners
are significant ly', different. Therefore, the characteristics of
transactions which determine their classification are of major
significance. The entire debt and capital structure of the business
is affected b, the evaluation of those characteristics.
The study i. also timely as a result of recent actions by the
Accoun ting Prin,.iples Board of the American Institute of Certified
Public Accountants. In December, 1966, the Board issued an opinion
which stated that under certain conditions a prescribed portion
of the price of convertible bonds should be classified as paid-in
capital. After one year, in which there was still little discussion
in the accouint;rng literature, the Board suspended the previous
opinion, at the request of several large investment bankers, while
it conducted further study. After another year the Board issued
a new opinion which renounced the 1966 opinion.
There are two major objectives of this study. The first
objective is to test the hypothesis that convertible bonds and
convertible preferred stocks have sufficient common characteristics
for them to be placed in the same major position statement classi-
fication rather than being classified as debt and owner's equity,
respectively. The second objective is to test the hypothesis that
both convertible bonds and convertible preferred stocks should be
classified as equity rather than debt. In order to test these two
hypotheses it will be necessary to establish the characteristics of
convertible securities and the factors to be considered in deter-
mining whether a transaction is debt or equity. These two points
may be considered as additional objectives, or as a part of the two
This study will begin with a search of the literature of
accounting, corporate finance, and security analysis in an effort
to determine the underlying rationale of convertible securities.
The next step will be to establish, from accounting, finance, and
legal sources, the factors to be tested in determining the debt or
equity nature of a financial interest. The various financial
statistical publications and the Standard and Poor Compustat tape
will be.used for the purpose of collecting empirical data concerning
convertible securities. The data thus collected will be evaluated
on the basis of the factors prescribed for determining debt or
There have been other empirical studies conducted in the past
which were primarily concerned with why convertibles were issued and
the volume of such issues. This study is much less concerned with
why they are issued than with the nature of such securities, but,
those studies will be referred to in establishing the rationale of
convertibles and for comparison with the current characteristics of
Once the data has been accumulated and evaluated on the basis
of the test factors it should be possible to draw certain conclusions
concerning the staAed hypotheses.
This is ani accounting-oriented study which is primarily concerned
with dcterr-ining the appropriate statement of financial position
classification of convertible securities. Accounting treatment rules,
however, are not developed in isolation from other disciplines and
in the case- o con.'crtible securities it seems particularly appropriate
to consider he views of writers in the areas of corporate finance and
security analysis. These writers have long discussed convertible
securities, whereas accounting writers until recently have given
only brief mention to them. Therefore, Chapter 2 will provide a
summation of the views expressed by several writers in order to
develop the underlying rationale for issuing securities convertible
into common stock.
Chapter 2 will serve to establish the general characteristics
of convertible securities, their relative use as a source of new
capital for the corporation, the asserted reason or reasons for
issuing such securities, and from the investor's standpoint the
reasons for buying convertibles. Included in the discussion of those
factors will be some reference to the comparative cost and risk
involved in issuing convertibles as compared to non-convertibles.
In addition to the development of general characteristics
which will be drawn upon and evaluated at a later point, Chapter 2
will include a test of the hypothesis that convertible bonds
and convertible preferred stocks have sufficient common characteris-
tics for them to be placed in the same major classification on the
statement of financial position.
Chapter 3 will be concerned with establishing the accounting
perspective of convertible securities. A study of the characteristics
of those securities in an effort to determine whether they should
be classified as debt or equity would obviously have no value in an
accounting system which does not make a distinction between debt
and equity. Therefore, it will be necessary to review the more
important aspects of the two most popular general theories of ac-
counting, the entity theory and the proprietary theory, and the
various interpretations of each, in order to determine the signi-
ficance, if any, of classification. Evidence will be presented to
show which of the theories is most commonly adhered to by practicing
The views of the Accounting Principles Board will be given
particular attention in Chapter 3. During the past two years the
Board has issued a series of opinions dealing with convertible
securities from the standpoint of earnings per share calculations
and the treating of a portion of the proceeds of a convertible
bond issue as paid-in capital on the statement of financial position.
The views of the Board will constitute a major portion of the dis-
cussion of accounting views because, as has been suggested, account-
ing writers generally have given only brief mention to convertible
securities. The views of other writers, however, will be incor-
porated into the study as a supplement to the views of the Board
In order to make a valid and supportable judgment concerning
the classification of convertible securities as either debt or equity
on the statement of financial position it is necessary to understand
what constitutes debt and equity. Statements of financial position
have long reflected the major categories of liabilities and owner's
equity. The implication is that accountants, as well as others
involved in the preparation of such statements, have sufficient
knowledge to recognize which category is appropriate for a particu-
lar transaction and that the factors to be evaluated in determining
debt or equity have been well established.
Chapter 4 will be devoted to a study of accounting, finance,
and legal sources in order to determine whether there is presently
an agreed upon set of factors which distinguish debt from equity.
If not, such a set will be tentatively developed to serve as a
frame-of-reference for the collection and evaluation of empirical
data relating to convertible securities, which is the purpose of
In addition to collecting evidence to support a particular
classification on the basis of the framework established, Chapter 5
will also be concerned with relating the empirical data to the
asserted characteristics described by the finance writers in
Chapter 2. Therefore, it will be necessary to make a determination
of such factors as comparative risk and yield between convertibles
and non-convertibles, the comparative cost to the corporation and
management intent with respect to the securities as evidenced by the
prescribed conversion terms, the potential increase in common stock
upon conversion, and the speed with which conversion occurs.
Once the characteristics of convertible securities have been
established and the data concerning those securities collected and
evaluated on the basis of the test for debt or equity, some conclusions
about the hypotheses should be possible. Chapter 6 will serve to
summarize the study and to draw those conclusions.
THE ROLE OF CONVERTIBLE BONDS AND
PREFERRED STOCKS IN FINANCIAL MANAGEMENT
The purpose of this chapter is to bring together the view-
point of several writers in the field of corporation finance and
security analysis along with some theoretical and empirical support
for those viewpoints. This information will provide worthwhile
background and support for later parts of the study. Since this
study of convertible securities is primarily concerned with the
accounting implications of those securities, it appears that a com-
prehensive evaluation of corporation finance and security analysis
is not necessary.
Corporate securities which are convertible into another form
are by no means new. According to Dewing they have existed almost
from the beginning of corporate enterprise. He points out that
while there are no characteristics common to all such securities,
that "Generally speaking, however, convertible securities are issued
in a more secure, less speculative form--a form of security with a
fixed or limited income return--and are convertible at the owner's
request and under certain clearly specified conditions into some
less secure, more speculative form of security, carrying the possi-
bility of an increased return." The conversion feature has been
1Arthur Dewing, Financial Policy of Corporations (4th ed.,
New York: Ronald Press, 1941), p. 144.
applied to a wide variety of situations in the past. For example,
bonds convertible into preferred or common stocks, secured bonds
into debentures, preferred stock into common, stock into bonds,
class A stock into class B, etc. However, in the current literature
the term generally refers to bonds or preferred stock which are
convertible into common stock. This is also the general definition
which will be attached to the term throughout this study. The
other types of convertibles are rare exceptions which would have
little, if any, bearing on the outcome of this study.
Contrary to the viewpoint expressed by Dewing, especially
in conjunction with the current general definition, a minimum of two
uni.'.ersal characteristics in addition to the conversion privilege
itself, are apparent in convertible securities. The first is the
presence of financial terms for the conversion of the bonds or
preferred into common stock. Granted, these terms are not
uni-ersally common, however, such securities always have explicit
terms for conversion. The conversion factor may be expressed as a
price or as a ratio. For example, a preferred issue may have the
ccn'.ersion terms expressed as one share of $100 par preferred conver-
tible into common at a price of $50, or as one share of preferred
convertible into two shares of common. Whichever form is followed
the result is the same. That is, the number of shares of common
stock a.%ailable, to the holder upon conversion, per bond or preferred
Three important practical limitations should be noted in
connection with the conversion price or ratio. First, convertibles
are bought and sold on the expectation that the market price of the
common stock will increase; therefore, the conversion price should
be above the existing common stock market price at the time of
issuance. Otherwise the company would be better off selling common
stock directly. In the situation where the corporation believes that
a large issue of common stock would glut the market, thus depressing
stock prices below the then existing level, the conversion price
may be set, as a minimum, at the then existing market price.
The second limitation concerns par value common stock. If the
common stock has a par value it may be illegal to issue it at a price
below par and in any case the holder would be subject to an assess-
ment for the difference. Thus, the conversion price should always
be above the par value of the common stock into which the senior
securities are convertible.
The third limitation is simply that the conversion price should
have a reasonable relationship to market price of the common stock
at the time of issuance. If the conversion price is set so far above
the then existing market price of the common that there is little
expectation that the conversion price will ever be reached, the con-
version feature loses its significance. The corporation might just
as well issue a standard bond or preferred stock because no rational
buyer would be willing to pay a premium for a privilege which is
likely to be unrealizable, at least in the foreseeable future.
The second universal characteristic of convertible securities
is the call provision. This is the right which the corporation has
to redeem the outstanding bonds or preferred stocks after giving
a call notice, usually 30 days. In his survey of convertible sub-
ordinated debentures, Broman found, among other things, that "An
analysis of the call provision indicated it to be a universal part
of the issues studied. In only three cases was there a provision
for a delay in inception." In his opinion the immediate call pro-
vision of convertible bonds provided the corporation with greater
flexibility than would be the case with standard bonds where the
call provision is frequently delayed for several years.
His findings are supported by a survey made by Weston and
Briylhal of convertible bonds issued between 1961 and 1963. They
found that . all the bonds had essentially the same call
provisions--they were callable immediately after issue with the
call premium starting at the coupon interest rate and declining
by percent per year to par."
Keith L. Broman, "The Use of Convertible Subordinated Deben-
tires by Industrial Firms, 1949-59," Quarterly Review of Economics
and Business, Vol. Ill (Spring, 1963), p. 68.
'J. Fredl Watson and Eugene F. Brigham, Managerial Finance
(2nd Ld., He:' York: Holt, Rinehart and Winston, 1966), p. 542.
The call provision of convertible securities has a signifi-
cant use potential which is not present in non-convertible
securities. With non-convertible securities the call provision is
employed by the corporation to redeem outstanding obligations by
the payment of cash. In a later section of this study evidence will
be presented to show that the call provision of convertible securities
may b! used to force conversion of the senior securities into
A third common, though not universal, characteristic of con-
vertible securities is their availability to common stockholders
on a preference basis because of the pre-emptive right of the common
stockholders. This is a well-known right which permits present
stockholders to participate ratably in any new issue of common stock.
They can, thereby, protect their existing voting power, their interest
in the assets and their share in the earnings of the corporation.
Convertible securities present a dilution threat to common stock-
holders and therefore evoke the pre-emptive right. According to
Pilcher, "The pre-emptive right of common stockholders to subscribe
to senior issues convertible into common shares is a time-honored
principle in the United States. Shareholders have a pre-emptive
right to subscribe for convertible obligations to the same extent
that they would have a right to subscribe for the shares of stock
into which securities are convertible." In addition he refers
C. James Pilcher, Raising Capital with Convertible Securitics.
Michigan Business Studies, Vol. XII, No. 2 (Ann Arbor: University of
Michigan, bureau of Business Research, 1955), p. 96.
to a New Jersey case in which the court held that an issue of
convertible bonds amounts to an issue of common stock and, therefore,
the pre-emptive right must be recognized.
It is clear that to the extent that the pre-emptive right is
present for new issues of common stock it is present for convertible
issues. The importance of this right will become apparent once the
purpose of issuing such securities, and the Ex.tent of conversion,
Relative Importance of Con.ertible Offering.
Accounrtantss ha.e long subscribed to the concept of materiality;
therefore before proceeding with this study of convertible securities
it seems appropriate to consider the relati.e importance of those
securities as a source of ne' capital. There is no uniform test of
what constitutes a material fact, thus reliance must be placed upon
subjective e. aluati on nevertheless, several wri ters have concluded,
on the basis of studies conducted, that a significant, ard increasing,
portion of neC capital is raised b/ issuing conertible securities.
