5.5 Application of the Equity Classification Conditions to Certain Convertible Debt Instruments
ASC 815-40
25-39 For purposes of
evaluating under paragraph 815-15-25-1 whether an embedded
derivative indexed to an entity’s own stock would be
classified in stockholders’ equity if freestanding, the
requirements of paragraphs 815-40-25-7 through 25-30 and
815-40-55-2 through 55-6 do not apply if the hybrid contract
is a convertible debt instrument in which the holder may
only realize the value of the conversion option by
exercising the option and receiving the entire proceeds in a
fixed number of shares or the equivalent amount of cash (at
the discretion of the issuer).
25-40 However, the requirements
of paragraphs 815-40-25-7 through 25-30 and 815-40-55-2
through 55-6 do apply if an issuer is evaluating whether any
other embedded derivative is an equity instrument and
thereby excluded from the scope of Subtopic 815-10.
25-41 Instruments that provide
the holder with an option to convert into a fixed number of
shares (or equivalent amount of cash at the discretion of
the issuer) for which the ability to exercise the option is
based on the passage of time or a contingent event shall
qualify for the exceptions included in paragraph
815-40-25-39. Standard antidilution provisions contained in
an instrument do not preclude a conclusion that the
instrument is convertible into a fixed number of shares.
25-42 Convertible preferred
stock with a mandatory redemption date may qualify for the
exception included in paragraph 815-40-25-39 if the economic
characteristics indicate that the instrument is more akin to
debt than equity. An entity shall consider the guidance in
paragraph 815-15-25-17 in assessing whether the instrument
is more akin to debt or equity. That paragraph explains
that, if the preferred stock is more akin to equity than
debt, an equity conversion feature would be clearly and
closely related to that host instrument.
ASC 815-40 — Glossary
Equity Restructuring
A nonreciprocal transaction between an entity and its shareholders that causes
the per-share fair value of the shares underlying an option
or similar award to change, such as a stock dividend, stock
split, spinoff, rights offering, or recapitalization through
a large, nonrecurring cash dividend.
Standard Antidilution Provisions
Standard antidilution provisions are those that result in adjustments to the
conversion ratio in the event of an equity restructuring
transaction that are designed to maintain the value of the
conversion option.
The conditions in ASC 815-40-25-10 (see Section 5.3) do not apply to an embedded
conversion option if the holder is only able to realize the option’s value by
exercising it “and receiving the entire proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of the issuer).” Thus, a conversion
option in such a convertible debt instrument may fail to meet one or more of those
conditions and still qualify for the own-equity scope exception to the derivative
accounting guidance. Convertible preferred stock may also qualify under this
exception if it has a mandatory redemption date and its economic characteristics
indicate that the instrument is more akin to debt than equity (ASC 815-40-25-42).
Because of the requirement related to a mandatory redemption date, convertible
preferred securities that are redeemable only at the option of the holder do not
qualify.
For an instrument to be exempt from the conditions in ASC 815-40-25-10, the
issuer must have the ability to settle it gross by delivering a fixed number of
shares, although the issuer might alternatively elect to settle the instrument in an
equivalent amount of cash. The holder’s ability to exercise the conversion option
may be “based on the passage of time or a contingent event” (ASC 815-40-25-41).
The following are examples of convertible debt instruments that do not qualify
for this exception because the number of shares to be delivered upon conversion is
not fixed:
-
A convertible debt instrument that contains a down-round provision (see Section 4.3.7.2).
-
A convertible debt instrument that contains a make-whole provision that adjusts the conversion rate so that the issuer is required to deliver additional shares if it fails to meet specified debt covenants.
The table below indicates whether certain adjustments to the conversion price
represent standard antidilution provisions and therefore would not prevent an entity
from applying the exception.
Examples of Adjustment to the Conversion Price | Type of Antidilution Provision |
|---|---|
Subdivision (stock split, stock dividend) | Standard |
Combination (reverse stock split) of outstanding common shares | Standard |
Issuance of common shares at a lower price than the conversion price in effect immediately before such issuance | Nonstandard |
Recurring quarterly cash dividend to all common shareholders | Nonstandard |
Recapitalization through a large nonrecurring cash dividend | Standard |
If the exception applies, an entity does not need to evaluate whether the issuer would
be required to net cash settle the conversion option as a result of the
circumstances described in ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through
55-6. Therefore, even if cash settlement of the conversion option is required as a
result of one or more of the conditions in those paragraphs, the convertible debt
would still meet the equity classification conditions in ASC 815-40. However, the
conversion option would not meet the equity classification requirements of ASC
815-40 if the entity could be forced to cash settle the embedded conversion option
(1) upon the occurrence of an event that is outside its control that is not
addressed in ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through 55-6 or (2)
upon the passage of time.
Although the equity classification conditions in ASC 815-40-25-10 do not apply to
convertible debt that is eligible for the exception, the embedded conversion option
still needs to be indexed to the entity’s stock to meet the scope exception in ASC
815-10-15-74(a).