12.3 Convertible Debt With No Equity Component

12.3.1 Background

If convertible debt that does not contain a bifurcated embedded conversion feature under ASC 815-15 or a separately recognized equity component is converted into the issuer’s equity shares under the instrument’s original conversion terms, (1) the net carrying amount of the debt is derecognized and cash, equity, or both are credited to reflect the consideration issued and (2) no gain or loss is recognized (see Section 12.3.2). In practice, this is often referred to “conversion accounting.”1 If the conversion qualifies as an “induced conversion” under ASC 470-20-40-16, the issuer first recognizes “an expense equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of securities issuable [under] the original conversion terms” and then applies conversion accounting (see Section 12.3.4).

12.3.2 Conversion in Accordance With the Original Conversion Terms

ASC 470-20

35-11 If the terms of conversion of a convertible debt instrument provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder, that interest should be accrued or imputed to the date of conversion of the debt instrument.

Contractual Conversion

40-4 If a convertible debt instrument accounted for in its entirety as a liability under paragraph 470-20-25-12 is converted into shares, cash (or other assets), or any combination of shares and cash (or other assets), in accordance with the conversion privileges provided in the terms of the instrument, upon conversion the carrying amount of the convertible debt instrument, including any unamortized premium, discount, or issuance costs, shall be reduced by, if any, the cash (or other assets) transferred and then shall be recognized in the capital accounts to reflect the shares issued and no gain or loss is recognized.

Interest Forfeiture

40-11 If the terms of conversion of a convertible debt instrument provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder, accrued interest from the last interest payment date, if applicable, to the date of conversion, net of related income tax effects, if any, shall be charged to interest expense and credited to capital as part of the cost of securities issued. Thus, the accrued interest is accounted for in the same way as the principal amount of the debt converted and any unamortized premium, discount, or issuance costs; the net carrying amount of the debt, including any unamortized premium, discount, or issuance costs and the related accrual for interest to the date of conversion, net of any related income tax effects, is a credit to the entity’s capital.

ASC 470-20-40-4 specifies the accounting for a conversion of a convertible debt instrument that (1) does not contain a bifurcated embedded conversion feature under ASC 815-15 and (2) is not addressed by other guidance (i.e., conversions of convertible debt that contain a separately recorded equity component as well as induced conversions). Under this guidance, no gain or loss is recognized upon the conversion of debt into shares, cash, or other assets in accordance with the debt’s original conversion terms. Conversion accounting does not apply if the minimum number of shares that were required to be issued under the original conversion terms have not been issued.

If the conversion feature is settled entirely in shares, the debt’s net carrying amount is credited to equity upon conversion to reflect the equity shares issued. For example, the issuer may make the following accounting entry:

Convertible debt

Equity — common stock/APIC

If the conversion feature is settled (1) entirely in cash upon conversion or (2) in a combination of cash and shares, the journal entry would differ because it would reflect the payment of cash in lieu of equity shares, but the issuer still would recognize no gain or loss on the conversion date.

The net carrying amount of the debt reflects any remaining unamortized discount or premium as of the date of conversion as well as any remaining unamortized debt issuance costs as of that date, in accordance with the definition of “net carrying amount of debt” in ASC 470-50 (see Section 9.3.1.3). The issuer should amortize any premium or discount and debt issuance costs up to the date on which the instrument is converted. As indicated in ASC 470-20-40-11, the carrying amount also includes any “accrued interest from the last interest payment date, if applicable, to the date of conversion, net of related income tax effects, if any,” irrespective of whether accrued unpaid interest is forfeited upon conversion. If convertible debt does not contain a bifurcated embedded conversion feature under ASC 815-15 (see Section 12.4) or a separately recognized equity component (see Section 12.5), the accrued interest cost, net of any related income tax effects, is credited to equity as part of the cost of any equity shares issued.

See Section 12.3.4 for a discussion of the accounting for induced conversions. See Section 12.4 for a discussion of the accounting for a conversion of a convertible debt instrument for which the embedded conversion option has been separated as an embedded derivative liability. Such accounting applies if the embedded conversion option has been separated from the host debt instrument upon or after issuance but before conversion. See Section 12.5 for a discussion of the application of conversion accounting to a convertible debt instrument with a separated equity component.