One such stud/ was made by Pilcher of all new public offerings
of United States corporate issues over '.300,000 during the period
1933 through 1952. He found that 9.3 percent of all bonds were
convertible vrhl 1e 35 3 percent of preferred stock issues were con-
vertible. For pri'.ate placements, uhich represented appro.xi-mate1y
55 percent of r ll issues, the re:.pect i'.e percentages were 0.5 and
8.2. Thu- pre-.e-iptive right was considered to be an important
factor in accounting for this difference between public offerings
and private placements.5
The above percentages do not tell the whole story since dollar
amount should also be considered. Lindsay and Sametz point out
that for the period 1900-1943 over $9 billion of convertible bonds
were issued. They say that this was "about 12 percent of the total
value of all bond issues.'6 More important, they believe, is the
fact that for industrials, convertibles accounted for 20 percent of
the bond issues. Furthermore:
That proportion has been growing in recent years
as industrials have resorted to income debentures
and subordinated debentures, most of which are
convertible. Probably one third to two fifths
of all industrial bonds issued in recent years
have been convertibles. An average of 14 percent
of all corporate bonds, in dollar amount, issued
between 1955 and 1959 were convertible; in 1959,
26.6 percent of the number of all listed new
issues were convertibles;22 remembering that most
utility issues are not convertible and that rail-
roads issue few new bonds, it is clear that this
26.6 percent of the number of all issues probably
represents well over 50 percent of the number of
industrial issues and over 25 percent of the dollar
amount of all industrial bonds issued.7
This contention is borne out by data selected from the Compustat
tape. Table 2-1 presents information about the number and amount of
5 bid., pp. 5-8.
Robert Lindsay and Arnold W. Sametz, Financial Management: An
Analytical Approach (Homewood: Richard D. Irwin, Inc., 1963), p. 380.
7lbid., p. 380. Their footnote 22 refers to: Forty-first
Annual Report of the National Bureau of Economic Research (New York,
May, 1961), Table 11, p. 65.
OUTSTANDDI II COIIVEFTI BLES
IIUIIBER PERC EIT OUTSTAIID I fJ PERCENT
YEAR OUTSTAID INII TO 19L48 (11 LLIOIS) TO 1948
1948 64 100 626 100
1949 66 103 609 97
1950 60 94 599 96
1951 68 Ou 738 118
1952 75 17 1,070 171
1953 77 120 1,340 214
1954 73 114 1,248 199
1955 75 117 1,377 220
1956 83 130 1,535 255
1957 104 162 2,074 331
1958 115 100 2,126 310
1959 178 2,082 333
1960 13 177 2,013 322
1961 125 195 2,133 342
1962 131 205 2,365 370
1963 139 217 2,545 407
1964 139 217 2,690 430
1965 142 222 2,902 464
1966 163 255 3,701 591
SOURCE: C compiled f r-m n in1Ci ria
of 629 corlpanies. )
icn p r'ic, i ed b C or.pu, u a.
outstanding convertible securities over a nineteen year period.
The data presented is a combination of bonds and preferred stocks.
It does not reflect a comparison of convertibles with non-
convertibles but simply the pattern of growth exhibited by con-
vertibles and was based on a sample of 629 companies.
Reasons for Issuing Convertible Securities
The Use of Convertibles When the
Firm Wants Debt or Preferred Stock
Senior securities which are convertible into common stock have
played a role in corporate financing for a long time and as was
shown in the previous section this role seems to be growing. The
use of such instruments gives rise to several questions. Why do
firms issue such securities? Why not issue straight bonds, preferred
stocks.or common stocks? Are such securities really bonds and
preferred stocks or are they a form of common stock? Why do buyers
like such securities?
There is rather widespread agreement among writers in the
field that a firm sells convertibles for one of two primary reasons.
Either the firm wants to increase residual equity capital and
decides that convertibles are the most advantageous way of bringing
about that result, or, the firm wants to increase its debt or
preferred stock and discovers that the conversion feature is neces-
sary to make the security sufficiently marketable at a reasonable
interest or dividend rate.
Prior to World War II the second reason was the most common
motivation for convertible issues. However, it should be pointed out
that convertibility was not merely a device resorted to by weak
firms. This type of security, as Dewing has stressed, was used by
some of the strongest and most ably managed corporations. Despite
this, the rationale underlying the issuing of convertibles was not
usually the creation of equity capital, rather it was to make the
bonds or preferred stock more attractive, thereby increasing demand
and obtaining a lower interest or dividend rate than would have been
possible without the conversion feature.
E'.en after World War II, according to the survey conducted by
Pilcher, which was referred to previously, it was found that "In
23 per cent of the companies responding to an inquiry, the desire
to 'sweeten' a senior security was cited as the primary motive for
the issuance of a convertible senior security.'' Another 15 percent
of the respondcris asserted that "sweetening" the senior issue and
raising equity, capital were equally important. In contrast to this
38 percent who felt that the conversion feature was necessary to
increase the marketability, Weston and Brigham found, in their
stud,, that "27 per cent used convertibles to sweeten debt issues."10
Dewing, LjP. cit., p. 153.
SPi Ich r, o cit., p. 85.
W10 eston and Frigham, op. cit., p. 542.
There are several other factors which may influence manage-
ment's decision to attach the conversion feature to an issue of
bonds or preferred even though conversion is not desired. The strength
and extent of these factors have not been sufficiently tested empirically
to say with any assurance that they have a certain degree of influence
on the sale of convertible securities. Nevertheless these other factors
should be briefly considered for any insight which they might provide
into the rationale for issuing such securities. The sequence in which
these factors are discussed should not be construed as an attempt to
rank them according to importance.
First, the conversion provision may be used to permit the issuing
company to reduce certain safeguards of senior securities, especially
sinking fund requirements. The use of a sinking fund is fairly common
with bond issues. The seller is required to establish and make regu-
lar contributions to the fund to insure that sufficient money will be
available to redeem the bonds at maturity. The contributions are
pro-rated over the life of the bonds and usually begin immediately
after the sale. On the other hand, when the bonds are convertible
it is not uncommon for the sinking fund contributions to be delayed
for several years if they are required at all.
This last point is suggested by Lindsay and Sametz when they
say that "To provide for retirement rather than automatic refunding
of debt, industrial bonds almost always provide for sinking funds
unless the issue is a convertible debenture.'' Broman does not
Lindsay and Sametz, op. cit., p. 379.
accept this conclusion because in his study of convertible sub-
ordinated debentures he found that a sinking fund was almost always
required. Howre'.'er, he also found that "The usual sinking fund
prov.'ision was less than 100 per cent, and all but one provided some
delay before their operation commenced. The typical delay in the
clauses of those issues studied was for ten or more years.12
Ueston and Crigham give support to the view expressed by
Broman because their study indicated that 88 percent of the converti-
ble bonds contained a sinking fund provision which usually began
after ten years' delay.13
One interpretation of the delay in the sinking fund provision
is that the firm fully expects the bonds to be converted rather
quickly into, commnc. stock. Therefore, there will be no need for
funds at the maturity date. Another possibility is that even though
the firm wants the bonds to remain outstanding it is beneficial to
delay making contributions into a sinking fund until the assets ac-
quired with the proceeds from the bond issue are fully productive
and making a contribution to profits. In addition the delay makes
more funds a-.ailable for current operations than would otherwise
be the case. This may be a significant benefit obtainable only with
the coinv.'-srsiron feature.
Broman, :p. cit., p. 68.
I'leston and Drigham, op. cit., p. 541.
Another reason for using the conversion feature even though
conversion is not desired is the current fashion in capital markets.
At any given time certain kinds of securities or certain provisions
seem to be especially attractive to investors. If investors desire
a convertible security the corporation may have little choice but to
include the conversion feature in order to market its securities.
Pilcher illustrates this situation with some quotes from corporation
executives. A vice president of a chemical corporation put it this
There are fads in financial markets; in other words
there are times when investment bankers advise that
convertible preferred are the fashion and are being
sought by investors.14
Another executive pointed out that:
While it was not our desire to include the conversion
privilege, it appeared at that time to be advantageous
so that the underwriters would find the issue more
salable. You might say we were forced by circumstances
and general market conditions to adopt convertibility.15
The above comments, while far from being conclusive, lend support
to the view that the conversion feature may sometimes be used merely
to stay in step with the market demand. If this is true then it would
appear likely that the volume of new convertible security issues would
fluctuate from year to year. The data previously discussed in con-
nection with the volume and growth of convertibles was for a period of
Pilcher, op. cit., p. 86.
Ibid., p. 87.
several years. The ind'.idual years showed substantial variation from
the average. This is not conclusive evidence of a causal link between
fashion and volurie of convertibles but, rather, suggests the possi-
A third factor which may influence the decision to employ the
conversion feature exists whenever the firm believes that it can
tap an otherwise unaccessible source of capital. There appears to
be a significant segment of potential investors who want a security
which combines the safety of a senior security with the speculative
possibility of common stock. This group of investors may be willing
to accept a lower interest in exchange for capital growth possibility.
Therefore, if the corporation can tap this market financing costs
may be reduced.
The mo0t prominent buyers in this segment of the capital market
are insurance companies banks, and various pension and trust funds.
These institutions are usually rigidly regulated and restricted as
to the kind of investments which they can make. .Insurance companies,
for example, are permitted to invest only a relatively small percent
in corimmon stock. The conversion feature added to bonds allows the
corporation to tap this source of capital.
Actually this particular incentl.e for using the conversion
option applies equally when the firm wants to raise additional common
equity capital and when it wants additional debt or preferred stock.
More will be said aLout this factor when discussing the use of conver-
tibles to raise equity capital.
All of the preceding reasons for issuing convertible securities:
to "sweeten" an issue to make it more attractive, to relax sinking
fund requirements or other restrictive provisions of the contract,
to meet the current fashion trend, or to tap otherwise unaccessible
sourcesof capital, are asserted to be of secondary importance in a
majority of cases. According to the finance writers the most important
reason is to increase common stock equity through a roundabout pro-
cess. Attention will now be turned to that significant aspect of
The Use of Convertibles When the
Firm Wants Common Equity Capital
The various surveys previously discussed indicate that in 6216
and 73 percent of all cases studied the primary reason for issuing
convertible securities was to raise common equity capital. In addi-
tion, the higher percentage was for more recent years, indicating a
growth in importance of this reason. It is apparent that a majority
of firms which issue convertible securities do not desire an increase
in debt or preferred stock. Rather they want to issue additional
common stock and, furthermore, they fully expect that to be the end
result of issuing convertibles. This raises two important questions.
If the firm wants to increase the common equity, why not issue common
Ibid., p. 85.
17Weston and Brigham, op. cit., p. 542.
stock directly? How can the firm be sure that conversion will
Actually there are several reasons why a corporation selects
to use a roundabout method of issuing common stock. These reasons
will be discussed first,and at a later point the means for forcing
conversion, if it does not take place voluntarily, will be con-
One important reason for issuing convertibles is to avoid the
downward price pressures on the firm's stock which would result from
placing a large neoi issue of common on the market. This is especially
relevant when the firm is attempting to raise such a large amount of
capital Lhat it would take a significant number of shares, relative
to the number currently outstanding, to provide the desired capital.
A favorite example in the literature of convertible securities
is American Telephone and Telegraph Company. Here is a company
which, b/ almost any standard, is strong and sound. Yet, the
management has chosen to make extensive use of convertible securities.
Weston and [righam point out that this company sold $10 billion of
convertible dcI:enlures between 1946 and 1957 of which 80 percent had
been conv.erted by 195,. They suggested that the sale of straight
debt would have unbalanced the financial structure of American
Telephone arnd Telegraph and "on the other hand, if AT&T had simply
issued large amounts of common stocks periodically, there would have
been price pressures on its stock, because the market is slow to
digest large blocks of stock."
Thus, by temporarily unbalancing its financial structure
with additional bonds American Telephone and Telegraph Company was
able to increase its common equity at a more favorable price than if
common stock had been sold directly. In addition to avoiding serious
financing problems, there was rapid and almost complete conversion.
As Weston and Brigham pointed out, "By using convertible debentures,
however, which provided for a lag of some six to nine months before
they were converted into common stock, AT&T received relatively
cheap money to finance growth."19
Pilcher refers to a company whose stock was currently selling
at a market price of $42 per share. The corporation was convinced
that in order to sell the necessary volume of new common stock the
price would have to be about $35 per share. Rather than suffer this
$7 reduction in market price the firm chose to issue convertible
debenture bonds convertible at $45 per share. Thus, for this company
the choice was between raising common equity at $35 or $45.20
Obviously, if the stock is sold at $35 more shares must be sold
to raise the desired capital than if the stock is, in effect, sold
at $45 per share. For illustrative purposes assume that the above
corporation wanted to raise $5 million common equity capital. Assume
further that the corporation has long followed the policy of paying
18eston and Brigham, op. cit., pp. 517-18.
Ibid., p. 518.
Pilcher, op, cit., p. 78.
$2 per share dividend on its outstanding common stock.
The direct sale of common stock at a price of $35 per share
would require 142,857 shares to raise the required $5 million capital.
The annual dividend for these new shares, at $2 per share, would
amount to $285,714. On the other hand, by selling the convertible
debentures and assuming that conversion takes place, there would
be 111,111 new shares issued upon conversion. The dividend require-
ment would be $222,222 per year for these new shares. The company
could maintain its dividend policy with an advantage of $63,492
The downward price pressure in the above example may have been
unusually strong, but it is not unusual for such pressure to
exist. Wleston and Brigham found that "All companies indicated that
c.ommoi on stock could have been sold at net prices ranging from 2 to 5
percent below the market price, the larger discounts being applicable
to small firms and to firms needing large sums of money relative
to the '.alue of their outstanding shares. Clearly, these firms
were not issuing convertible securities because they could not sell
anything else. They were selling convertibles because they wanted
to get a better price for their common stock than would have been
possibl-e wlth a direct common stock issue.
