Chapter 7 — Special Accounting Models for Certain Types of Debt

7.6 Convertible Debt

7.6.1 Background

ASC 470-20

Convertible Debt Instruments

05-4 A convertible debt instrument is a complex hybrid instrument bearing an option, the alternative choices of which cannot exist independently of one another. The holder ordinarily does not sell one right and retain the other. Furthermore, the two choices are mutually exclusive; they cannot both be consummated. Thus, the instrument will either be converted or be redeemed. The holder cannot exercise the option to convert unless he forgoes the right to redemption, and vice versa.

05-5 A convertible debt instrument may offer advantages to both the issuer and the purchaser. From the point of view of the issuer, convertible debt has a lower interest rate than does nonconvertible debt. Furthermore, the issuer of convertible debt instruments, in planning its long-range financing, may view convertible debt as essentially a means of raising equity capital. Thus, if the fair value of the underlying common stock increases sufficiently in the future, the issuer can force conversion of the convertible debt into common stock by calling the issue for redemption. Under these market conditions, the issuer can effectively terminate the conversion option and eliminate the debt. If the fair value of the stock does not increase sufficiently to result in conversion of the debt, the issuer will have received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost.

05-6 On the other hand, the purchaser obtains an option to receive either the face or redemption amount of the instrument or the number of common shares into which the instrument is convertible. If the fair value of the underlying common stock increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) benefits through appreciation. The purchaser may at that time require the issuance of the common stock at a price lower than the fair value. However, should the fair value of the underlying common stock not increase in the future, the purchaser has the protection of a debt security. Thus, in the absence of default by the issuer, the purchaser would receive the principal and interest if the conversion option is not exercised.

05-7 Entities may issue convertible debt instruments that may be convertible into common stock at the lower of a conversion rate fixed at time of issuance and a fixed discount to the market price of the common stock at the date of conversion.

05-7A Entities also may issue convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement.

05-8 Certain convertible debt instruments may have a contingently adjustable conversion ratio; that is, a conversion price that is variable based on future events such as any of the following:

A liquidation or a change in control of an entity
A subsequent round of financing at a price lower than the convertible security’s original conversion price
An initial public offering at a share price lower than an agreed-upon amount.

05-8A Certain convertible debt instruments may become convertible only upon the occurrence of a future event that is outside the control of the issuer or holder.

Instruments

15-2A The guidance on convertible debt instruments in this Subtopic shall be considered after considering the guidance in the Fair Value Option Subsections of Subtopic 825-10 on financial instruments.

15-2B The guidance on convertible debt instruments in this Subtopic shall be considered after considering the guidance in Subtopic 815-15 on bifurcation of embedded derivatives for an embedded conversion option or other embedded feature (for example, an embedded prepayment option) as applicable (see paragraph 815-15-55-76A). The relevant guidance in this Subtopic does not affect an issuer’s determination under Subtopic 815-15 of whether an embedded conversion option or other embedded feature shall be separately accounted for as a derivative instrument.

15-2C The guidance in this Subtopic does not apply to a convertible debt instrument award issued to a grantee that is subject to the guidance in Topic 718 on stock compensation unless the instrument is modified as described in and no longer subject to the guidance in that Topic. The guidance in this Subtopic does not apply to stock-settled debt that is subject to the guidance in Subtopic 480-10 on distinguishing liabilities from equity or other Subtopics (see paragraph 470-20-25-14), unless the stock-settled debt also contains a substantive conversion feature (as discussed in paragraphs 470-20-40-7 through 40-10) for which all relevant guidance in this Subtopic shall be considered in addition to the relevant guidance in other Subtopics.

15-2D For purposes of determining whether an instrument is within the scope of this Subtopic, a convertible preferred stock shall be considered a convertible debt instrument if it has both of the following characteristics:

It is a mandatorily redeemable financial instrument.
It is classified as a liability under Subtopic 480-10.

For related implementation guidance, see paragraph 470-20-55-1A.

Debt Instruments With Detachable Warrants

25-3 . . . [I]f stock purchase warrants are not detachable from the debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument and the accounting specified in paragraph 470-20-25-12 shall apply.