Connecting the Dots

For certain convertible debt instruments, the issuer may elect to settle a conversion partially or fully in cash. In such cases, the issuer must elect to settle the conversion value in cash on a date before the settlement occurs (e.g., 30 days before the cash settlement occurs). Consequently, if the election is irrevocable and the issuer elects to settle all or a portion of the conversion value in cash, the embedded conversion feature will no longer meet the own-equity exception in ASC 815-10-15-74(a). Therefore, the issuer will have to bifurcate the embedded conversion feature as a derivative instrument under ASC 815-15. This bifurcated derivative will generally represent a nonoption embedded derivative that the issuer must initially recognize at zero in accordance with ASC 815-15-55-160 through 55-164. However, the issuer must recognize in earnings the change in fair value of the bifurcated embedded derivative. The issuer would do so from the date of the irrevocable notice to settle a portion of the conversion in cash until the settlement date (i.e., a derivative balance will exist after initial bifurcation). Depending on variations in the issuer’s share price, the change in fair value could represent an asset or a liability.

Conversion accounting is still appropriate in these circumstances because the separation of the conversion feature is incidental to the settlement of the debt instrument in accordance with its original conversion terms. In the application of conversion accounting, the net carrying amount of the convertible debt will include the fair value of the bifurcated embedded derivative. Therefore, no gain or loss will be recognized on the conversion date (i.e., the settlement date). Nevertheless, the gain or loss on the bifurcated embedded derivative should not be reversed (i.e., it will remain recognized in earnings). Thus, while the conversion of the instrument does give rise to a gain or loss that is reported in earnings (i.e., for the period between the date on which the issuer elects cash settlement and the settlement date), it does not invalidate the application of conversion accounting as of the settlement date. That is, extinguishment accounting is not required. The alternative views discussed in Section 12.4 are not relevant to these types of settlements.

12.3.3 Conversion Upon the Issuer’s Exercise of a Call Option

12.3.3.1 General

ASC 470-20

05-11 An entity may issue equity securities to settle a debt instrument that was not otherwise currently convertible but became convertible upon the issuer’s exercise of a call option when the issuance of equity securities is pursuant to the instrument’s original conversion terms. This Subtopic provides related guidance.

40-5 The following guidance addresses accounting for the issuance of equity securities to settle a debt instrument (pursuant to the instrument’s original conversion terms) that became convertible upon the issuer’s exercise of a call option:

Substantive conversion feature. If the debt instrument contained a substantive conversion feature as of time of issuance, the issuance of equity securities shall be accounted for as a contractual conversion. That is, no gain or loss shall be recognized related to the equity securities issued to settle the instrument.
No substantive conversion feature. If the debt instrument did not contain a substantive conversion feature as of time of issuance, the issuance of equity securities shall be accounted for as a debt extinguishment. That is, the fair value of the equity securities issued should be considered a component of the reacquisition price of the debt.

Sometimes, the terms of a convertible debt instrument include both (1) an option for the issuer to call the instrument and (2) a right for the holder to exercise the conversion feature if the issuer calls the instrument. In this circumstance, the accounting for the conversion of the instrument into the issuer’s equity shares in accordance with the original terms of the debt depends on whether the conversion feature was (1) otherwise currently convertible and (2) substantive as of the instrument’s issuance date (see Section 12.3.3.2).

If the conversion option is nonsubstantive at issuance and the instrument becomes convertible upon the issuer’s exercise of the call option, the conversion of the instrument into equity shares is accounted for as a debt extinguishment (see Section 9.3). As long as the conversion feature is nonsubstantive at issuance, and provided that the holder does not currently have the ability to convert the instrument unless the issuer exercises its call option, extinguishment accounting applies even if the instrument would have become convertible upon the passage of time (e.g., a conversion option that becomes exercisable on the instrument’s maturity date or on specified prior dates).

The conversion of an instrument into the issuer’s equity shares is accounted for as a conversion (see Section 12.3.2) as long as it otherwise qualifies for such accounting if either (1) the conversion feature is substantive at issuance or (2) the holder has the ability to exercise the conversion feature irrespective of the issuer’s exercise of its call option.