Another reason for issuing convertible securities, which is
sorrmc.hai. related to the above price pressures and increased number of
e's-, ton and Brigham, op. cit., p. 543.
shares, has to do with dilution of earnings. When a corporation
undertakes to raise long-term or permanent capital there is probably
an expansion program planned. The firm needs the money now while
it may take months or years for the construction to be completed and
for returns to be received on the invested funds. If the company
sells common stock to finance the expansion the new and old share-
holders must share the earnings from the old assets.
It is clear that until such time as the expansion begins to
contribute to earnings there will be a dilution of earnings per
share. The more shares the firm must issue to raise the desired
funds, the greater will be the dilution. While this may not have
any immediate effect on the corporation it is likely to make the
old shareholders rather unhappy. Since market price is frequently
geared to earnings per share their shares may lose value.
Furthermore, if the corporation does not have a fixed dividend
policy, as previously discussed, the dividend per share will probably
be reduced since the new shareholders would participate in the dividend
distribution. The only way the company could maintain the same
approximate dividend per share would be to retain less current
earnings in the business or dig into past earnings. Either way the
old stockholders will likely end up with diluted equity or lower
dividends or both.
On the other hand, by issuing convertible securities the cor-
poration can delay the issuance of new common shares until such time
as the new investment is in operation and making a sufficient con-
tribution to the earnings of the corporation. Of course, this does
not eliminate the reduction in earnings per share because interest
or dividends must be paid on the convertible bonds or preferred
stock. However, if the corporation issues convertible bonds the
interest is deductible b, the corporation for income tx; purposes
and the after tax cost ma, be such that earnings per share will be
reduced much less than would be the case \where additional shares of
coIITImon were issued.
In the case of downward price pressures, it is apparent that
convertibles provide an excellent alternative to issuing common
stock at the lower price. Howc'.'er, in the case of earnings per share
dilution, as a reason for issuing corn'ertibles, things are not
nearly so clear. Until the nc.' in'.'estinent begins contributing to
earnings there is going to be di lution no matter which alternative
is chosen. There will either be more shares to participate in the
earnings or more interest expense to be deducted from earnings. It
is impossible to sa, positive, that one lternalti..'e is better than
the other. Each rust be analyzed to deterriine which alternative
is most adv'antageous in a particular case.
For example, continuing thepre.iousl, assumed case where, be-
cause of price pressures, it was necei sar, to issue 1]2,857 shares
of coiilmon to roi sc $.5 ii I lli on,assume that the conpn,an \.vas presently
earning $4 million a year and had 1 million shares of common
outstanding. The stock was earning $4 per share. If the company
chose to issue common stock directly the total outstanding shares
would be 1,142,857 which would be earning $3.50 per share.
Assuming that the company sold convertible bonds at an interest
rate of 6 percent the annual interest would be $300,000. After
income tax, assuming a 50 percent rate, the net income would be
reduced to $3,850,000, assuming that the expansion has not yet had
time to contribute to earnings. The earnings per share for the 1
million outstanding shares would be reduced from $4 to $3.85 rather
than to $3.50 when common stock was issued directly.
When financial managers believe that their stock is presently
undervalued in the market another reason exists for issuing
convertible securities rather than common stock. But, why should
the stock be undervalued in the market, and why does management
think the value will rise (which must be the case if conversion is
to take place)?
Lindsay and Sametz suggest three reasons why a corporation may
believe that its common stock is undervalued in the market:
1. A general cyclical stock market decline that
sweeps all stock prices down, regardless of
2. A few recent years of poor company or industry
earnings that are in process of being reversed
but meanwhile have caused the common stock to
sell at distress prices.
3. The corporation is about to take off into a
period of great expansion and earnings growth,
and the market is likely to increase the
multiple of earnings (or the price/earnings
ratio) at which the stock sells.22
Pilcher thinks that expected growth is a particularly important
factor in managements' belief that their stock is undervalued. He
refers to correspondence from various corporate officials, one of
Because of our opinion that the . industry has
a bright future, it was decided that the common
stock of this corporation was undervalued. There-
fore we elected to sell a convertible preferred
stock carrying conversion privileges above the
current market for the stock. This, in effect,
resulted in the ultimate sale of common equity at
a higher price than would have been possible other-
Thus, when a corporation is convinced that its stock is under-
valued in the market convertible securities offer an advantageous
alternative. From the viewpoint of the corporation it is certainly
more desirable to have a delayed sale of common stock at a higher
price than to sell stock directly at the current depressed prices.
Of course, the management may be overly optimistic about the future
and the conversion may never take place. Then the corporation will
be stuck with debt or preferred stock when common equity was desired.
If the corporation desires common equity then it must attempt to
make a realistic appraisal of future earnings in order to make its
decision concerning the use of convertibles. In addition the
2Lindsay and Sametz, op. cit., p. 397.
23 cher, t., 70.
Pilcher, o2. cit., p. 70.
conversion price must not be set so far above the present market
price that it is not likely to be reached.
There are few statistics available to indicate the importance
of expected growth or undervalued stock as a motivation for the
issuance of convertibles. There are also, probably, many firms that
are overly optimistic about the future. Therefore, the only general
statement that can be made is that if the firm has good reason to
believe that its stock is undervalued and if the firm wants to
increase its common equity, then convertibles provide an opportunity
to sell common stock on a delayed basis at a favorable price. The
firm would have the advantage of issuing fewer shares and minimizing
dividend requirements. The disadvantage is that the evaluation of
the future may not come about and the company would have on its
hands a type of security which it did not desire.
A corporation may also decide to issue convertible bonds or
preferred stocks in order to penetrate that segment of the capital
market which is unwilling or unable to participate in a direct
common stock issue. This reason was previously mentioned in conjunc-
tion with those firms which want debt or preferred stock and need
to make those issues more attractive. However, it is probably a
more important reason in the situation where the company wants to
indirectly increase its common equity.
The demand for convertible securities may be somewhat a matter
of fashion or a fad. Whatever the reason there is, apparently, a
substantial group of investors who prefer a security which combines
the safety of a bond or preferred stock with the speculative
characteristic of common stock. The face value of a convertible
usually has mi.uch, but not all, of the same protection as a non-
conrerLible issue of Lhe parLicular company. Once the conversion
price is reached the con.'crtible securities assume the speculative
nature of corimmon stoc;..
In a later section more .'11 be said about convertibles from
the investor viewpoint t and in a later chapter the possibility of
separating the value of convertible securities into two parts: the
value as a straight security and the equity value. At this point all
that is necessary is the recognition that some investors want and
will purchase convertible securities and the corporation may issue
such securities in order to tap that market.
The above comments refer to the individual investors who may
not fully understand the complexity of convertible securities.
However, there is another group of investors interested in converti-
bles, but not in conmon stock as such, who no doubt thoroughly
understand Lheir speculative nature. This is the institutional
investors such as life insurance companies, some pension funds, and
banks. These insLitutions are highly regulated and are severely
restricted in their p-rtfolio management, especially as to the amount
of coirmmon stc:lk i.hich LhE ,' can hold. They are free, however, to
invest in convertible bonds, thus, providing corporationswith an
excellent potential market for such securities.
It was pointed out previously that for private placements,
which presumably would reflect institutional investors, only .5
percent of bond offerings and 8.2 percent of preferred stocks were
convertible. Thus it might appear that these investors are not
particularly interested in convertibles, yet Weston and Brigham
found this to be one motivation for convertible issues. They said
that "The investment officers of many of these institutions are
thought to feel that it would be desirable to have more equities
than regulations permit. Convertible bonds provide these inter-
mediaries with a method of indirectly holding more equities than the
Thus, these institutions not only understand the speculative,
or equity, nature of such bonds but that may be precisely why they
acquire them. Without violating the laws governing their particular
institution they can hold what the regulatory agencies and accountants
regard as debt but which they know provides an opportunity for capital
gain. The institution can continue to hold the convertible, once con-
version parity has been reached, and obtain capital growth in line
with the growth of common stock market price. Of course, they are not
allowed to convert, except on a temporary basis, which may hinder
the corporation in obtaining its goal of an indirect common stock issue.
Pilcher, op. cit., pp. 5-8.
25Weston and Brigham, op. cit., p. 544 (emphasis added).
If the institution wants to realize its capital gain it can
either sell the bond at the higher price or it can convert and
immediately sell the stock. Likewise, if the corporation calls the
bonds the institution can sell to someone who will convert or
convert and sell the stock. Either way the institution has earned
a capital gain on a so-called debt security.
Another reason why corporations may issue convertible securities,
especially bonds, when they eventually want to increase the common
equity is sinimpl' the flotation cost. These costs,'which include
such things a: registration with the Securities and Exchange Commis-
sicn, underwriting fees and distribution charges, are usually smaller
for bond: and preferred stocks than for common stocks. One source
reports that for the period 1951-55 the flotation cost for 615
issues, expressed as a percent of gross proceeds, was as follows:
1.49 percenT. for 265 bond issues sold, 4.34 for 129 preferred stocks,
and 10.28 for 230 commons.
The flotation cost for convertibles may not be exactly the same
as the average for all bonds and preferred stock but this gives an
idea of the difference in cost among the various issues. It is
interesting to note that Pilcher found four cases where "the
in _estment banl.er p,-id the corporation for the privilege of under-
writing thr- con/rertiL le is-ue."27
26Co.t of Flotation of Corporate Securities, 1951-1955, Securities
and Exclhance Cooni*mission (Washington, D. C.: 1957), pp. 37-40.
27 P Icl er, ,p. cit., p. 81.
Of course in evaluating the total cost of capital the corpora-
tion must consider several variables in addition to flotation cost.
However, once the corporation has decided that it wants to increase
common equity and the choice now is between a direct issue and a
convertible issue of bonds the difference in flotation cost may
be a decisive factor. If.the firm is fairly certain that conversion
will occur and flotation costs will be 5 to 8 percent less with
convertible issues,a strong motive certainly exists for the issuance
There are undoubtedly several other factors which, at one time
or another, motivate corporate management to decide upon a converti-
ble issue when an increase in common equity is desired. However,
the reasons discussed above are the most common and adequately
illustrate the situations where convertibles may be used advanta-
geously. For convenience they will be restated:
1. To avoid the downward price pressures on the
firm's stock which would result from placing a
large new issue of common on the market.
2. To avoid dilution of earnings and increased
dividend requirements while the expansion program
is getting underway.
3. To avoid the direct sale of common stock when the
corporation believes that its stock is currently
undervalued in the market.
In the present discussion it does not seem necessary to go into
an analysis of those variables. For those who are interested, the topic
is treated extensively in G. David Quirin, The Capital Expenditure
Decision (Homewood: Richard D. Irwin, Inc., 1967), pp. 95-160.
4. To penetrate that segment of the capital
market which is unwilling or unable to parti-
cipate in a direct common stock issue.
5. To minimize the flotation cost.
Additional Reasons for Buying Convertible Securities
The previous discussion of why corporations elect to issue con-
vertible securities provides considerable insight into investor
motivation. In many instances the corporation felt compelled to issue
convertibles because that was what the market demanded. Among the
reasons for issuing convertibles, which simultaneously would be
reasons for buying, were: (1) convertible securities considered
to be fashionable at the moment; (2) investors are attracted to a
security which combines protection with the opportunity for capital
growth (even though they may not fully understand the risk involved);
and (3) many institutions, such as insurance companies, desire to
increase their equity holdings but are prohibited from doing so by
In addition to these reasons inventors may'desire convertibles
as a hedge against stock market declines or because of the lower
rmrgin requirements. Cohen and Zinbarg explain how the convertible
operates as a hedge:
A 'convertible hedge" refers to a transaction in
which a bearish investor buys a convertible and
simultaneously sells short the common stock
into which it may be converted. If the stock
declines in price, as he anticipates, the price
of th- con'.ertible declines less than proportionately
(he hopes). He then sells the convertible at a
loss, buys common at the depressed price, and covers his
short sale at a greater profit than the loss on the
convertible. If he is wrong about the market, and a
rise in the stock's price confronts him with a potential
loss on the covering of the short sale, he has two
alternatives. If the price of the convertible has risen,
he can sell it at a profit which offsets the short-sale
loss in whole or in part. Indeed, the price rise of the
convertible may exceed that of the stock, resulting in
a net profit. At the very worst, if the price of the
convertible has not risen, he can exercise his conver-
sion privilege and use the shares received to cover the
short sale. His maximum loss will be the difference
between the cost of the convertible and the proceeds of
the short sale, namely the "premium" which he paid over
conversion value. Thus, the main purpose of a "converti-
ble hedge" is to profit from a declining stock market
at a predetermined risk.29
In those rare cases where the price of the convertible is below
the conversion parity and the conversion privilege is immediately
operative a process similar to the above called "arbitrage" will
motivate buying the issue. This situation provides a risk-free
opportunity for a small profit. This is accomplished by: (1) buying
the convertible issue and selling the common stock at the same time;
(2) immediate conversion into common; (3) using the common to cover
The difference in margin requirement for buying common stock
and bonds or preferred stocks may also provide an incentive for
investing in convertibles. In the past a person desiring to buy on
margin could legitimately borrow at least 75 percent of the convertible
2Jerome B. Cohen and Edward D. Zinbarg, Investment Analysis
and Portfolio Management (Homewood: Richard D. Irwin, Inc., 1967),
footnote 6, p. 418.
purchase price from a bank. On the other hand, the Federal
Reserve's variable margin requirements on common stock was such
that 50 percent or less could be borrowed. In early 1969, the margin
requirement for common stocks and corn,.rtible bonds was 70 and 50,
re- pecti '.:-ly. It would appear that such a vast difference in margin
requiremiernts could ha'.e had significant influence upon investment
decis ions, in the past.
