12.4 Convertible Debt With a Bifurcated Embedded Conversion Feature

The guidance in U.S. GAAP does not clearly address whether conversion or extinguishment accounting applies to a conversion in situations in which the conversion feature has been bifurcated as a derivative instrument under ASC 815-15. Therefore, as discussed in the example below, it may be acceptable to apply either type of accounting. Similarly, since there is no clear guidance in U.S. GAAP on whether inducement accounting applies to such a conversion, it may be acceptable to use either inducement accounting (because of the lack of an explicit scope exception; see Section 12.3.4) or extinguishment accounting. The example is not, however, intended to address situations in which the conversion feature is bifurcated solely as a result of an issuer’s election to cash settle all or a portion of the conversion when that election precedes the settlement date of the conversion by a short period and is made in accordance with the original terms of the instrument (i.e., the bifurcation is incidental to the settlement of the instrument). As discussed in Section 12.3.2, conversion accounting would apply in these circumstances.

Example 12-4

Accounting for Convertible Debt With a Bifurcated Conversion Option That Is Converted in Accordance With Its Stated Conversion Terms

On January 1, 20X7, Entity D issued a convertible debt instrument with a stated interest rate of 5 percent and a principal amount of $1,000. At the option of the holder, the debt could be converted into 100 shares of D’s common stock at any time. If the debt is not converted before January 1, 20X9, D would be required to repay the principal amount of the debt in cash. The fair value of D’s common stock on January 1, 20X7, was $10 per share.

Entity D separately accounted for the embedded conversion option as a derivative liability under ASC 815-15 because of assumed net-cash settlement requirements upon the occurrence of certain events outside of D’s control. However, the stated terms of the convertible debt instrument require physical share settlement upon conversion. The following additional facts are related to the convertible debt instrument:

On January 1, 20X7, the fair value of the embedded conversion option was $200.
On June 1, 20X8, the fair value of the embedded conversion option was $400 ($300 of intrinsic value plus $100 in time value). The carrying amount of the host contract was $950. There was no accrued or unpaid interest.
On June 1, 20X8, the holder converted the instrument in accordance with its original conversion terms and received 100 shares of D’s common stock, which had a fair value of $1,300 ($13 per share × 100 shares).

In addition, assume the following:

The embedded conversion option was bifurcated from the host debt contract on the issuance date of the convertible debt instrument.
It was deemed reasonably possible that the embedded conversion option could be exercised on the instrument’s issuance date.
According to the terms of the convertible debt instrument, (1) the issuer does not have the option to partially settle a conversion in cash (e.g., the issuer cannot settle the principal amount in cash and the excess conversion value in common shares) and (2) accrued and unpaid interest is not forfeited upon conversion.

Alternative views on the accounting for such a conversion are discussed below.

View 1 — Extinguishment Accounting

Equity should be increased by the settlement-date fair value of the common shares issued and a gain or loss should be recognized in earnings for the difference between (1) the fair value of those shares and (2) the sum of the carrying amounts of the debt host and the bifurcated conversion option liability.

Accordingly, D would record the following journal entry upon conversion:

This view is based on the premise that once the embedded conversion option has been separated from the debt host contract under ASC 815-15, the debt instrument no longer has an equity conversion feature (i.e., the financial instruments are considered separate for accounting purposes). ASC 470-50-40-3 indicates that both of the separated liabilities are subject to extinguishment accounting and that the guidance on early extinguishments of debt in ASC 470-50-40-2 (which requires a gain or loss to be recognized on the basis of the difference between the reacquisition price and the net carrying amount of the extinguished debt) applies to extinguishments that are effected by the issuance of common stock. Under ASC 470-50-40-3, the reacquisition price of extinguished debt is determined on the basis of the value of either the common stock issued or the debt — whichever is more clearly determinable.

View 2 — Conversion Accounting

Equity should be increased by the sum of the carrying amounts of the debt host and bifurcated conversion option liability, with no gain or loss recognized in earnings.

Accordingly, D would recognize the following journal entry upon conversion:

This view is based on the premise that ASC 470-20-40-4, which requires conversion accounting (i.e., no gain or loss is recorded), applies to the conversion of the debt instrument in accordance with its original terms. Thus, ASC 470-20-40-4 would apply in this scenario since the debt host and bifurcated conversion option liability were settled in accordance with the original conversion privileges. Under ASC 470-50-40-5, conversion accounting applies if a debt instrument is tendered to exercise detachable warrants that were originally issued with the debt, provided that the debt is permitted to be tendered toward the warrants’ exercise price under the terms of the securities at issuance. That guidance, which does not specify that it applies only to warrants classified in equity, supports the conclusion that regardless of whether the debt host and the embedded conversion option are considered to be separate for accounting purposes, extinguishment accounting does not apply (i.e., conversion accounting applies) if the settlement of those instruments occurs in accordance with the conversion privileges provided in the terms of the debt at issuance. Consequently, the instrument’s form and that of the conversion terms, rather than the accounting classification, determines the appropriate accounting for the conversion.

View 3 — Conversion Accounting With Immediate Expense of Unamortized Discount

The remaining unamortized discount on the debt host should be immediately recognized in earnings, and then equity should be increased by the sum of the carrying amounts of the debt host and the bifurcated conversion option liability, with no additional gain or loss recognized in earnings.

Accordingly, D would recognize the following journal entries upon conversion:

This view is based on an analogy to the guidance in (1) ASC 815-15-40-1 on the accounting for a conversion of a debt instrument with a previously bifurcated embedded conversion option in accordance with its original conversion terms and (2) ASC 815-40-40-2 on the accounting for a reclassification of a bifurcated derivative liability to equity. Under ASC 815-40-40-2, any unamortized discount on the debt host is immediately recorded to income, and then the carrying amount of the liability is reclassified to equity. Because the issuer meets the conditions for classification of the embedded conversion option immediately before settlement of the conversion, ASC 815-15-40-1 applies to the settlement of the debt host and bifurcated conversion option liability and ASC 815-40-40-2 specifies the treatment of the reclassification of the embedded conversion option liability. Therefore, the issuer reclassifies the bifurcated conversion option liability to equity immediately before accounting for the conversion as specified by ASC 815-15-40-1.

On the basis of our understanding of the views of the staff of the SEC’s OCA, we believe that the SEC staff would not object to any of the three alternative views discussed in the above example because (1) the guidance in GAAP does not specifically address the issue and (2) each alternative view emanates from a reasonable interpretation of analogous guidance. However, an entity should disclose which view it applied and how that view affected its statement of financial performance and results of operations.

Note that the analysis in the above example does not apply to a convertible debt instrument with a bifurcated embedded conversion option that is converted into common shares in accordance with its original conversion terms on the instrument’s maturity date. On that date, there is no remaining unamortized discount on the debt host, and the sum of the debt host and embedded conversion option would be expected to equal the intrinsic value, if any, of the conversion right in the instrument.

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.