Convertibility of Debt Instrument	Conversion Feature Substantive at Inception	Conversion Feature Not Substantive at Inception
Convertible only upon the issuer’s exercise of a call option	N/A. (By definition, such a conversion option is not substantive as of the issuance date.)	Accounted for as an extinguishment.
Convertible upon the issuer’s exercise of a call option and could otherwise become convertible in the future	Accounted for as a conversion.	Accounted for as an extinguishment.
Currently convertible even if the issuer has not exercised its call option	Accounted for as a conversion. Because the instrument is convertible without the issuer’s exercise of a call option, the accounting does not depend on whether the conversion option was substantive on the issuance date.

This guidance does not apply to transactions that would not otherwise qualify for conversion accounting (see Section 12.2) or to induced conversions. See Section 12.4 for a discussion of the accounting for a conversion of a convertible debt instrument for which the embedded conversion option has been separated as an embedded derivative liability. Such accounting applies if the embedded conversion option has been separated from the host debt instrument upon or after issuance but before conversion.

12.3.3.2 Determining Whether a Conversion Feature Is Substantive

ASC Master Glossary

Substantive Conversion Feature

A conversion feature that is at least reasonably possible of being exercisable in the future absent the issuer’s exercise of a call option.

ASC 470-20

40-6 The assessment of whether the conversion feature is substantive may be performed after time of issuance but shall be based only on assumptions, considerations, and marketplace information available as of time of issuance.

40-7 By definition, a substantive conversion feature is at least reasonably possible of being exercised in the future. If the conversion price of an instrument at issuance is extremely high so that conversion of the instrument is not deemed at least reasonably possible as of time of issuance, then the conversion feature would not be considered substantive.

40-8 For purposes of determining whether a conversion feature is reasonably possible of being exercised, the assessment of the holder’s intent is not necessary. Therefore, even if such an instrument included a conversion feature that provided for conversion due solely to the passage of time (for example, the instrument will become convertible at a date before its maturity date), it would be inappropriate to conclude that the conversion feature is substantive. Also, an instrument that became convertible only upon the issuer’s exercise of its call option does not possess a substantive conversion feature.

40-9 Methods that may be helpful in assessing whether a conversion feature is substantive include the following:

The fair value of the conversion feature relative to the fair value of the debt instrument. Comparing the fair value of a conversion feature to the fair value of the debt instrument (that is, the complete instrument as issued) may provide evidence that the conversion feature is substantive.
The effective annual interest rate per the terms of the debt instrument relative to the estimated effective annual rate of a nonconvertible debt instrument with an equivalent expected term and credit risk. Comparing the effective annual interest rate of the debt instrument to the effective annual rate the issuer estimates it could obtain on a similar nonconvertible instrument may provide evidence that a conversion feature is substantive.
The fair value of the debt instrument relative to an instrument that is identical except for which the conversion option is not contingent. Comparing the fair value of the debt instrument to the fair value of an identical instrument for which conversion is not contingent isolates the effect of the contingencies and may provide evidence about the substance of a conversion feature. If the fair value of the debt instrument is similar to the fair value of an identical convertible debt instrument for which conversion is not contingent, then it may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
Qualitative evaluation of the conversion provisions. The nature of the conditions under which the instrument may become convertible may provide evidence that the conversion feature is substantive. For example, if an instrument may become convertible upon the occurrence of a specified contingent event, the likelihood that the contingent event will occur before the instrument’s maturity date may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.

40-10 The guidance in paragraphs 470-20-40-7 through 40-9 does not address the treatment of an instrument for purposes of applying Subtopic 260-10.

In evaluating whether a conversion option is substantive as of the debt’s issuance date, an issuer considers the assumptions that were made and the marketplace information that was available as of that date even if the assessment is performed subsequently. A conversion option may be deemed substantive if — as of the instrument’s issuance date — there is at least a reasonable possibility that it will become exercisable by the holder upon (1) the passage of time or (2) the occurrence or nonoccurrence of a specified event (other than the issuer’s exercise of the call option) that is likely to occur. However, in accordance with ASC 470-20-40-7, a conversion option that currently has a reasonable possibility of becoming exercisable would not be considered substantive if, as of the instrument’s issuance date, its exercise was not reasonably possible (e.g., because the conversion option is deeply out-of-the-money).