Bonds ,s.. Preferred Stock
One objecti'.e of this sLud, is to test the hypothesis that
con,.ertible bonds and preferred stocks should receive similar
accounting treatmLent in reporting the capital structure of the firm.
Despite the fact that this h,'pothes i. has not yet been considered,the
teril'"con,.ertible securities" has beer used repeatedly throughout this
chapter. The implication, of course, being that the term covered both
conertible bonds and convertible preferred stock and that a discus-
sion of one was automatically a discussion of the other. This was in
keeping wi th the approach of financial writers who usually group the
two secure ties together.
Since th:sr- wri tears rarely explain, in their discussion of
conv.er tibics. why the., anal yze all conv.'ertibles together it is
nec-cesar, to consider tlieir %.iews to rd non-convertible debenture
Londs and preferred tLocks'. e'.s a further refinement special atten-
tior wi lIl be gi'.er to sL.ubcirdinaled debei:tures which, it appears, are
ihe most common form,, of co,.err i ble Lbonds. For example, Broman, in
the study referred to previously, elected to investigate only
convertible subordinated debentures. Weston and Brigham in their
study, also referred to previously, found that all but two of the
convertible issues were subordinated. In addition, a recent issue
of Moody's Bond Survey described 35 prospective taxable-bond
offerings of which all 12 of the convertible issues were subordinated
Subordinated debentures are bonds whose claim to assets comes
after other specified senior debt. Frequently the subordination is to
all other creditors, in which case the claim to assets may be con-
sidered more nearly in the nature of a "first" preferred stock33 than
of a "last" debt.
From a legal point of view bonds and preferred stocks are two
distinct kinds of securities. Bonds are debt and the interest is
a tax-deductible expense. On the other hand, preferred stock is
considered to be a part of the equity and the dividend payments are
regarded as a distribution of earnings and are not a tax-deductible
expense. In addition bondholders have a legal right to enforce the
payment of periodic interest and the face value at maturity, a
right which preferred stockholders do not enjoy. On the assumption
Broman, op. cit.
31Weston and Brigham, op. cit., p. 542.
3Moody's Bond Survey, Vol. 60, No. 23 (June 3, 1968), p. 638.
3Lindsay and Sametz, op. cit., p. 380.
that the legal viewpoint should not necessarily be the controlling
influence the following discussion will be conducted from the point
of view of the financial manager.
Lindsay and Sametz assert that preferred stocks issued in the
last 25 years have almost uniformly been "cumulative, nonparticipating,
callable, nonvoting, and preferred as to assets." They believe
that these features combined with other fairly standard protective
provisions give the preferred a striking resemblance to bonds. As
they see it, the typical protective provisions are as follows:
1. Restriction of size of dividends on common stock
to pro i.de liquidity for future preferred divi-
2. Limi nations on further issues of the same pre-
ferred or of new issues of securities (such as
bonds) that would have prior preferences, by a
requirement that the preferred must vote approval
by more than a majority, usually two thirds, of
such new issues or that certain financial ratios be
3. In the event that dividends are passed, usually for
two to six quarters, the preferred stockholders
acquire voting power sufficient to elect a number
of theI members, sometimes a majority, of the board
of directors of the corporation.
4. A staLteent about the preferred' claim to assets,
usually specifying that they are entitled to
share the proceeds of assets in liquidation ahead
of the coimion stock to the extent of the par or
stated ,alue plus dividend arrears.35
They conclude that "Clearly, these are bondlike preferred stocks."
3 Linds-j, and Sametz, o2. cit., p. 386.
3 Ibid., pp 387-3.o8.
36 i 3
Ibidl., p. 38,7
Other writers, such as Johnson, also believe preferred stock is
best regarded as quasi-debt. He points out that "one indication
of the 'debt-like' position of preferred stockholders is that we
bargain with them. In contrast, there should be no bargaining be-
tween the company and residual owners. His reasoning is that the
company does not have interests separate from the residual owners.
Thus since bargaining implies two or more parties with different interest,
with one party gaining what the other loses, there is nothing to bar-
gain about when the interests are the same.
According to Johnson the bargaining area for debt and preferred
stock "centers on provisions for retirement, claim on income, claim
on assets, and voice in management.. He also asserts that these
four provisions are what distinguish debt from equity. The following
discussion of those characterizing provisions will reflect the present
writer's interpretation of Johnson's viewpoint.40
Maturity. A common feature of bonds is that they have specified
maturity dates while preferred stocks do not. Since repayment of
bonds is compulsory at maturity date a sinking fund provision is
usually included in the bargaining between the corporation and inves-
tors. Despite the absence of a maturity date, provisions are sometimes
3Robert W. Johnson, Financial Manaqemnt (2nd ed., Boston:
Allyn and Bacon, Inc., 1962), p. 480.
Ibid., p. 482.
Ibid., p. 135.
4The Johnson discussion of debt characteristics is ibid., pp.
425-_45 and preferred stock is ibid., pp. 482-491.
made for the coi-ipu!sory, retirement of preferred stock.
The irpcortance of the inclusion or omission of a maturity date
can be diminished or disappear entirely when the intent of manage-
ment is the v.c I untary retirement of bonds and preferred stock. In
order Lco protect itself the corporation prefers to have the right
toc repay boards at will rather than be forced to follow a predetermined
schedule. CorporatLions often bargain with bondholders for the right
Lo refund! bonds at maturity date. They also often attempt to include
a call prc,.'ision in the bcnd issue-. This enables the corporation
to retire al I, or part, of the bonds at will upon the payment of the
face amoTiunlt plus at agreed upon premium.
If the corporation is successful in acquiring the right to
voluntary ly repay or retire the bonds, and if the right is exercised,
the specified maturity date is meaningless. Under these conditions
bonds and preferred stock would be completely alike because preferred
stock alnmst always includes a call provision. Maturity will occur
when the fir rm decides to e/'.ercise the call.
Claim on income. The bondholders have a prior claim on income
to the preferred stockholders, but both have claims prior to the
residual owners. The claim on income in both cases is a fixed
amoriunt since, as a general rule, neither participates with the
residual owners in distribution of earnings above the stated amount.
The amount of the bondholders claim is e:'pressed as a percentage
of the face value of the bond while the preferred claim may be
expressed as a percentage of the par or a dollar amount.
Unless the bonds are income bonds, in which case there must
be income for a claim to exist, the bondholders have a certainty
of receiving interest payment. Because of legal provision the
failure to pay bond interest is grounds for the bondholders to
instigate bankruptcy proceedings against the corporation.
Preferred stock is usually cumulative, which means that if
preferred dividends are not paid in any period,they accumulate and
must be paid before any common dividend can be paid. This pro-
vision does not provide year to year certainty of receiving divi-
dends but it does provide substantial long-run certainty in most
cases. The common stockholders would probably become unhappy
if they never received dividends and would likely push for cor-
rective measures. Of course if the company was losing money the
claim would be uncertain as would the bondholders' claim.
In addition t.o being concerned about the interest of common
stockholders, many corporate directors feel that they have a moral
obligation to pay preferred dividends if at all possible just as
they have a legal obligation to pay bond interest. They also
recognize that a continued failure to pay preferred dividends may
create problems in future financing.
Claim on assets. Both bondholders and holders of stock which
is preferred as to assets have a claim on assets prior to the
residual owners. Some bonds are secured by specific assets; however,
debenture bonds and preferred stock have no specific assets pledged
as security. They are protected only by the margin which exists
between the assets and secured debt.
In the case of subordinated debentures, which are of special
interest here, the claims of senior creditors, including ordinary
debenture holders, must be settled before any payment is made on
the subordinate issue. Such claims are immediately prior to the
claims of preferred stockholders.
Debenture bondholders and preferred stockholders are willing
to forego a specific claim on assets simply because they look to
earnings to satisfy their claims. If they anticipate the necessity
to press a claim against the assets to enforce their rights they would
not, or at least should not, have made the investment.
Voice in management. Unless the charter of a corporation con-
tains a specific provision to the contrary, the preferred stock-
holders are entitled to voting rights. Such a provision is usually
included, thus limiting the preferred stockholder's voice in
manaqenent to restrictions on dividend payments and future issues
of equal or senior securities. This is the same right which bond-
holders norm ;all obtain.
The bondholders and the preferred stockholders may obtain,
through ba rga ininr], the right to vote or to elect a specific number
of directors upon the company's default of certain features of the
corn racL. S3m ri. defaults which may give them voting rights are:
failure to pay interest or dividend; failure to maintain assets
at a certain ratio to outstanding bonds or preferred; and failure
to make sinking fund payments.
The preceding comparison of non-convertible bonds and preferred
stocks on the basis of maturity date, claim on income, claim on
assets, and the right to a voice in management suggests that from the
financial manager's viewpoint these securities have substantial
The discussion up to this point has been concerned with pro-
visions which are incorporated to a varying extent in bonds and
preferred stock. Thus the similarity of characteristics is a matter
of degrees. The financial writers, however, have made a very
specific comparison between bonds and preferred stock in the com-
putation of the cost of capital.
Many writers do not devote any time to an analysis of the cost
of preferred stock. They merely point out in a footnote or in one
or two short paragraphs that the analytical procedure for preferred
is similar to the procedure for bonds. Others treat common stock
as the only equity capital which gives the impression that they
consider preferred to be like bonds.
Others, like Quirin, analyze both bonds and preferred stock
and pointedly assert that the same procedure applies in both cases.
He says that "From the point of view of the common stockholders,
preferred stock represents an alternative source of senior funds
having many of the characteristics of debt but certain advantages
in particular circumstances."41 He also agrees with the point
made previously, and for the same reasons, that a company will not
casually decide to pass a preferred dividend.
According to Quirin the cost of capital when raised by
issuing boards, when the firm receives the full face value, is the
interest rale adjusted for taz: deductibility of interest. The formula
where 1- is the cost, T is the tax rate and R is the rate of interest.
A more complex formula is necessary when the bonds are sold at a
premium or discount. In that case the formula is
(l-T) rR+n (P-Qo)
where P is the par value of the bonds, n is the number of years to
maturity and Q is the sum received, net of all underwriting cost.
In his analysis of preferred stock he points out that:
The cost of a straight preferred issue, like that of
a debt issue, is most accurately calculated by using
Formula (1) [a more general formula than given above]
particularly ) when there is a sinking fund involved or when
it is planned to call parts of the issue at specified
date.. The corn.entional approximation treats preferred
Qu irin, o_ ci t., p. 102.
Ibid., pp. 100-10 .
as a perpetual obligation and the dividend as an
interest payment which is not tax-deductible giving
'where D is the annual dividend.
Quirin also evaluated the cost of capital raised by issuing
convertible securities. He treated convertible bonds and preferred
stocks as a single source of capital and asserted that:
Such issues, then, contain built-in future dilution
(for the common stock) as an intrinsic feature,
and are best regarded as an indirect way of selling
common stock above the present market. Their cost
should be evaluated as the higher of: (a) their
cost calculated on the assumption that conversion
does not take place and they remain as senior obliga-
tions in their original form, or (b) their cost when
considered as if they were common stock, calculated
from the formula for common stock cost, but substituting
in the denominator the effective issue price on a common
stock basis, i.e., the proceeds from each share divided
by the number of common shares into which it may be
Weston and Brigham chose to view the cost of debt and preferred
stock from a definitional standpoint. In each case the cost is that
rate of return which must be earned on the debt or preferred stock-
financed investments in order to keep unchanged the earnings availa-
ble to common stockholders. For debt this is the interest rate and
for preferred it is the dividend rate or the dollar amount of divi-
dend divided by the proceeds from the sale of a new issue of preferred
43Ibid., pp. 102-103.
4 Ibid., p. 111.
stock.4 Of course, as they point out, the different tax treat-
ment of interest payments and preferred dividends must be taken
The c'idence presented in this section makes it clear that
from the vief.'pcint of many wri ters in the field of corporate finance
it is appropriate for financial managers to treat debenture bonds
and preferred stock as one kind. of security. There are degrees of
differences; therefore one may be more advantageous than the other
under certain circumstances.