Convertible Debt Instruments

25-14 If a debt instrument has a conversion option that continuously resets as the underlying stock price increases or decreases so as to provide a fixed value of common stock to the holder at any conversion date, the instrument shall be considered stock-settled debt that is subject to the guidance in Subtopic 480-10 or other Subtopics (such as Subtopic 718-10, 815-15, or 825-10). Example 4 (see paragraph 470-20-55-18) illustrates application of the guidance in this paragraph.

ASC 470-20 applies to an issuer’s accounting for convertible debt unless (1) the issuer has elected the fair value option1 or (2) the embedded conversion option must be bifurcated under ASC 815-15.

If an issuer elects to account for convertible debt at fair value on a recurring basis under the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), no embedded derivative features would be bifurcated and any issuance costs would be expensed at inception (see Section 5.5). The convertible debt instrument would be subsequently remeasured to its fair value on each reporting date, with such changes in fair value reflected in earnings except for the portion of the changes attributable to the change in instrument-specific credit risk, which would be reported in OCI (see Section 6.3).

If the fair value option has not been elected, an issuer of convertible debt applies the following steps in ASC 815-15-55-76A to account for the debt instrument:

“Step 1. Identify embedded features, including the embedded conversion option that must be evaluated under Subtopic 815-15.”
“Step 2. Apply the guidance in Subtopic 815-15 to determine whether any of the embedded features identified in Step 1 must be separately accounted for as derivative instruments.”
“Step 3. Apply the guidance in Subtopic 470-20 to account for the convertible debt instrument (including the embedded conversion option and any other embedded features, which are not separately accounted for as a derivative instrument in Step 2) as a liability.”
“Step 4. If one or more embedded features are required to be separately accounted for as a derivative instrument based on the analysis performed in Step 2, that embedded derivative shall be separated from the host contract in accordance with the guidance in this Subtopic.”

If the embedded conversion option must be bifurcated as a derivative liability under ASC 815-15, the recognition and measurement guidance in ASC 470-20 does not apply. However, if the embedded conversion option does not have to be bifurcated under ASC 815-15 but there are other embedded features that must be bifurcated (e.g., redemption options or interest features), the guidance in ASC 470-20 applies. See Chapter 8 for discussion of the evaluation of embedded derivative features in convertible debt instruments.

In the remaining discussion below, it is assumed that the issuer has not elected the fair value option and that the embedded conversion option is not bifurcated under ASC 815-15.

7.6.2 Convertible Debt Not Issued at a Substantial Premium

ASC 470-20

25-12 A debt with an embedded conversion feature shall be accounted for in its entirety as a liability and no portion of the proceeds from the issuance of the convertible debt instrument shall be accounted for as attributable to the conversion feature unless the conversion feature is required to be accounted for separately as an embedded derivative under Subtopic 815-15 or the conversion feature results in a premium that is subject to the guidance in paragraph 470-20-25-13.

25-15 If the issuance transaction for a convertible debt instrument within the scope of this Subtopic includes other unstated (or stated) rights or privileges in addition to the convertible debt instrument, a portion of the initial proceeds shall be attributed to those rights and privileges based on the guidance in other applicable U.S. generally accepted accounting principles (GAAP).

Upon the initial recognition of convertible debt, the issuer presents the entire amount attributable to the debt as a liability. The initial carrying amount of the convertible debt liability is reduced by any direct and incremental issuance costs paid to third parties that are associated with the convertible debt issuance (see Section 5.3). No amount attributable to the debt is initially recognized within equity unless the instrument is issued at a substantial premium (see Section 7.6.3). In determining the amount attributable to the convertible debt instrument, the issuer should allocate the proceeds to other unstated (or stated) rights and privileges on the basis of the guidance in other U.S. GAAP (see Section 3.4). For example, if convertible debt is issued with detachable warrants, the issuer should allocate the proceeds received to the two instruments in accordance with ASC 470-20-25-2.