Under ASC 470-20, a conversion feature would not be considered substantive as of the instrument’s issuance date in any of the following circumstances:

The holder has no ability to exercise the conversion feature (i.e., it is not exercisable) unless the issuer exercises its call option.
It is not reasonably possible for the holder to obtain the ability to exercise the conversion feature (i.e., it is not reasonably possible that the feature will become exercisable) unless the issuer exercises its call option. For example, this would be the case if the only circumstance in which the holder can obtain a right to convert the instrument (other than the issuer’s exercise of the call option) is a specified event that does not have a reasonable possibility of occurring.
It is not reasonably possible that the holder will exercise the conversion feature (e.g., the conversion price is extremely high relative to the current share price as of the issuance date).

In evaluating whether a conversion option is substantive as of the issuance date in accordance with ASC 470-20-40-9 (e.g., when determining whether it is reasonably possible that the holder will exercise the conversion feature), an issuer should consider the following:

The smaller the fair value of the conversion feature relative to the fair value of the debt instrument, the more likely it is that the conversion option is not substantive.
The smaller the difference between the convertible debt’s effective interest rate and the effective interest rate on a hypothetical nonconvertible debt instrument with the same terms except for the conversion feature, the more likely it is that the conversion option is not substantive.
The greater the difference between the fair value of the convertible debt and the fair value of a hypothetical convertible debt instrument with the same terms (except that the conversion feature is not contingent), the more likely it is that the conversion option is not substantive.
The smaller the likelihood of a contingent event that would make the conversion feature exercisable, the more likely it is that the conversion option is not substantive.

12.3.3.3 Illustration

ASC 470-20

Example 9: Illustration of a Conversion of an Instrument That Becomes Convertible Upon the Issuer’s Exercise of a Call Option

55-67 This Example illustrates an instrument subject to the guidance in paragraphs 470-20-40-5 through 40-9.

55-68 An entity issues a contingently convertible instrument on January 1, 2006, with a market price trigger, a $1,000 par amount, and a maturity date of December 31, 2020. The debt instrument is convertible at the option of the holder if the share price of the issuer exceeds a specified amount. The issuer can call the debt at any time between 2009 and the maturity date of the debt. If the issuer calls the debt, the holder has the option to receive cash for the call amount or a fixed number of shares as specified in the terms of the instrument upon issuance, regardless of whether the market price trigger has been met. In 2010, the issuer calls the debt before the market price trigger being met and the holder elects to receive a fixed number of shares (as specified in the terms of the instrument).

Example 9 in ASC 470-20-55 describes a contingently convertible debt instrument (the “CoCo”). Since the holder does not have the ability to convert the CoCo debt before the issuer calls it (because the market price trigger is not met), the transaction is evaluated on the basis of the guidance in ASC 470-20-40-5 on conversions that occur upon the issuer’s exercise of a call option. If the feature had been substantive at issuance, the conversion would have been accounted for as a conversion (see Section 12.3.2). If the feature had been nonsubstantive at issuance, the conversion would have been accounted for as an extinguishment (see Section 9.3).

If the facts were altered so that the market-price trigger had been met when the issuer exercised its call option, the guidance in ASC 470-20-40-5 on conversions that occur upon the issuer’s exercise of a call option would not have applied because the holder already had an unconditional right to elect to convert the debt when the issuer chose to call it. In those circumstances, the conversion would have been accounted for as a conversion irrespective of whether the conversion feature was substantive at issuance.

12.3.4 Induced Conversions

12.3.4.1 Scope

ASC 470-20

05-10 Some convertible debt instruments include provisions allowing the debtor to alter terms of the debt to the benefit of debt holders. In some circumstances, conversion privileges for a convertible debt instrument are changed or additional consideration is paid to debt holders for the purpose of inducing prompt conversion of the debt to equity securities (sometimes referred to as a convertible debt sweetener). Such provisions may be general in nature, permitting the debtor or trustee to take actions to protect the interests of the debt holders, or they may be specific, for example, specifically authorizing the debtor to temporarily reduce the conversion price for the purpose of inducing conversion.

40-13 The guidance in paragraph 470-20-40-16 applies to conversions of convertible debt to equity securities pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the terms of the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. That guidance applies only to conversions that both:

Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.