45Weson and Brigham, op. cit., pp. 282-283.
THE ACCOUNTING PERSPECTIVE
The previous chapter was concerned with establishing the view-
point of financial writers toward convertible securities. Emphasis
was placed upon the relative importance of convertible securities
as a source of capital for corporations, the various reasons for
corporations selling and investors buying such securities, and a
comparison of the characteristics of bonds and preferred stocks
from the corporation's viewpoint. The views of accounting writers
were not considered and no effort was made to answer two basic
questions. That is, what difference does it make whether converti-
ble bonds and preferred stocks have similar characteristics and
whether they are treated as debt or equity in the financial state-
The purpose of this chapter is to explore the accounting litera-
ture which pertains to convertible securities in order to formulate
tentative answers to the above questions, and to establish the
accounting viewpoint toward convertible securities. Special atten-
tion will be given to the various publications of the American
Institute of Certified Public Accountants and the American Accounting
Association; partly on the assumption that these publications repre-
sent an influential segment of the accounting literature, and partly
because it is only in the opinions of the Accounting Principles
Board that convertibles are discussed to any major extent. A search
of the literature suggests that Crad, was reflecting the traditional
attitude of man, accounting writers whcn he said that "since there
is little controversy, regarding accounting for equity capital,
there is no need for length, commcnts."I If there has been little
controversy, regarding accounting for equity capital there has been,
until the last two ears, even less controversy regarding accounting
for convertible securities.
Before dealing specifically, with the cause of the recent
controversy, it will be worthwhile to consider certain points which
pertain to accounting generally, and therefore to convertible
securities. These points will be presented in summary form on the
assumption that tihe reflect the views of most accountants.
The first point is simply the definition of accounting. While
man, definitions have been suggested, probably the most basic and
most frequent IC cited definition is the one formulated by the
Committee on Terminolog, in 1941 which stated that "Accounting is
the art of recording, classifying, and summarizing in a significant
manner and in terms of mroney, transactions and events which are,
in part at leest, of a financial character, and interpreting the
results thercof."'2 For the present stud> the key words are
Paul Cr-d,. Inventory of Generally Accepted Accounting Princi-
ples for bus-inass Enterprises. Accounting Research Study No. 7 (New
York' : A-e:ican InT.i tutr ol Ccrti ied r'ublic Accountants, Inc., 1965),
LAriiric.c,.i Instilutce of Certified 'jblic Accountants. Accounting
Research eand Ter inoclo E. lc.tins. (Final Edition.) (New York:1961),
Terlin olor' i p. 9.
"classifying . in a significant manner."
The Committee chose not to amplify the definition which it
put forth,thereby placing upon individual accountants the responsi-
bility of determining whether the accounts in financial statements
were properly classified. A committee of the American Accounting
Association was more specific when it pointed out that "Classifi-
cation, arrangement, and summarization should be employed for the
purpose of indicating similarity, disimilarity, relative importance,
and interrelationships among the data."
That same committee also stressed the need for financial state-
ments to be useful, especially to investors. The Committee asserted
that "The underlying determinant of adequacy of disclosure in
published financial reports is their usefulness in making decisions,
particularly with respect to investment problems." At another
point the Committee said that if investors are misled or not advised
of important matters the disclosure is inadequate. For example,
"Statements may be misleading if they contain inappropriate classifi-
cations or descriptions, or improper emphasis.
The importance of reflecting the viewpoint of investors was
also stressed in the introduction to Accounting Research Bulletin
American Accounting Association, Concepts and Standards Under-
lying Corporate Statements, Supplementary Statement No. 8, 1954.
No. 43. As a result of the increasing use of the corporate system
during the past fifty years "the problems in the field of accounting
have increasingly come to be considered from the standpoint of the
buyer or seller of an interest in an enterprise."
Another concept which has widespread acceptance in the account-
ing literature is materiality. Rather than conduct a historical
survey of the materiality concept, as was done by Reininga, this
point will be illustrated by some statements from accounting Research
Study No. 7. In that study it is stated that:
Accounting and auditing literature and pronounce-
ments are replete with references to items and
matters which are: material, significant, of sub-
stantial importance, substantial, materially dis-
torting, immaterial, inconsiderable in amount, of
little or no connFquence, nnl significant, etc . .
The fact that no comri;ttee- of the institute has
defined the terms material siqr ificant, or con-
sequential merely serves to eniphasize the fact that
the problem involk.ed is largely a matter of judg-
mrent to be exercised in the light of all the then-
existing surrounding circu.nista nces .8
The following general definition of the concept is suggested:
A statemen- t, fact, or item is material, if giving
full consideration to the surrounding circumstances,
as they, exist at the tien- it is of such a nature
that its disc closure, or the method of treating it,
would be likely to influence or to "make a difference"
Accounting Research and Tern-inoloqy Bulletins, op. cit.,
Eul letin No. 43, p. 7.
7\-/arren-i Reininga, "The Unlkno,. i Ilaterial ity Concept," Journal
of Accountanc-, (February 196c) pp. 30-35.
8Grad y, up cit., pp. 38-39.
in the judgmentt and conduct of a reasonable
The purpose of the preceding discussion was to illustrate that
certain basic concepts of accounting require an understanding of con-
vertible securities. Since accounting is concerned with classifica-
tion, and classification requires recognition of similarity and dis-
similarity, it is essential that the characteristics of convertible
bonds and preferred stocks be investigated. If they have similar
characteristics they should be placed in the same classification.
On the other hand, if the characteristics are different there may
be sufficient justification for different classifications.
In addition, the evidence presented in the previous chapter
indicates that convertible securities are probably "material" items
on a statement of financial position, therefore an inappropriate
classification may be misleading to present and prospective inves-
tors. Such a classification would defeat a basic purpose of published
financial reports which is to provide useful information for investors'
Selected General Theories of Accounting
Over the years several general theories, or concepts, have been
advanced in the accounting literature. Among these are: proprietary
theory, entity theory, fund theory, social institution theory,
91bid., p. 40.
1William J. Vatter, The Fund Theory of Accounting and Its Impli-
cations for Financial Reports (The University of Chicago Press, 19L7).
commander theory,1 and economic theories of the firm. The pro-
prietary and entity theories are the most commonly discussed theories,
with the others being treated as refinements, modifications or
attempts at reconciliation of those two theories.
The purpose of this section is to determine whether the
selection of a particular "theory" enhances or negates the previously
discussed basic concepts of accounting and whether such selection
has any bearing on the treatment of convertible securities. If so,
which theory is most representative of current practice? There is
no need, within the scope of this study, to draw a conclusion con-
cerning which theory is best, or ought to be the theory of accounting.
In addition, only the two main theories, the proprietary theory and
the enrtiti theor',, will be discussed, which should serve adequately
for the present purpose.
According Lo the proprietary theory the firm is owned by some
specified p-rson or group. The ownership interest may be represented
by a sole proprietor, a partnership, or by a number of stockholders.
In air, event Lhe assets of the firm belong to these people and any
liabilities of the firm are their liabilities. Revenues received
b-, the firm i-immediately increase the owner's net interest in the firm,
which is the total assets minus the total liabilities. Likewise
all e.penisesc incurred by the firm immediately decrease their net
Louis Goldberg, An Inquiry into the Nature of Accounting
(American Accountirn Association, 1965).
interest in the firm. This is the same thing as saying that profits
become the property of the owners, and not the firm, at the time
they are earned.
To the owners, according to Lorig, "The business is merely a
segregated portion of their financial interests, accounted for
separately because it is convenient or necessary for various reasons
to do so.,12 This viewpoint combined with the immediate effect of
profit on their net interest means, to those who adhere to the pro-
prietary theory, that "The proprietors are the center of interest
at all times, and their viewpoints are the ones reflected in the
The proceeding comments reflect a generally accepted summary
of the proprietary theory. However, there is widespread difference
of opinion concerning the composition of the proprietorship group.
For example, Husband takes a narrow view and asserts that "The
preferred stockholders occupy a 'hybrid' position, a resultant
of the cross breeding of bonds and common stock. On the theory
that the common stockholders occupy the entrepreneurship position
in the corporation, preferred stock, like bonds, represents hiring
of capital services. Consistent therewith, preferred stock dividends
are best treated as cost."14 Staubus has also advocated the narrow
12A. N. Lorig, "Some Basic Concepts of Accounting and Their
Implications," The Accounting Review (July 1964), pp. 564-565.
13Reginald S. Gynther, "Accounting Concepts and Behavioral
Hypotheses," The Accounting Review (April 1967), pp. 275.
14G. R. Husband, "The Entity Concept in Accounting," The Account-
ing Review (October 1954), p. 561.
version in his "residual equity" concept. He would exclude the
preferred stockholders, unless the stock was participating preferred,
from the ownership group. He points out that "One way of emphasizing
the residual equity is to convert the primary expression of the
accounting equation, assets equal equities, to the form: assets
minus specific equities (liabilities, including preferred stock)
equal the residual equity."15
The other extreme view is that all long-term investors, whether
bondholders, preferred stockholders or common stockholders, are part
of the proprietorship group. For example, Chow believes that "a
concept of proprietor broadly defined as the totality of private
interests or the long-term investors as a class would be more logical
and workable from the standpoint of theory and practice."16
The more common viewpoint is probably the one which compro-
mises the two extremes. That is, the proprietors of a business
are the preferred and common stockholders, even though it is recognized
that the preferred stockholders usually have no voice in the manage-
ment of the business. Nevertheless according to Lorig, "In practice,
the financial return to them [the preferred stockholders] is always
considered a distribution and is chargeable only to net profits,
current or accumulated, and payable only when declared in the form
1G-. J. Staubus, "The Residual Equity Point of View in Accounting,"
The Account ing Revice- (January 1959), p. 13.
16Y. C. Cho., "The Doctrine of Proprietorship," The Accounting
Reviewc (April 1942), p. 162.
of a dividend. Both classes of stockholders, therefore, are dis-
tinctly different from the creditor group, and this distinction is
basic in the proprietary concept."
Since the proprietary theory asserts that profits become the
property of the owners at the time they are earned, whether they are
distributed or not, it appears that Lorig is contradicting that theory
when he emphasizes dividend declarations as a determinant of financial
return. It should be noted, however, that Lorig's statement reflects
a traditional accounting viewpoint concerning the distinction between
stockholders and creditors.
While not necessarily the first to do so, the entity theory
was described and put forth as a more appropriate theory of accounting
by Paton in 1922. In the preface he briefly summarized the pro-
prietary theory and recognized that such a theory might be adequate
for a sole proprietorship or a simple partnership. However, he felt
that "as an explanation of the accounting system of the corporation,
the present dominant form of business organization, such an arrange-
ment of accounting principles is seriously defective."18
In order to overcome this serious defect his book was charac-
terized as an attempt:
. to present a restatement of the theory of
accounting consistent with the conditions and needs
Lorig, op. cit., p. 565.
8William A. Paton, Accounting Theory (Reprint ed., Chicago:
Accounting Studies Press, Ltd., 1962), p. iii.
of the business enterprise par excellence, the large
corporation, as well as applicable to the simpler,
more primitive forms of organization . the view
that the balance sheet is composed of three distinct
categories, assets, liabilities, and proprietorship,
and that the first two of these classes are of impor-
tance primar il-, in that their difference discloses
the last, is abandoned, and the theory of the accounting
system is presented in terms of the two fundamental
dimensions, properties and equities.T9-
Therefore, the entit, theory, like the proprietary theory, is
a point of view toward the firm and the people concerned with its
operation. Those who hold the entity viewpoint place the firm, and
not the owncrs, at the center of interest. The essence of the theory
is that stockholders as well as creditors are outside the firm. The
firm exists as a separate and distinct entity apart from those who
contributed the capital of the firm.
The assets and liabilities belong to the entity and not the
owners. As revenue is received it becomes the property of the entity.
Likewise, expenses incurred are obligations of the entity. Any net
profits are the property, of the entity and accrue to the stockholders
onl, when a dividend is declared. The undistributed profits, if any,
still belong to the entit' "and this is not affected by the inclusion
of undistributed profits in the stockholders' section of the printed
balance sheet. The entit', concept person sees this as mere conform-
ing to conventional and regulatory reporting procedures."20
19 bid. pp. ii i-iv.
20'CG ntlher, or. cit. p. 276.
In the accounting literature frequent reference is made to the
need for separate accounting of the activities of the firm and of the
owners. This proposition is treated as a basic postulate, concept or
assumption of accounting. For example, in his list of basic postu-
lates Moonitz asserts that "Economic activity is carried on through
specific units or entities. This proposition refers to the basic unit
of economic organization and points the way for a similar orientation
of accounting data.''2
In his list of basic assumptions Mattessich states that "An
entity is a social institution which may own and owe economic objects
and which can (but need not) be owned by one or more agents or other
entities."22 This appears to be a restatement of the legal definition
of a corporation and further indicates that an entity is not neces-
sarily owned by anyone.
