Chapter 12 — Debt Conversions
Chapter 12 — Debt Conversions
12.1 Background
This chapter describes the accounting for a conversion of debt into
the debtor’s equity shares.
12.2 Scope
ASC 470-20 addresses the issuer’s accounting for a conversion of
debt into the issuer’s equity shares in accordance with the debt’s original
conversion terms (see Section
12.3.2) or under an induced conversion (see Section 12.3.4). The guidance
in ASC 470-20 does not apply to any of the following:
-
A conversion that occurs upon the issuer’s exercise of a call option if the instrument did not contain a substantive conversion feature as of its issuance date. This type of transaction must be accounted for as a debt extinguishment even if the instrument was converted in accordance with its original conversion privileges. See Sections 9.3.5 and 12.3.3 for further discussion.
-
A conversion that occurs in accordance with changed conversion privileges and does not meet the criteria for induced conversion accounting. This type of transaction must be accounted for as a debt extinguishment. See Sections 9.3.5 and 12.3.4 for further discussion.
-
A modification or exchange of debt, including convertible debt. This type of transaction must be evaluated under ASC 470-50. See Sections 9.3.5 and 10.2.12 for further discussion.
-
A conversion of debt, including convertible debt, into a variable number of shares in accordance with a share-settled redemption feature (e.g., it is determined that the number of shares delivered has a fair value equal to the redemption amount). This type of transaction must be accounted for as a debt extinguishment. See Sections 8.4.7.2.5 and 9.3.5 for further discussion.
-
The repayment of debt, including convertible debt, by the delivery of the debtor’s equity shares if the debtor is using its own shares as a means of currency to settle the debt obligation’s value (e.g., the number of shares delivered is determined to have a value equal to the monetary amount of the debt obligation). This type of transaction must be accounted for as a debt extinguishment. See Sections 9.2.3.2 and 9.3.5 for further discussion.
-
The repayment of debt, including convertible debt, by the delivery of the debtor’s equity shares if the settlement is a TDR. This type of transaction must be accounted for as a TDR. See Chapter 11 for further discussion.
-
A conversion of debt into equity shares of a third party. This type of transaction must be accounted for as a debt extinguishment.
In certain circumstances, the tendering of debt upon the exercise of
a detachable warrant is accounted for as a debt conversion and not as a debt
extinguishment (see Section
9.3.6). Further, it may be appropriate to apply extinguishment
accounting to conversions of convertible debt for which the conversion feature was
separated as a derivative instrument under ASC 815-15 (see Section 12.4).
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
1
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.
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 12-2
Accounting for Convertible Debt With a Bifurcated
Conversion Option That Is Converted in Accordance With
Its Stated Conversion Terms
On January 1, 20X7, Company A 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 A’s common stock
at any time. If the debt is not converted before January 1,
20X9, A would be required to repay the principal amount of
the debt in cash. The fair value of A’s common stock on
January 1, 20X7, was $10 per share.
Company A 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 A’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 A’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, A 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, A 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, A 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.
12.5 Convertible Debt With a Separated Equity Component
ASC 815-15
40-1 If a
holder exercises a conversion option for which the carrying
amount has previously been reclassified to shareholders’
equity pursuant to paragraph 815-15-35-4, the issuer shall
recognize any unamortized discount remaining at the date of
conversion immediately as interest expense.
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.