40-14 A conversion includes an exchange of a convertible debt instrument for equity securities or a combination of equity securities and other consideration, whether or not the exchange involves legal exercise of the contractual conversion privileges included in terms of the debt. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.

40-15 The changed terms may involve any of the following:

A reduction of the original conversion price thereby resulting in the issuance of additional shares of stock
An issuance of warrants or other securities not provided for in the original conversion terms
A payment of cash or other consideration to those debt holders that convert during the specified time period.

The guidance in the following paragraph does not apply to conversions pursuant to other changes in conversion privileges or to changes in terms of convertible debt instruments that are different from those described in this paragraph.

For various reasons, such as to reduce interest costs or improve debt-equity ratios, an issuer may seek to induce debt holders to promptly convert convertible debt into equity shares under changed conversion terms that are effective for a limited period and involve additional consideration. That is, the issuer may make an “inducement offer.” The additional consideration offered can take any form (e.g., reduced conversion price, issuance of warrants or other securities, issuance of other noncash assets, payment of cash).

If convertible debt is converted in accordance with an inducement offer that meets the conditions described above, neither conversion only accounting (as described in Section 12.3.2) nor extinguishment accounting (as described in Section 9.3) applies; instead, the issuer must recognize an inducement expense upon the conversion. Such accounting applies to conversions that have all of the following characteristics:

The debt’s original terms contained conversion privileges (i.e., the debt was convertible into the issuer’s equity shares).
Either the debtor or the holder offered revised conversion terms that gave the holder an economic incentive to convert. For example, a debtor might offer each holder that elects to accept the inducement offer a reduced conversion price, additional instruments (e.g., warrants), or cash or other consideration in addition to the shares that would have been issued under the original conversion terms (“sweeteners”).
To induce prompt conversion, the inducement offer contained an exercisability period that was limited. An offer that does not include a limited exercisability period is not a change that is made to induce prompt conversion. Although ASC 470-20-40-13(a) does not address the length of such period, the examples in ASC 470-20-55 imply that 30 or 60 days could qualify as “a limited period of time.” When the conversion terms are altered for the remaining term of the convertible debt instrument, a modification of the convertible debt instrument has occurred (see Chapter 10).
The convertible debt was converted under the revised conversion terms.
For each converted instrument, all equity securities that were issuable in accordance with the instrument’s original conversion terms were in fact issued (i.e., the conversion can result in the issuance of additional equity shares but cannot result in the issuance of fewer equity shares than the number required to be issued in accordance with the original conversion privileges). (Note that some convertible debt instruments may be settled entirely in cash in accordance with the original conversion privileges [i.e., Instrument X]. For these convertible debt instruments, inducement accounting may be applied even if no shares are issued upon settlement. For other convertible debt instruments under which all or a portion of any conversion must be settled in shares, inducement accounting applies only if all of the equity shares that are required to be issued under the original conversion terms are issued.)

Therefore, induced conversion accounting does not apply in any of the following circumstances:

The original debt instrument did not contain a conversion feature.
The instrument was converted under the original conversion terms (see Section 12.3.2).
The terms were adjusted for some purpose other than to induce conversion (e.g., to settle a legal dispute about the correct interpretation of the conversion terms).
The offer was not for a limited period (i.e., the changed conversion privileges have no stated expiration date or are available for the remaining term of the convertible debt).
The inducement offer involves the issuance of fewer equity securities than the original conversion terms required.
The inducement offer involves the issuance of different equity securities than those that were issuable under the original conversion terms (e.g., preferred stock instead of common stock).
The fair value of the consideration transferred is equal to or less than the fair value of the securities issuable under the original conversion terms.

In the evaluation of whether inducement accounting applies, it does not matter whether:

The inducement offer is initiated by the debtor or the holder.
The inducement offer is provided to all holders, some holders, or only one holder of the debt.
Some holders accept the offer and others do not (i.e., inducement accounting applies only to a holder or holders that accept the offer).
The inducement transaction involves the legal exercise of contractual conversion privileges (i.e., the legal form of the inducement transaction does not matter). For example, a repurchase of convertible bonds in the open market may be accounted for as an induced conversion if it involves the issuance of all of the equity securities that were required to be issued under the original conversion terms and the other requirements for inducement accounting are met (e.g., the convertible instrument allowed the issuer to elect to settle a conversion entirely in cash).
The ability to modify the conversion terms to induce conversion was contemplated in the original terms of the debt instrument (i.e., the original terms of the instrument explicitly permit contractual revisions for the purpose of inducing conversion).
The inducement offer involves the issuance of equity securities only or a combination of equity securities and cash or other consideration (as long as the inducement offer does not reduce the number of equity shares issuable under the original conversion terms).
The conversion option is out-of-the-money, at-the-money, or in-the-money.
The holder’s carrying amount of the convertible debt differs from the principal amount.