Grady took a similar approach in describing the basic concepts
of accounting. He explained it this way:
A business entity consists of an organization of
persons and properties which have been brought to-
gether for certain economic objectives. . The
business corporation created under incorporation
statutes is recognized as an entity in its, own right,
separate and distinct from its stockholders .
The separation of ownership from management of the
business entity is a primary factor in imposing
Maurice Moonitz, The Basic Postulates of Accounting. Accounting
Research Study No. I (New York: American Institute of Certified Public
Accountants, 1961), p. 22.
22Richard Mattessich, Accountinq and Analytical Methods (Homewood:
Richard D. Irwin, Inc., 1964), p. 38.
on the entity the fiducuary accountabilities to
its stockholders. The summary of generally accepted
principles later set forth is classified in relation
to these fiducuary accountabilities.23
The purpose of the above comments was to illustrate and emphasize
that in many contexts the entity concepts relate to the separation
of the accounting records of the firm and the owners. In that case the
term "entity concept" may not reflect the perception of the firm held
by those who ascribe to the "pure" entity viewpoint. The confusion
would be reduced if writers adhered to Gynther's explanation. He
indicated that "The 'independence' or 'separateness' of the entity's
accounting records is commonly referred to as the 'entity convention'
and not the 'entity concept.' If th'e hot dog vendor maintains separate
accounting records for his business as he should (the entity convention),
it does not follow-; that he has an entity viewpoint regarding the business--
althl'i: cigh this is possible.25
Does the choice of a particular accounting theory have any
pertinence to a study concerned with the accounting treatment of con-
vertible securities? As previously discussed, those who hold the
proprietary v.ieuJpoint place the owners at the center of interest and
expect the accountir ng reports to reflect that interest. On the other
hand, Lorig suniniiarized the common views of the entity theorists and in
addition I-:i the attitude toward the ownership of properties and profit
23Grady, ~p. cit., p. 26.
2 ;Gynlher, :,. cit., p. 276.
25 d. 2 6.
Ibid., p. 276.
previously mentioned he asserted that "The accounting and financial
reporting are for all interested parties, including the entity's admin-
istration. They are not intended specifically for the stockholders."26
He believes that the views of the entity theorists regarding an
incorporated business indicate that "the stockholders are closer to a
creditor status than the creditors are to an owner status. And since
under the entity concept the stockholders and long-term creditors
are to be treated similarly, it is logical that both classes should
be regarded as creditors."27
Therefore the answer to the above question is a definite yes.
Since the proprietary theory places ownership at the center of interest
for accounting purposes it is essential to determine whether converti-
ble securities represent a part of the ownership if that theory is
adopted. On the other hand, since the entity theory suggests similar
treatment for stockholders and long-term creditors there would be no
point discussing the debt or equity nature of convertible securities
if that theory were adopted.
The fact that it does make a difference which theory is followed
indicates that some consideration should be given to which of the two
theories is most common in current practice. This is a problem fo.
substantial empirical research which is beyond the scope of this stud',.
However, several writers have addressed themselves to the problem. For
Lorig, op. cit., p. 567.
27 bid., p. 567.
example, Lorig lists nineteen differences in accounting and financial
reporting which have been influenced by the two concepts. He concludes
that in sixteen out of nineteen "the proprietary viewpoint seems to be
the one generally held.28 He stated the conflicts in the form of
questions which he answered yes or no (using P.C. for proprietary
concept and E.C for entity concept). In addition he elaborated
the yes or no with some brief comments. The questions pertained to
such things as ownership of profits, properties, and undistributed
earnings, the treatment of taxes, the book value of stock, etc. Several
of the questions and comments will be repeated here in order to illustrate
1. Are the net earnings of a business to be considered
income of the stockholders (or other owners)?
P.C. Yes E.C. No
Undcr the entity concept, the income is that of the
business enterprise itself until dividends are
declared or distribution otherwise made.
2. Should earnings per share be reported?
P.C. Yes E.C. No
The earnings per share has real significance to
the stockholders under the proprietary theory.
Under the entity concept the earnings do not
belong to the stockholders and the amount per
share would carry misleading inferences.
3. Are corporate retained earnings, or earned surplus,
part of the stockholders' equity?
P.C. Yes E.C. No
According to the entity theory, the retained
earnings must be regarded as belonging to the
Ibid., p. 572.
17. Should the calculated .book value per share of
common stock include a proportionate part of
P.C. Yes E.C No
The retained earnings do not belong to the stock-
holders under the entity concept. Hence the
book value cannot properly include any part of
18. Is the common account form of balance sheet (debits
on one side, credits on the other) the clearest
form for presenting the financial position?
P.C Yes E.C. No
The equation for the entity concepts is "Assets =
Equities (or Liabilities)" and this corresponds
to the account form. The equation for the
proprietary concept is "Assets Liabilities =
Proprietorship" and the report form of financial 29
position expresses that relationship most clearly.
Gynther is not willing to accept the approach used by Lorig
because he thinks that the wide variety of viewpoints within the two
main concepts makes it difficult to prepare one comprehensive listing
of differences, but he also comes to the conclusion that the pro-
prietary theory is most commonly followed by accountants. He states
his views in the form of hypotheses. For example he says "It is
hypothesized that most stockholders with substantial holdings of
shares in corporations have the proprietary outlooks. . Further
it is claimed here that most accountants in public practice have a
proprietary outlook. . To most accountants the prime function of
the accounting system is to reflect the interests of the shareholders."30
29Ibid., pp. 570-572.
3Gynther, op. cit., pp. 282-283.
The opposite view is taken by Goldberg. He indicates that
"The theory which is probably most widely adopted nowadays by accounting
writers and teachers . is the entity theory, and it is the one
which is most generally accepted by the present generation of practicing
accountants . 31 It should be noted,however, that Goldberg
equates the entity concept with the entity convention which may account
for his statement.
Since it is not practical to prove, empirically, the prominence
of one or the other of the two theories this study will proceed on the
assumption that, while the entity convention may be popular, the
proprietary theory is most commonly followed by accountants.
Convertible Securities from the Accounting Viewpoint
One conclusion which may be drawn from a survey of the accounting
literature is that many accounting writers do not give any specific
attention to con.'ertible securities. At best, such securities receive
onr,- brief mention and even then there is no analyses of the charac-
teristics of these securities. The report from a committee of the
Amenrican Accounting Association will serve as one example of this tend-
ency. The report first noted that the term "entities" covered both
creditor and stockholder interest. It was then pointed out that "a
particular corporate security may combine some of the characteristics
3 1 G o I
Gold!l:.ci op. cit., p. 109.
321bi; pF. 109-110.
of both creditor and stockholder interests. Equities should be
reported in financial statements in a manner which emphasizes their
dominant characteristic.'33 If the report had stopped there it would
be appropriate to assume that the committee would include convertible
securities in the group of hybrid securities which should be analyzed
for the purpose of determining the dominant characteristics. However,
the report appears to have precluded that assumption by the comment,
two paragraphs later, that "When a liability is discharged by con-
version to a stock equity, the market value of the liability is ideally
the measure of the new equity created.34
Thus the only specific reference to convertibles is in the con-
text of a liability being converted into a stock equity. There is
no suggestion whatever that perhaps, on the basis of dominant
characteristics, convertible bonds should have been reported as a
part of the stockholders' interest and not as a liability prior to
the conversion. The purpose here is not to assert that convertible
bonds should be so classified but, rather, to point out that the
committee, apparently, automatically considered such securities to be
a part of the liabilities despite the fact that the hybrid nature of
some securities was recognized.
Another study devoted only one short paragraph to convertible
securities. The comments, while brief, were explicit about the nature
33American Accounting Association, Accounting and Reporting
Standards for Corporate Financial Statements, 1957 Revision.
of convertible bonds. The entire paragraph was as follows:
Liabilities sometimes exist in a form which may be
converted into owner's equity at the option of
the obligee. For example, bond indentures may
provide that under certain prescribed conditions
bonds can be exchanged for shares of stock at the
option of the bondholders. Until conversion occurs,
these bonds are liabilities. Upon conversion there
is an increase in stockholders' equity and a reduc-
tion of liabilities. Until actual exchange, the
bonds have a known maturity date and maturity value.
These comments reflect the traditional viewpoint of accountants re-
garding convertible securities. Convertible bonds are liabilities
and convertible stocks are owners' equity. There is no concern about
dominant characteristics. Apparently ,' an'y conflict in the minds of
the writers has been resol.'ed in fa..or of tradition with the key
factors being a known maturity date and maturity ,.alue.
On the basis of the evidence presented in the previous chapter
concerning the relati'. importance of convertible securities in
corporate financing, the choice of words in the above statement seems
to be misleading. More appropriate wording night Le as follows:
"Liabilities often exist in a form which may be converted. . For
ex.aml'le, bond indentures frequently y. ... The change in terms
would not necessary ly ha'.e altered the conclusion of Sprouse and
nooni t, but may have resulted in a more comprehensive discussion,
Robkert T. Sprouse and haurice Iloonitz, A Tentative Set of
Broad Acccuntllrri Principles for Business Ent~rprise. Accounting Research
Study iNo. 3 (. Y'orl:: American II~n.titute of CCertified Public Accountants,
1962), p. 38.
In the Grady study, previously mentioned, there are several
references to convertible securities. Most of these are repetitions
of earlier Accounting Research Bulletins and pertain to the value
to be placed on the common stock issued through a conversion process
and to the computation of earnings per share when conversion has taken
place. The comments reflect a concern for the effect of conversion
on current year earnings per share and comparative statistics for a
period of years. There was no reference to the nature of conver-
In a different context, Grady made a statement which appears
to be especially pertinent to the present study. In his discussion
of invested capital which is attributable to stock outstanding he
said "Stock outstanding may consist of preference and common stocks.
Debentures subordinate to the claims of creditors are also sometimes
classified as invested capital. The accountant should not ordinarily
object to this, if full disclosure is made."37 The pertinence of
this statement is based upon the evidence presented in the previous
chapter which indicated that convertible bonds are frequently
Therefore, if there is no objection to classifying ordinary
subordinated debentures as invested capital there should be even less
Grady, oF. cit., pp. 196, 308, 309.
37Ibid., p. 198.
objection to such classification when the conversion feature is
added. Yet, there was no mention whatever of such a possibility.
In order to gain some insight into the rationale for the above
statement and to get his thinking on the present study the present
writer addressed some questions to Mr. Grady. His reply, with the
exception of the last paragraph, which pertained to permission to
quote, was as fol lows:
Where so-called Debentures are subordinate to creditors,
it is ob.'ious that they become a special form of equity.
As such, a full explanation of their terms is required
for the information of creditors, whose claims are
senior to them, and for preference and common stock-
holders wh:ise position is junior to that of the debentures.
The disclosure should fairly present the principal terms
of the Indenture agreement, including the terms of
conversion into stock, if they are convertible, and the
contingencies, if any, whereby they might become lia-
bilities of the corporation.
I trust 'our study will include a review and analysis
of several specific indentures and perhaps some history
of the eventual conversion or liquidation. This should
place you in a better position to judge whether the
probabilities inherent in this special form of invested
capital, justifies the treatment described in ARS No. 7.3
The abo.'e letter contains an interesting paradox. On the one
hand there is the observation that subordinated debentures are
obviously' a special form of equity. Furthermore, such securities
ma; become liabilities of the corporation only through the existence
of some possible contingencies, which are not stated. Thus, there
is a strong implication that not only should the accountant not
38Paul Grady, Personal correspondence, July 5, 1968.
object to reporting these securities as a part of equity, but that
such treatment is the most appropriate.
On the other hand, when the subordinated debentures are con-
vertible, Grady suggests that reporting them as equity requires
justification based upon some inherent probabilities. Again he
does not specify what the probabilities are that would justify such
treatment. It appears that he is referring to a historical study
of the eventual conversion or liquidation of convertible issues,
and the question of what probability of conversion justifies treating
these securities as equity remains unanswered. In addition, there
is no attempt to explain why the attachment of the conversion feature
to a subordinated debenture makes the accounting treatment uncertain
when the treatment of non-convertible subordinated debentures is
Opinions of the Accounting Principles Board
This section will be devoted to a rather extensive coverage
of those opinions issued by the Accounting Principles Board of the
American Institute of Certified Public Accountants which contain
specific reference to convertible securities. Therefore, it seems
appropriate to briefly consider the responsibility and authority of
that Board. The Board was charted by the Council of the Institute
and the Charter contains, among others, the following provisions:
1. Authority for Issuance
The Board shall have the authority and the
duty to issue, in its own name, pronouncements
on accounting principles.