Example 7-10

Issuance of Convertible Debt Instrument Without Any Other Instruments

Entity A issues a five-year convertible debt instrument at par for net cash proceeds of $8 million, which is its principal amount. The instrument has a stated interest rate of 1.5 percent per annum and an embedded conversion option that gives the holder the right to convert the debt on its maturity date into a fixed number of A’s shares of common stock subject to standard antidilution adjustments. The interest rate on the convertible debt is lower than that on similar nonconvertible debt issued by A, since investors are willing to accept a lower rate because of the value of the embedded conversion option. Entity A estimates that if the embedded conversion option had been issued separately as a freestanding financial instrument, its fair value at inception would have been $1 million. Further, A has determined that it does not have to bifurcate the conversion option as a derivative under ASC 815-15. Therefore, A makes the following journal entry at issuance:

Convertible debt is subsequently accounted for at amortized cost in accordance with the interest method described in ASC 835-30 (see Section 6.2). Reported interest expense on convertible debt to which ASC 470-20-25-12 applies is generally lower than that on similar nonconvertible debt, since the issuer is “paying” for the low interest rate by providing an equity conversion feature that is not recognized for accounting purposes.

In GAAP, there are several exceptions to the prohibition in ASC 470-20-25-12 against separately recognizing a conversion feature embedded in a convertible debt instrument:

If the conversion feature meets the bifurcation criteria in ASC 815-15 (see Section 8.4.7), it is accounted for separately from the debt host contract as a derivative at fair value, with changes in fair value recognized in earnings.
If the conversion feature was bifurcated as a derivative but no longer meets the bifurcation criteria, ASC 815-15-35-4 requires the issuer to reclassify the previously bifurcated conversion option into equity (see Section 8.5.4.3).
If the convertible debt is modified or exchanged and the modification or exchange is not accounted for as an extinguishment, the amount of any increase in the fair value of the conversion feature associated with the modification or exchange reduces the carrying amount of the debt, with a corresponding increase in equity (see Section 10.4.3).
If the convertible debt is issued at a substantial premium to its face amount, it is presumed that the premium should be accounted for in equity (see the next section) unless the conversion feature requires bifurcation as a derivative under ASC 815-15-25-1 (see Section 8.4.7).

7.6.3 Convertible Debt Issued at a Substantial Premium

ASC 470-20

25-13 If a convertible debt instrument is issued at a substantial premium, there is a presumption that such premium represents paid-in capital.

Sometimes, convertible debt is sold or initially recognized at a substantial premium over the principal amount to be repaid at maturity. In this circumstance, there is a presumption that the premium should be recognized in equity as paid-in capital if it is substantial.

ASC 470-20-25-13 applies only to convertible debt instruments that are not specifically addressed in other GAAP; therefore, it does not apply to:

Convertible debt instruments with a conversion feature that must be bifurcated as a derivative under ASC 815-15 (see Section 8.4.7).
Debt instruments that contain a conversion feature that economically represents a share-settled redemption feature (see Section 8.4.7.2.5).

The guidance on allocating a substantial premium to paid-in capital may apply in circumstances in which, for example:

An acquirer assumes an acquiree’s outstanding convertible debt in a business combination.
Convertible debt is issued upon the exercise of a physically settled liability-classified warrant.

While ASC 470-20 does not define substantial, in practice, a premium of 10 percent or more is considered substantial. In certain circumstances, however, a premium of less than 10 percent may also be considered substantial (e.g., for a zero-coupon convertible debt instrument that is initially recognized at a premium because of the value of the conversion feature and for which negative interest expense would be reported if the premium was not allocated to equity).

Although ASC 470-20 does not specifically address such cases, an entity may be able to overcome the presumption that it should record a substantial premium in APIC if the premium is not attributable to the value of the equity conversion feature. For example, the presumption may be overcome if:

The convertible debt was issued or assumed at a premium because it pays a higher coupon rate than similar nonconvertible debt.
The convertible debt includes an embedded feature other than the conversion feature that significantly increased the proceeds received for the debt.

When convertible debt is initially recognized under ASC 470-20-25-13, the principal amount of the debt is recognized as a liability, and the premium is recognized in APIC. The issuer should also determine whether the instrument contains any other embedded features that must be bifurcated as derivatives under ASC 815-15 (e.g., a put, call, redemption, or indexation feature; see Chapter 8). While the issuer should reduce the initial carrying amount of the convertible debt by any direct or incremental issuance costs paid to third parties that are associated with the debt’s issuance, the guidance in U.S. GAAP does not explicitly address whether or, if so, how to allocate such costs between an instrument’s debt and equity components (see Section 3.5).