An entity applies extinguishment accounting (see Section 9.3) to any settlement of convertible debt whose terms are different from the original conversion terms or is otherwise outside the scope of the accounting requirements for induced conversions. Induced conversion accounting can never be applied if the settlement would not have been treated as a conversion, aside from the incremental consideration the issuer provides to the holders. Accordingly, induced conversion accounting would not apply to a convertible debt instrument for which the principal amount must be settled in cash and the excess conversion spread must be settled in equity shares if (1) the principal amount is settled partially or fully in equity shares or (2) the excess conversion spread is settled partially or fully in cash.

Changing Lanes

In December 2023, the FASB issued a proposed ASU that would clarify whether induced conversion accounting can be applied when:

The conversion includes the incorporation, elimination, or modification of a volume-weighted average price formula that affects the amount of cash or number of shares to be delivered to the counterparty upon conversion of a convertible debt instrument that the issuer may settle partially or fully in cash.
The convertible debt instrument is not currently convertible in the absence of an induced conversion offer.

Until the proposal is finalized, there may be diversity in practice. Entities should consider disclosing their accounting for any such conversions that could be affected by this guidance.

12.3.4.2 Recognition and Measurement

ASC 470-20

40-16 If a convertible debt instrument is converted to equity securities of the debtor pursuant to an inducement offer (see paragraph 470-20-40-13), the debtor shall recognize an expense equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of securities issuable pursuant to the original conversion terms. The fair value of the securities or other consideration shall be measured as of the date the inducement offer is accepted by the convertible debt holder. That date normally will be the date the debt holder converts the convertible debt into equity securities or enters into a binding agreement to do so. Until the debt holder accepts the offer, no exchange has been made between the debtor and the debt holder. Example 1 (see paragraph 470-20-55-1B) illustrates the application of this guidance.

40-17 The guidance in the preceding paragraph does not require recognition of gain or loss with respect to the shares issuable pursuant to the original conversion privileges of the convertible debt when additional securities or assets are transferred to a debt holder to induce prompt conversion of the debt to equity securities. In a conversion pursuant to original conversion terms, debt is extinguished in exchange for equity pursuant to a preexisting contract that is already recognized in the financial statements, and no gain or loss is recognized upon conversion.

Under ASC 470-20, when a conversion must be accounted for as an induced conversion, the issuer should recognize an inducement expense equal to the fair value of the consideration transferred (including the fair value of the additional securities issued and that of any other sweetener, such as cash, warrants, or other securities issued) in excess of the fair value of the securities issuable under the original conversion terms. No gain or loss is recognized for the securities that were issuable under the original conversion terms (i.e., conversion accounting applies). Thus, in an induced conversion that involves only the issuance of additional shares, for example, the issuer may make the following accounting entry:

Convertible debt

Debt conversion expense (inducement loss)

Equity — common stock

Although conversions in accordance with changed conversion terms are otherwise accounted for as debt extinguishments, it would be inappropriate to record a debt extinguishment gain or loss related to the shares issuable under the original conversion terms in an induced conversion subject to ASC 470-20-40-13.

The inducement expense is recognized as of the date the inducement offer is accepted by the convertible debt holder (i.e., generally the earlier of (1) the conversion date and (2) the date the holder enters into a binding agreement to convert), not as of the date the inducement offer is made.

Similarly, in the calculation of the inducement cost, the fair value of the securities or other consideration transferred as part of the inducement transaction is measured as of the date the inducement offer is accepted by the holder, not as of the date the inducement offer is made. If different holders accept the same offer on different dates, there may be multiple measurement dates.

