6.3 Conversion Features in an Equity Host
6.3.1 Background
An equity instrument often contains features that require or permit the
instrument to be converted into another form of the issuer’s equity. The most
common scenario is a preferred stock agreement that contains a feature allowing
holders to convert their preferred shares into common stock (1) at the option of
one of the parties to the contract, (2) upon the occurrence of certain events,
or (3) after a certain period of time. As discussed in greater detail below,
equity conversion features generally do not require bifurcation from an equity
host contract because such features are considered clearly and closely related
to the host contract.
6.3.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of equity
conversion features embedded in an equity host contract. As previously noted, an
entity should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance before reaching a conclusion.
Bifurcation Condition
|
Condition Met?
|
Analysis
|
---|---|---|
Not clearly and closely related (see Section 4.3.2)
|
No
|
A conversion feature that allows a hybrid instrument in
the form of a share (e.g., preferred stock) to be
converted into another type of the entity’s equity
(e.g., common stock) is considered clearly and closely
related to the equity host contract. In addition,
cash-settled conversion features are similarly typically
considered clearly and closely related to an equity host
since the monetary value of the cash conversion is based
on the value of the equity shares.
|
Hybrid instrument not measured at fair value through
earnings on a recurring basis (see Section 4.3.3)
|
Typically, no
|
From the issuer’s perspective, equity
host contracts would not be measured at fair value on a
recurring basis since they are not eligible for the fair
value option in ASC 815-15 or ASC 825-10. Legal form
equity contracts that require liability classification
(and thus are potentially subject to recurring fair
value measurement) would not typically be considered
equity hosts in the evaluation of embedded features.
From the holder’s perspective, the determination of
whether the hybrid instrument is measured at fair value,
with changes in fair value recorded through earnings,
will depend on whether the instrument is (1) an equity
method investment, (2) considered a debt security in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or (3) an equity security
in the scope of ASC 321.
|
Meets the definition of a derivative (see Section 4.3.4)
|
It depends
|
The conversion of a hybrid instrument in the form of a
share (e.g., preferred stock) into another form of an
entity’s equity may meet the definition of a derivative
if both the host contract and the instrument issued are
RCC. In addition, the feature may meet the definition of
a derivative if the conversion feature could be settled
in cash. See Section
6.3.4 for further details.
|
Meets a scope exception
|
It depends
|
The issuer should evaluate whether the equity conversion
feature meets the scope exception for certain contracts
on own equity or share-based payment transactions.
Conversion features that can be cash settled in a manner
outside the issuer’s control would generally not qualify
for this scope exception.
|
6.3.3 Clearly-and-Closely-Related Analysis
A conversion feature that allows a hybrid instrument in the form of a share
(e.g., preferred stock) to be converted into another type of an entity’s equity
(e.g., common stock) is considered clearly and closely related to an equity host
contract. In addition, a conversion feature that can be settled in cash or
shares would also be considered clearly and closely related to the host contract
because the monetary value of the conversion, regardless of the form of
settlement, is based on the monetary value of the equity shares. Accordingly,
cash-settled conversion features are also typically considered clearly and
closely related to an equity host.
Because the “not clearly and closely related” criterion is generally not met for
conversion features in an equity host contract, most entities would not be
required to evaluate whether the conversion feature meets the definition of a
derivative. Despite that practicality, we discuss the derivative considerations
for illustrative purposes in the following section.
6.3.4 Derivative Analysis
The table below presents the characteristics that would be evaluated to determine
whether an equity conversion feature embedded in an equity host would meet the
definition of a derivative. In a manner consistent with conversion features in a
debt host, the determination often comes down to whether or not the feature
meets the net settlement criterion.
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
---|---|---|
Underlying and notional amount or payment provision
|
Yes
|
An equity conversion or exchange feature has both an
underlying (the fair value of the equity instruments
that would be issued upon conversion and, if applicable,
the occurrence or nonoccurrence of any exercise
contingency) and a notional amount (the number of shares
that would be issued upon conversion).
|
Initial net investment
|
Yes
|
The initial net investment in an embedded feature is its
fair value (i.e., the amount that would need to be paid
to acquire the equity conversion feature on a
stand-alone basis without the host contract). Generally,
an equity conversion or exchange feature has an initial
net investment that is smaller than would be required
for a direct investment that has the same exposure to
changes in the stock price (since the investment in the
equity host contract does not form part of the initial
net investment in the embedded feature).
|
Net settlement
|
It depends
|
The net settlement characteristic is met if either (1)
the equity conversion or exchange feature can be
explicitly net settled (e.g., its fair value can be
settled net in shares or net in cash) or (2) the shares
that would be issued upon conversion are RCC. Shares of
publicly traded entities may be considered RCC; however,
non-publicly-traded shares will never be considered RCC
(see Section
1.4.3.4 for further discussion of RCC).
The net settlement characteristic is not met if the
equity conversion or exchange feature must be gross
physically settled and the shares that would be
delivered upon conversion are not RCC. See Section 6.2.4.3 for
further discussion of net settlement considerations for
equity conversion features.
|