12.5 Convertible Debt With a Separated Equity Component

An equity component is recognized upon the issuance of a convertible debt instrument at a substantial premium. In these situations, the liability for the convertible debt instrument recognized at issuance would generally equal or closely approximate the principal amount of the debt instrument. It is therefore appropriate to account for the conversion of such an instrument in accordance with its original conversion terms, as discussed in Section 12.3.2.

Even if a convertible debt instrument does not contain a separately recognized equity component on the issuance date (i.e., a substantial premium does not exist), an equity component may be recognized after issuance if the issuer (1) reclassifies to equity an embedded conversion feature that was previously classified as an embedded derivative liability or (2) modifies or exchanges the convertible debt instrument in a transaction that does not result in extinguishment but in which the fair value of the embedded conversion option is increased (see Section 10.4.3.3.1).

ASC 815-15-40-1 addresses the accounting for scenarios in which a convertible debt instrument with a separate equity component that resulted from a previous reclassification of the embedded conversion option from a liability to equity is converted in accordance with the instrument’s original terms. Under that guidance, any remaining unamortized discount upon conversion is immediately recognized as interest expense.

A convertible debt instrument may contain an equity component that resulted from a previous modification or exchange that increased the conversion option’s fair value. The Codification does not specifically address the accounting for any unamortized discount that remains on the conversion date if such an instrument is converted into common stock in accordance with the instrument’s original conversion terms. However, given its similarity to a separately recognized equity component that resulted from a previous reclassification of the embedded conversion option from a liability to equity, an entity should immediately amortize any unamortized discount on the debt that remains on the instrument’s conversion date in accordance with its original conversion terms and recognize such amount as an expense.