Because a separated equity component (a premium) is contained within the convertible debt to which the guidance on substantial premiums in ASC 470-20-25-13 applies, the issuer cannot elect the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4). Therefore, except for any bifurcated embedded derivatives, the liability-classified portion of the convertible debt instrument is subsequently measured at amortized cost, which the issuer determines by using the interest method described in ASC 835-30 (see Section 6.2). The issuer does not subsequently remeasure the amount initially recognized for the premium in equity.

Example 7-11

Assumption of Convertible Debt in a Business Combination

Entity A acquires Entity B and assumes B’s outstanding convertible debt. The convertible debt’s fair value ($1.2 million) is significantly higher than its principal amount ($1 million). Entity A determines that it does not have to bifurcate the conversion option as a derivative under ASC 815-15. In accordance with ASC 805-20-30-1, the acquirer in a business combination measures liabilities assumed at their acquisition-date fair values. Because the difference between the convertible debt’s fair value and face amount is substantial, A allocates a portion of the initial carrying amount equal to the excess of the fair value over the face amount (i.e., $200,000) to equity (APIC) under ASC 470-20-25-13.

Example 7-12

Liability-Classified Physically Settled Warrant

On January 15, 20X0, Company A issues to Company B a freestanding warrant for its fair value. The warrant gives B the right to exercise the warrant for $100 in cash during the next five years and to receive A’s $100 par value convertible debt. The debt is convertible into 10 shares of A’s common stock, whose fair value is $10 per share on January 15, 20X0. Company B exercises the warrant on February 15, 20X3, when the fair value of A’s stock is $20 per share and the fair value and carrying amount of the warrant is $110. Although the warrant requires physical settlement upon its exercise, A has determined that the warrant must be classified as a liability. Company A would record such exercise and the resulting issuance of the convertible debt as follows:

As a result of this accounting, A records the convertible debt at a substantial premium. Under ASC 470-20-25-13, there is a presumption that the premium represents APIC.

7.6.4 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance

7.6.4.1 Overview

ASC 470-20

05-12A An entity for which the cost to an investment banking firm (investment bank) or third-party investors (investors) of borrowing its shares is prohibitive (for example, due to a lack of liquidity or extensive open short positions in the shares) may enter into share-lending arrangements that are executed separately but in connection with a convertible debt offering. Although the convertible debt instrument is ultimately sold to investors, the share-lending arrangement is an agreement between the entity (share lender) and an investment bank (share borrower) and is intended to facilitate the ability of the investors to hedge the conversion option in the entity’s convertible debt.

05-12B The terms of a share-lending arrangement require the entity to issue shares (loaned shares) to the investment bank in exchange for a nominal loan processing fee. Although the loaned shares are legally outstanding, the nominal loan processing fee is typically equal to the par value of the common stock, which is significantly less than the fair value of the loaned shares or the share-lending arrangement. Generally, upon maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to the entity for no additional consideration.

05-12C Other terms of a share-lending arrangement typically require the investment bank to reimburse the entity for any dividends paid on the loaned shares. Typically, the arrangement precludes the investment bank from voting on any matters submitted to a vote of the entity’s shareholders to the extent the investment bank is the owner of the shares.

ASC 470-20 provides guidance on an issuer’s accounting for equity-classified share-lending arrangements on its own shares that are executed in contemplation of a convertible debt issuance. In practice, an issuer may enter into such an arrangement to help ensure the successful completion of the convertible debt offering by facilitating investors’ ability to economically hedge their exposure to the share price risk associated with the issuer’s stock that is inherent in the convertible instrument.

Example 7-13

Own-Share Lending in Conjunction With Convertible Debt Issuance

Issuer A is issuing convertible debt. However, before agreeing to buy the debt, certain prospective investors would like to ensure that they can economically hedge their exposure to the share price risk related to A’s stock that is associated with the embedded conversion option. Accordingly, the prospective investors enter into derivative contracts on the underlying shares (e.g., options, forwards, or total return swaps) with Bank B that offset the exposure related to the “long” position in A’s stock that would result from the convertible debt investment. To economically hedge its own exposure from writing such derivatives, B borrows the underlying shares and sells them short in the market.