Such pronouncements are expected to comprehend
basic postulates, broad principles, and rules
or other guides for the application of account-
ing principles in specific situations. . They
are to be based on what the Board determines to
be adequate research and are expected to be
regarded as authoritative written expressions of
generally accepted accounting principles.39
Each opinion issued by the Board carries a notation stating
that the authority of the opinion rests upon general acceptance, but
that departures from the opinion must be justified by those who
adopt other practices. In addition, the notation sets forth the posi-
tion of the Council of the Institute that:
a. "Generally accepted accounting principles" are
those principles which have substantial
b. Opinions of the Accounting Principles Board 4
constitute "substantial authoritative support."
Furthermore , ith Council, while recognizing that there may exist
"substanIial authoritative support" for accounting principles which
differ from the Board opinions, has asserted that whenever the accountant
prepares financial statements which contain departures from the opinion
such departures nust be disclosed in footnotes to the financial state-
rnents. The influence which the Board has upon accounting principles
should be rather obv.ious.
Americri an Institute of Certified Public Accountants, Charter
of thc A-.cojunting Principles Board.
\rAmerican Institute of Certified Public Accountants, Council
of the Irnst;i.te. "Disclosure of Departures from Opinions of Account-
ing Principles Board" (October 1964).
Since December 1966, the Accounting Principles Board has issued
four opinions in which specific attention was given to convertible
securities.1 The third opinion suspended the second, and the fourth
revoked the second; however, the rationale of each is of importance
to this study and will be discussed.
Opinion No. 9 is concerned with two major aspects of reporting
the results of operations for a firm. The first aspect is the determi-
nation of net income and the treatment of extraordinary items and
prior period adjustments. The second aspect, and the one which
involves convertible securities, is the computation and reporting
of earnings per share.
The Board began its discussion of earnings per share by stressing
the importance of such a statement when used in conjunction with other
financial statements. The Board then said that the term "earnings
per share," unless qualified, "refers to the amount of earnings ap-
plicable to each share of common stock or other residual security
outstanding."42 Again the problem arises concerning the composition
of the proprietorship or residual equity group. Obviously, the
Board does not accept the previously discussed "narrow view" which
holds that only the common stockholders should be included. The
4American Institute of Certified Public Accountants, Account-
ing Principles Board, "Opinion No. 9: Reporting the Results of
Operations" (December 1966); "Opinion No. 10: Omnibus Opinion--1966"
(December 1966); "Opinion No. 12: Omnibus Opinion--1967" (December
42 pinion o. 9, p. par. 33.
"Opinion No. 9,".p2. cit. par. 33.
Board continued the above statement by saying that "When more than
one class of common stock is outstanding, or when an outstanding
security has participating dividend rights with the common stock,
or when an outstanding security clearly derives a major portion
of its value from its conversion rights or its common stock charac-
teristics, such securities should be considered 'residual securities'
and not 'senior securities' for purposes of computing earnings per
Only the last of the three situations described above may be
considered as a significant addition to "residual securities" as
traditionally, defined. There is little purpose in treating different
cla.sscs oi common stock as a special situation. All common stock-
holdcrs, regardless of class, have been generally accepted as part
of the proprietorship or residual equity group. And even the narrow
residuall equity" view held by Staubus included participating preferred
stock in the ownership group. On the other hand, by asserting that
under cerLain circumstances convertible securities should be regarded
as residual securities, the Board has indirectly questioned the treat-
mernt of such securities on the statement of financial position.
The Board did not suggest how the accountant might determine
whether the major portion of the value of an outstanding security
w!. "clearly derived" from its conversion rights or its common stock
characteristics. In fact, throughout the remainder of the opinion
bid., par. 33.
all references to convertible securities applied only to those con-
vertible issues which do not qualify as residual.
The purpose of this study would have been better served if the
Board had elaborated its brief treatment of convertibles as residual
securities. Unfortunately that was not the case but, in dealing with
the other convertible securities, the Board expressed some views which
should be considered.
The Board approved the traditional procedure relating to
convertible securities when computing earnings per share. According
to the Board, "When senior stock or debt is converted into common
stock during a period, earnings per share should be based on a weighted
average of the number of shares outstanding." This is simply a more
positive statement of the position outlined in an earlier Accounting
Research Bulletin which indicated that "earnings per share should
ordinarily be based on weighted average. . .5 However, the Board
also added the comment that if the effect of conversion would be
material it would be appropriate to prepare "pro forma computations
of earnings per share, showing what the earnings would have been if
the conversion had taken place at the beginning of the period 46
Similar pro forma computations are also to be made when conversion
takes place after the close of the period prior to the completion and
issuance of the financial statements.
4 bid., par 38.
45Grady, op. cit., p. 308.
46 No. 9 it. par. 38.
'Opinion No. 9,"op. cit., par. 38.
The Board expressed particular concern for adequate disclosure
in those situations where earnings per share may be subject to dilu-
tion in the future because of existing contingencies which would
permit the issuance of additional shares of common stock. Foremost
among these contingencies are outstanding convertible preferred stock
or convertible bonds and outstanding stock options. In those cases
where the potential dilution is material, the Board again suggested
pro forma computations of earnings per share "showing what the earnings
would be if the conversion or contingent issuances took place. The
Board strongly'recommends that such per share data be disclosed in
the statement of income."4
The Board further reflected its concern in the next paragraph
by observing that "The fact that the relationship between current
market and conversion prices makes conversion or other contingent is-
suance unlikely in the foreseeable future is not sufficient basis for
omission of the disclosure of the pro forma earnings per share
data .. .48 The position of the Board seems to be clear: Whenever
the potential dilution is material there must be a pro forma compu-
tation of earnings per share showing what the earnings would be if
the conti agency eventuates.
In summary, it can be said that the Board, in rendering its
opinion on earnings per share, paid particular attention to the potential
71bid., par. 43.
'*Ibid., par. 44.
effect of convertible securities upon the computed earnings. First,
by requiring that under certain conditions such securities should be
treated as residual securities and secondly, by insisting upon pro
forma computations under various other circumstances, the Board
alerted the profession to the need for special treatment of conver-
Since the Opinion just discussed was limited to reporting the
results of operations, and especially the computation of earnings per
share, the Board did not consider the statement of financial position
treatment of convertible securities. This was one of the topics
covered briefly in another Opinion issued at the same time. The Board
expressed the following attitude:
A portion of the proceeds received for bonds or other
debt obligations which are convertible into stock,
or which are issued with warrants to purchase stock, is
ordinarily attributed to the conversion privilege or
to the warrants, a factor that is usually reflected
in the stated interest rate. In substance, the acquirer
of the debt obligation receives a "call" on the stock.
Accordingly, the portion of the proceeds attributable
to the conversion feature or the warrants should be
accounted for as paid-in capital. . 9
Thus, in this latter Opinion the Board took the position that
under certain circumstances a portion of the proceeds from the sale
of convertible bonds should be treated as paid-in capital while in
the previous Opinion, under certain circumstances, the entire converti-
ble issue should be treated as residual. Of course, in Opinion No. 9
'9'Opinion No. 10,"op. cit., par. 8.
the Board was dealing with the computation of earnings per share
while in Opinion No. 10 the statement of financial position classifi-
cation of convertible issues was the topic.
Perhaps there is no conflict between the two opinions, but they
do give rise to certain speculations. In Opinion No. 10 the Board
said that the amount to be recorded as paid-in capital "may ordinarily
be measured as the difference between the price at which the debt
was issued and the estimated price for which it would have been issued
in the absence of the conversion feature."50 It may be recalled that
in Opinion No. 9 it was stated that the convertible security should
be treated as a residual security if it derived a major portion of its
value from the conversion feature. Therefore securities which are
treated total) as residual in income statement computations will only
be partiall, if at all, recorded as paid capital in the statement of
financial pcsit ion.
A sur.'e) of various accounting journals for several months
following the issuance of the two previously discussed opinions indi-
cates that the sections pertaining Lo convertible securities were
quietly, accepted by he profession. There were no articles or letters
to the editors criticizing the actions of the Accounting Principles
Board. Ho~-e.'er, after one year the Board chose to suspend that section
of Opinion r !o. 10 perLairning to converLible securities.
0Ibid., par. 9
In announcing the temporary suspension the Board explained
that since the issuance of the Opinion setting forth the accounting
treatment for the proceeds of convertible bonds or warrants the fol-
lowing developments had occurred
. the Board has observed developments in the use
of securities of this character and experiences in
the application of those paragraphs of the Opinion.
In addition, the Board has received views of interested
parties relative to the nature of these securities
and the problems in implementing the paragraphs. These
observations and views have suggested that because certain
aspects of these instruments, particularly in the case
of convertible debentures, raise difficult estimation
and other problems, further study is needed in this
area. Also, because of the actual or potential equity
nature of these instruments, the relationship between
the accounting for the proceeds and the treatment
of "residual securities"in the determination of earnings
per share has created problems which need to be studied
Since the "views of interested parties" were not presented in
the accounting journals it is not possible to evaluate those views.
However, a rather brief indication of the views and their source
was revealed by Savoie. According to him each Board member received
a telegram, which "was signed by 12 of the country's largest invest-
ment banking firms and 5 of the largest law firms,'52 requesting a
discussion and restudy of Paragraphs 8 and 9 of Opinion No. 10. The
Investment Bankers Association had received the exposure draft of the
Opinion but did not respond at that time. Now certain new information
51'Opinion No. 12,"o cit., par. 11.
52Leonard M. Savoie, "Controversy Over Accounting Principles
Board Opinions," The Journal of Accountancy (January 1968), p. 40.
was made available to the Board and it agreed to a meeting. Savoie
says that "The questions raised relate mainly to practical diffi-
culties in arriving at a value to place on the conversion feature of
convertible debentures through the process of relating the convertible
debenture price to the price of a straight debt security without
the conversion feature.'53
Savoie seems to minimize another aspect of the investment
banker's concern and yet his mention of it gives rise to the prospect
that it may have been a significant factor. He says that "This
issue, too, has overtones of earnings per share. Allocation of a
portion of proceeds of a convertible debt issue to the conversion
feature results in debt discount which must be amortized against
future earnings. Thus, convertible debt is less appealing than it
would be without this requirement.'54
The impression is thus created that reaction to Opinion No. 10
cam.,- onl, fromrr the direction of investment bankers and not from
accountanits or management. Furthermore, the expressed criticism
concernr-d technical procedures for implementing the Opinion and not
the theoret;ial bases of the Opinion.
In addition to the temporary suspension of Paragraphs 9 and 10
of Opinion 11o. 10 the Board ruled that until its new Opinion pertain-
ing to conrier tible securities is issued, and which may be retroactive,
531bid., p. 40.
"a dual presentation of earnings per share of common stock should be
furnished on the face of the statement of income55 by those firms
which would have been subject to the Opinion. The presentation
should show earnings per share (1) based upon the average number of
shares outstanding and (2) assuming complete conversion of all out-
standing convertible securities. The Board says that "The purpose
of the dual presentation is to recognize and emphasize the complex
nature of these securities, including the existence of equity charac-
teristics, and the possibility that conversion of the security or
exercise of options or warrants may affect earnings per share of
The most recent activity of the Board, relative to convertible
securities, was the release of an exposure draft of a new opinion
and a new opinion. The exposure draft is intended to be an expansion
and clarification of the previous Opinion dealing with earnings per
share and the new opinion pertains to accounting for convertible
debt and debt issued with stock purchase warrants. The Board included
a summary of the significant points and parts of the summary of the
earnings per share Opinion are repeated here:
1. A dual presentation of earnings per share
figures will be required on the face of the
income statement for (a) primary earnings
per share--earnings attributable to each
share of common stock and equivalent share
55 Opinion No. 12," op. cit., par. 15.
6Ibid., par. 15.
of common stock attributable to residual
securities and (b) fully diluted earnings
per share--earnings attributable to each
share of common stock assuming all conver-
sions, exercises and contingent issuances
had taken place.
2. Residual securities are defined as those
which (including options and warrants) clearly
derive a substantial portion of their value
from their conversion'rights or other common
3. The test for determining residuality of a
security at and subsequent to issuance is
based on the relationship between investment
value and the market price of the convertible
4. The exposure draft takes the position that
the residual security concept should be applied
only in the computation of earnings per share;
no changes should be made in the basic accounting 57
and financial presentation for residual securities . .
In Opinion Ilo. 14, the new opinion, the Board discussed the
arguments on both sides for treating a portion of the proceeds of a
con'.'crtible bond as paid-in capital and concluded that ". no
portion of the proceeds from the issuance of the types of converti-
ble debt securities .. should be accounted for as attributable to
the conv'.ersion feature. In reaching this conclusion, the Board places
greater eight on the inseparability of the debt and the conversion
option . and less weight on practical difficulties."58
57American Institute of Certified Public Accountants, Accounting
Principles Board,"Exposure Draft, Proposed APB Opinion: Earnings
Per Share"(Iic.-.ember C, 1968).
58American Institute of Certified Public Accountants, Accounting
Principles Board, "Opinion No. 10: Accounting for Convertible Debt
and DebLt Issued .-ith Stock Purclase Warrants" (March 1969).