Because the inducement expense recognized must equal the fair value of the additional securities issued upon conversion regardless of the convertible debt’s net carrying amount and the total fair value of the consideration paid on conversion, some accounting outcomes may be economically counterintuitive. For example, an offer that is settled entirely in cash might result in the recognition of a debt extinguishment gain, whereas an offer of equal economical value that is settled in shares might result in the recognition of an inducement loss. Further, the amount credited to equity to reflect the shares issued may exceed their fair value.

Example 12-1

Recognition of Inducement Loss

Issuer A has outstanding convertible bonds that it accounts for as convertible debt under ASC 470-20-25-12 (i.e., entirely as a liability). Their net carrying amount is $1 million. The original conversion price was $20 (i.e., the issuer would deliver 50,000 shares upon conversion). To induce prompt conversion, A reduces the conversion price to $16 for a limited period (i.e., 62,500 shares), and the holders accept the offer. The current stock price is $15. Accordingly, the fair value of the securities issuable under the original conversion terms was $750,000 (50,000 × $15) and the fair value of the securities issuable under the revised conversion terms is $937,500 (62,500 × $15). Because the consideration issuable under the changed conversion privileges exceeds the consideration under the original terms, A recognizes an inducement loss under ASC 470-20 equal to the fair value of the additional shares, $187,500 (12,500 × $15). However, if A had repurchased the shares for a cash payment of $937,500 instead of issuing shares worth $937,500, it would have recognized a debt extinguishment gain of $62,500 ($1,000,000 – $937,500).

12.3.4.3 Illustrations

ASC 470-20

Example 1: Induced Conversions of Convertible Securities

55-1B The following Cases illustrate application of the guidance in paragraph 470-20-40-16 to induced conversions of convertible securities:

Reduced conversion price for conversion before determination date, increase in bond fair value (Case A)
Reduced conversion price for conversion before determination date, decrease in bond fair value (Case B).

55-2 For simplicity, the face amount of each security is assumed to be equal to its carrying amount in the financial statements (that is, no original issue premium or discount exists).

Case A: Reduced Conversion Price for Conversion Before Determination Date — Bond Fair Value Increased

55-3 On January 1, 19X4, Entity A issues a $1,000 face amount 10 percent convertible bond maturing December 31, 20X3. The carrying amount of the bond in the financial statements of Entity A is $1,000, and it is convertible into common shares of Entity A at a conversion price of $25 per share. On January 1, 19X6, the convertible bond has a fair value of $1,700. To induce convertible bondholders to convert their bonds promptly, Entity A reduces the conversion price to $20 for bondholders that convert before February 29, 19X6 (within 60 days).

55-4 Assuming the market price of Entity A’s common stock on the date of conversion is $40 per share, the fair value of the incremental consideration paid by Entity A upon conversion is calculated as follows for each $1,000 bond that is converted before February 29, 19X6.

55-5 Therefore, Entity A records debt conversion expense equal to the fair value of the incremental consideration paid as follows.

Case B: Reduced Conversion Price for Conversion Before Determination Date — Bond Fair Value Decreased

55-6 On January 1, 19X1, Entity B issues a $1,000 face amount 4 percent convertible bond maturing December 31, 20X0. The carrying amount of the bond in the financial statements of Entity B is $1,000, and it is convertible into common shares of Entity B at a conversion price of $25. On June 1, 19X4, the convertible bond has a fair value of $500. To induce convertible bondholders to convert their bonds promptly, Entity B reduces the conversion price to $20 for bondholders that convert before July 1, 19X4 (within 30 days).

55-7 Assuming the market price of Entity B’s common stock on the date of conversion is $12 per share, the fair value of the incremental consideration paid by Entity B upon conversion is calculated as follows for each $1,000 bond that is converted before July 1, 19X4.

55-8 Therefore, Entity B records debt conversion expense equal to the fair value of the incremental consideration paid as follows.

55-9 The same accounting would apply if, instead of reducing the conversion price, Entity B issued shares pursuant to a tender offer of 50 shares of its common stock for each $1,000 bond surrendered to the entity before July 1, 19X4. See paragraph 470-20-40-14.

Footnotes

As noted in Section 12.2, conversion accounting does not apply in certain circumstances in which a debt instrument is settled for the issuer’s equity shares in accordance with the original conversion privileges.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.