Because B cannot secure a sufficient number of underlying shares in the market (i.e., they are not readily available to market participants) or the price is too high, it borrows the underlying shares by entering into a share-lending arrangement directly with A. The terms of the arrangement require B to pay a nominal processing fee to A (e.g., the par value of the shares) that is significantly less than the agreement’s fair value.

Issuer A is motivated to enter into the agreement because the pricing and successful completion of the convertible debt offering depend on the investors’ ability to enter into derivative contracts to hedge their equity price exposure, which in turn depends on B’s ability to borrow the shares.

During the period in which the shares are on “loan,” they are legally outstanding and the holder is legally entitled to any dividends paid on them, although it must reimburse A for such payments. Upon the conversion or maturity of the convertible debt, B must physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is contractually entitled to a cash payment equal to the shares’ fair value.

7.6.4.2 Scope

The guidance on the issuer’s accounting for own-share lending arrangements in ASC 470-20 applies to arrangements that have the following terms and characteristics:

The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
The counterparty will return the loaned shares to the issuer on the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
The arrangement qualifies as equity under GAAP.
The arrangement was executed in contemplation of a convertible debt issuance or other financing.

In evaluating whether the contract qualifies as equity under GAAP, the issuer should consider the requirements in ASC 480 and ASC 815-40.

Connecting the Dots

For a discussion of the evaluation of whether an own-share lending arrangement qualifies as equity under ASC 815-40, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity, in particular Sections 2.9, 4.3.5.12, and 5.2.3.6.

7.6.4.3 Initial Accounting

ASC 470-20

25-20A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value (in accordance with Topic 820) and recognized as an issuance cost, with an offset to additional paid-in capital in the financial statements of the entity.

30-26A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value in accordance with Topic 820.

Own-share lending arrangements within the scope of this guidance are initially recorded at fair value and recognized as a debt issuance cost with an offset to APIC in the issuer’s financial statement (i.e., Dr: Debt; Cr: Equity — APIC).

The terms of a share-lending arrangement entered into in contemplation of a convertible debt issuance typically require an entity to issue its common shares to a counterparty (e.g., the bank) in exchange for a nominal processing fee. The processing fee is significantly less than the fair value of the shares and is typically less than a market fee that would be charged in a share-lending arrangement that was not entered into in contemplation of a convertible debt issuance. To promote the issuance of the debt, the issuer may sometimes accept less than the market rate on the share-lending arrangement. The fair value of the share-lending arrangement will be determined on the basis of the difference between the contractual processing fee and a market-based fee that would typically be charged for lending such shares, adjusted as necessary to reflect the nonperformance risk of the share borrower.

Example 7-14

Initial Accounting for Own-Share Lending Arrangement

Issuer A issues convertible debt at par for cash proceeds of $250 million. The stated interest rate on the debt is 2.5 percent per annum. The debt is due five years from the issuance date and is convertible into A’s equity shares at the holder’s option. Issuer A determines that the convertible debt should be accounted for under ASC 470-20-25-12. Accordingly, the equity conversion option is not separately recognized as an equity component under ASC 470-20.

In contemplation of the convertible debt issuance, A executes a share-lending arrangement with Bank B to help ensure the successful completion of the debt offering, and A receives $100,000 for the arrangement (which is also the par amount of the shares issued). However, the fair value of the arrangement is $15 million. Issuer A evaluates the share-lending arrangement under ASC 470-20 and ASC 815-40 and determines that it qualifies as equity.

On the date that both the debt issuance and the share-lending arrangement occur, A makes the following journal entry:

7.6.4.4 Subsequent Accounting

ASC 470-20

35-11A If it becomes probable that the counterparty to a share-lending arrangement will default, the issuer of the share-lending arrangement shall recognize an expense equal to the then fair value of the unreturned shares, net of the fair value of probable recoveries, with an offset to additional paid-in capital. The issuer of the share-lending arrangement shall remeasure the fair value of the unreturned shares each reporting period through earnings until the arrangement consideration payable by the counterparty becomes fixed. Subsequent changes in the amount of the probable recoveries should also be recognized in earnings.

Unless an issuer elects to account for debt arising from an own-share lending arrangement at fair value under the fair value option in ASC 825-10, it uses the effective interest method to amortize any debt discount (or reduced premium) that is created by recognizing the arrangement. The amount recognized in equity is not remeasured as long as (1) the share-lending arrangement qualifies as equity under ASC 815-40 and (2) it is not probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration).