The Board has thus come full cycle in its attitude. First
it required that a portion of convertible bond proceeds be treated
as equity, it then suspended that requirement, and now forbids
such treatment. It is interesting to note, however, that the Board
still says that such securities have debt and equity characteristics.
The remainder of this study will be concerned with more clearly
developing those characteristics and evaluating the debt and equity
nature of convertible securities.
DEBT VERSUS EQUITY
The traditional statement of financial position requires the
classification of items reported on the right-hand side of the state-
ment into two major categories: liabilities and ownership. This
presupposes that all financial interest in the enterprise is either
a creditor interest or ownership interest. It is further assumed
thai the person preparing the statement has the capacity to recognize
which catc-gory is appropriate for a particular interest.
There ai'e at least two disturbing fallacies reflected in the
above.' assurnptiois. The first is simply the fact that as business
enterprises, and particularly corporation, have become more complex,
so have the types of financial interests. Some interests, such as
those of trade ccditors, do not present any particular problem. The
difficulty stems, to a great extent, from the wide variety of securities
which are issued. As early as 1922, Paton was expounding on the "almost
indefinite '.a'iety of preferred stocks'.' and the "great variety of
There c:re preferred issues which are "callable" or "redeemable"
at the optior, of the corporation on the basis of certain agreed upon
\:illi ir A. Paton, Accounting Theory (Reprint ed., Chicago:
Account i .g Stud;e. Press, Ltd., 1962), p. 70.
2Ibid., r,. 71.
conditions. The preferred stockholders may "participate" with
common stockholders in any distribution of earnings above a certain
amount and dividends are frequently "cumulative." The preferred
shares may also be "convertible" into other securities, particularly
into common stock. A specific preferred stock issue may contain any
combination of these features.
Among the many bond issues are "income" bonds, "mortgage" bonds,
"collateral trust" bonds, "debenture" bonds and "convertible" bonds.
In addition there are numerous different features incorporated into
these major types of bond issues. In fact, Paton claimed that "virtually
every specific issue has its peculiar features in regard to income,
safety of principal, and control of operation."3 In support of the
entity theory of accounting he asserted that "if all corporate stocks
and bonds were to be arranged in a series according to degree of risk
attaching to each, beginning with the most speculative types of common
stock at one extreme, followed by the better grade common issues,
the less conservative preferred stocks, the highly safeguarded pre-
ferred issues, and all the various grades of bonds grouped according
to security, it would be impossible to draw any hard and fast line
of division which followed security types and corresponded to the
proprietor, creditor grouping of the sole-proprietorship or the
4lbid., pp. 72-73.
The second major fallacy in the traditional assumptions about
balance sheet classification is that despite the wide variety of
securities the person preparing the statement can be expected to
"properly" classify the particular interest as creditor or ownership.
Unfortunately, there does not appear to be a definitive statement of
the distinction between a creditor interest and an ownership interest
which the person preparing the statement of financial position can
use as a guide-to-action in carrying out his responsibility for clas-
sification. Various writers have set forth what they.believe to be
the appropriate distinction, while others, like Paton in the state-
ment above, simply say that it is impossible to develop such a
definitive stDatcL eni2rt. This is clearly the easiest way out of the
dilernma and perhaps the only way out.
This \would require that accountants adopt the entity theory
and disconrtinue the proprietary theory, which would entail a major
re-ex/Taminatiocn c:f accounting thought. The purpose of this study is
not to attempt that re-examination, rather it is to take the present
classification systern as given and through empirical data provide
some assistance in the classification of one of the numerous securities:
the "convertible," both bond and preferred stock.
Before unJertaLing the empirical investigation it seems alto-
gether appropriate and necessary to establish a framework for the
research. ConbSeqLurntll at this point an effort will be made to sum-
marize the ..ariouLI views of what constitutes the distinction between
debt and equity. In the next chapter the empirical data will be
related to the characterizing features of debt and equity thus
Criteria for Classification as Debt or Equity
In the discussion which follows, certain of the criteria will
be attributed to a particular writer even though the view may not be
unique to that individual, but in some cases this may be the situation.
Some of the criteria are based upon widespread opinion while others
reflect the present writer's interpretation.
According to Johnson5 the key factor in determining whether
a particular security represents a creditor interest or ownership
interest is bargaining. This view was discussed previously in con-
nection with evaluation of similarities and dissimilarities of bonds
and preferred stocks. Therefore, only a brief review will be given
at this point. He believes that it is impossible for there to be
any bargaining between the owners and the company. The interest of
the owners is the same as the interest of the company and vice versa,
On the other hand, there is commonly bargaining between the
company and creditors, especially long-term creditors. The bargaining
relates to four factors which are the distinguishing features of debt
Robert \V. Johnsoi, Financial lManagqment (2nd ed., Boston:
Allyn and Bacon, Inc., 1962), pp. 135-138.
and equity: "maturity, claim on income, claim on assets, and right
to voice in management.'6
These four features establish a set of opposites. If the
security is a debt there is a due date which means that repayment will
be required at a specified time. If the security reflects ownership
there is no due date because there is no commitment on the part of
the company to return the original investment. Only by selling
his shares or liquidating the company can the owner recover his invest-
The crditorsc'clairi on income is prior to the owners'. They
also ha.e a certainty of that claim because interest on debt is con-
sidercd a legal obligation, whereas the owners have no legal recourse
if dividends are not paid, except in rare cases. A third factor which
pertains to the claim on income is the amount of the claim. Creditors
have an agreed upon rate of interest which they can expect to receive.
The, rece'.e no r.ore o; no less,while the owners have a claim on
what is a'.ailable after other outlays. Thus what the owners receive,
if anything, fluctuates from year to year.
The claim on assets feature of the bargain is meaningful only
in the event of liquidation, and neither creditors nor owners would
make their initial cor.iritments on the basis of expected liquidation.
In the event that the unexpected does occur the creditors have a
claini prior to t.he', o rners.
61bid., p. 133.
The agreement between the company and creditors does not
usually allow the creditors any direct voice in the management of the
company. There are frequently agreements which provide that upon the
occurence of specified contingencies the creditors obtain certain
Legal Status and Investment Character7
The traditional textbook basis for the classification of
securities, according to Graham, Dodd and Cottle, is the legal dis.-
tinction between the position of creditors and owners and the safety
of bonds versus the opportunity for speculative gain of stocks. They
object to the present classification for a number of reasons, the first
being that preferred stocks are placed with common stocks when, "so
far as investment practice is concerned, the former undoubtedly belong
with bonds." They express the view that preferred stockholders
consider themselves not as partners in the business but as senior
security holders, and they are "owners of the business only in a
technical, legalistic sense; but they resemble bondholders in the pur-
pose and expected results of their investment."9
They see bonds being equated with safety, but this may be mis-
leading because safety does not necessarily follow from an obligation
Benjamin Graham, David L. Dodd and Sidney Cottle, Security
Analysis (4th ed., New York: McGraw-Hill Book Company, Inc., 1962), p. 98.
8bid., p. 98.
to pay interest and to redeem the bond at maturity. The legal
recourse also fails to provide safety because "Safety depends upon
and is measured entirely by the ability of the debtor corporation to
meet its obligations."l0
Thesc writers offer an alternative plan for classification which
eliminates the strict creditor-owner division. This plan will not
be considered at this point because the concern here is with how to
make th.e distinction, rather than its elimination.
Dilution of Earnings Per Share
The Accounting Principles Board has been devoting considerable
attention to the problem of the appropriate computation of earnings
per shri-. The various opinions of the Board concerning this matter
were reviewed in the previous chapter and will not be repeated here
except to note that a major point was what constituted a residual
security. It is clear that the Board treated securities other than
common stock as residual. It also appears reasonable to conclude that
if a security, represents a residual interest it also represents an
ownership interest rather than a creditor interest.
The conclusion of this writer is that the major test of the
residual nature of a security, implied in the Board's opinion, is whether
the sccr*r;'ty has the potential to dilute earnings per share, not
ncressaril', at the time of issue but at some time in the future. If this
pot-.:-til e>.istL the security is residual.
OIbid. p. 99.
Weston's Senior Versus Residual Classification
In a recent article Weston reviewed the opinions of the Account-
ing Principles Board which pertained to earnings per share. He con-
cluded that a determination of the relative values of the senior
security characteristics and the residual security characteristics
would involve many problems of interpretation and application. He
offered the following factors as those which would normally be con-
Senior security characteristics
Fixed dividend rate
Preference of such fixed dividend
over other securities
Cumulative nature of fixed dividend
Residual security characteristics
Participating features, with common
Voting rights 12
Weston qualified these factors by pointing out that liquidation
or redemption play an insignificant part in the evaluation of a complex
security unless redemption or liquidation are imminent. The conversion
feature, on the other hand, is the residual security characteristic
Frank T. Weston, "Reporting Earnings Per Share," Financial
Analysts Journal (Vol. 23, No. 4, July-August, 1967), p. 50.
121bid., p. 50.
which is most meaningful for value determination.13
Maturity Value and Maturity Date
In their discussion of the nature of liabilities and owners'
equities, Sprouse and Moonitz explicitly set forth the criteria for
distinguishing the interests of owners and creditors. According to
them there are to grounds or which to make the distinction:
First, the amount of the ov.ners' equity is residual
in nature while the maturity values of liabilities
are independentl, determined. Whenever a change in
assets is not exactly offset by a change in liabilities,
or vice versa, the difference is automatically
reflected ii the owners' equity as the residual
interest. Second, liabilities are in a continuous
and irresistible process of maturing while the
owners' equity matures onl., at the volition of the
owners of the business enterprise or their repre-
sentatives or upon iultirate liquidation. Thus,
liabilities are obligati-rn., the amounts and maturities
of which are not solely, within the control of the
business enterprise. L'
Legal Di st i net i on n
The legal vic. of creditors and owners revolves around the
income tax and harnkruptcy la's. It is well established that interest
payments on debts are deductible by the corporation in determining
its income tax liability while payments to owners in the form of divi-
dends are not deductible. Likewijie, the non-payment of interest or
1 Ibid., p. 50.
14Robert T. Sprouse and laurice Moonitz. A Tentative Set of Broad
Accounting Principilc: for Eusiness Enterprise. Accounting Research
Stud Hio. 3 (I ow York. Aerircan Institute of Certified Public Accountants,
1962), p. 38.
principal when due constitutes grounds for the creditors to initiate
bankruptcy proceedings,while the owners have no such recourse if
dividends are not paid.
Obviously the mere statement of the law does not solve the
problems of what constitutes debt, and therefore interest payments and
which individuals are entitled to institute bankruptcy. Especially
in the area of taxation there have been a number of cases concerning
the deduction of payments. Several of these cases were cited by Johnson
in a 1955 article and he felt that one particular case15 well summarized
the combination of factors which distinguish debt securities from
ownership securities. In that case the "securities were held to be
evidence of indebtedness and the interest tax-deductible on the grounds
that: (1) the securities were called'debenture certificates' and the
phraseology throughout was of a debt instrument; (2) a fixed amount
was to be repaid at a definite maturity date; (3) a fixed amount of
interest, not dependent upon earnings, was to be paid at definite
dates; (4) the rights of the debenture holders were subordinate to all
creditors but superior to stockholders; (5) the certificates carried
no voting power; and (6) the taxpayer presented good business reasons
for issuing the debentures.'16
1Clyde Bacon, Inc., v. Commissioner of Internal Revenue
4TCll07, Acg. (1945).
1Robert W. Johnson, "Subordinated Debentures: Debt that Serves
as Equity," The Journal of Finance (Vol. X, March 1955), p. 14.
In a current issue of The Journal of Accountancy7 a letter
from the Internal Re.cnue Service concerning the issue of debt versus
equity was quoted. Reference was made to a more recent case in
which the factors normally considered are listed. In that case the
court held that "There are at least eleven separate determining fac-
tors general used b, the courts in determining whether amounts
advanced to a corporation constitute equity capital or indebtedness.
The; are (1) the names given to the certificates evidencing the
indebtedness; (2) the presence or absence of a maturity date; (3) the
source of the payments; (4) the right to enforce the payment of
principal and interest; (5) participation in management; (6) a status
equal to or inferior to that of regular corporate creditors; (7) the
intent of the parties; (8) 'thin' or adequate capitalization;
(9) identity of interest between creditor and stockholder; (10) pay-
ment of interest onli' out of 'dividend' money; and (11) the ability
of the corporation to obtain loans from outside lending institutions."l8
The above letter from the Internal Revenue Service specifically
mentioned the widespread use of convertible bonds in corporate
financing and concluded that:
. subordination and convertibility are only
two of many factors to be considered in determining
whether a bond issue represents equity or indebted-
ness. The presence of both factors does not
'Benjamin Crund, "Tax Clinic," The Journal of Accountancy
(January 1969), p. 75.
10. H. Ir'.use Crain & Milling v. Commissioner of Internal
Revenue, 279 F. 2d 123.