If it becomes probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration), the issuer must recognize an expense equal to the fair value of the unreturned shares adjusted for the fair value of any probable recoveries. The offsetting entry for the expense is to APIC (i.e., Dr: Loss; Cr: Equity — APIC).

Even though the share-lending arrangement is classified in equity, it is appropriate to record an expense because the issuer incurs a loss from the counterparty’s failure to satisfy its obligation to return the loaned shares. Under the contractual terms of the instrument, the issuer should have received the shares back (or an equivalent amount of consideration), but instead it received no value or something of lesser value because of the counterparty’s default.

The amount of the loss (i.e., the fair value of the unreturned shares adjusted for probable recoveries) is remeasured each period (e.g., for changes in the fair value of the unreturned shares) until the consideration payable becomes fixed. The issuer recognizes changes in the amount of the loss in earnings with an offset to APIC.

7.6.5 Temporary Equity

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A

2. ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer. As noted in ASR 268, the Commission reasoned that “[t]here is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital.”

3(e). Convertible debt instruments that contain a separately classified equity component. Other applicable GAAP may require a convertible debt instrument to be separated into a liability component and an equity component.FN8 In these situations, the equity-classified component of the convertible debt instrument should be considered redeemable if at the balance sheet date the issuer can be required to settle the convertible debt instrument for cash or other assets (that is, the instrument is currently redeemable or convertible for cash or other assets). For these instruments, an assessment of whether the convertible debt instrument will become redeemable or convertible for cash or other assets at a future date should not be made. For example, a convertible debt instrument that is not redeemable at the balance sheet date but could become redeemable by the holder of the instrument in the future based on the passage of time or upon the occurrence of a contingent event is not considered currently redeemable at the balance sheet date.

12. Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

d. For convertible debt instruments that contain a separately classified equity component, an amount should initially be presented in temporary equity only if the instrument is currently redeemable or convertible at the issuance date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the issuance date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the issuance date.

16. [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

d. For convertible debt instruments that contain a separately classified equity component, an amount should be presented in temporary equity only if the instrument is currently redeemable or convertible at the balance sheet date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the balance sheet date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the balance sheet date.FN15

23. Convertible debt instruments that contain a separately classified equity component. For convertible debt instruments subject to ASR 268 (see paragraph 3(e)), there should be no incremental earnings per share accounting from the application of this SEC staff announcement. Subtopic 260-10 addresses the earnings per share accounting.

_____________________

FN8 See Subtopics 470-20 and 470-50; and Paragraph 815-15-35-4.

FN15 ASR 268 does not impact the application of other applicable GAAP to the accounting for the liability component or the accounting upon derecognition of the liability and/or equity component.

In financial statements filed with the SEC under Regulation S-X, issuers of equity-classified instruments that are redeemable for cash or other assets in circumstances that are not under the issuers’ sole control must (1) present such instruments on the face of the balance sheet in a caption that is separate from both liabilities and stockholders’ equity (i.e., as “temporary equity”) and (2) apply specific measurement, disclosure, and EPS guidance to them. In addition, an issuer that is subject to the SEC’s requirements should consider whether it must classify as temporary equity all or a portion of the equity component of a convertible debt instrument that contains such a component, including each of the following:

Convertible debt instruments that contain a separately recognized equity component as a result of a previous modification or exchange involving the instrument that (1) was not accounted for as an extinguishment and (2) increased the fair value of the conversion option (see Section 10.4.3).
Convertible debt instruments that contain a separately recognized equity component as a result of the reclassification of a previously bifurcated embedded conversion feature (see Section 8.5.4.3).

Terms and features that could trigger classification as temporary equity are not limited to those that are explicitly described as redemption or put features but also include, for example, certain call, conversion, and liquidation features that could force the issuer to redeem an instrument for cash or assets in circumstances that are not solely within its control.

For convertible debt instruments that contain a separately recognized equity component, ASC 480-10-S99-3A(3)(e) limits the scope of the application of the guidance on temporary equity to scenarios in which the convertible instrument is currently redeemable or convertible by the investor for cash or other assets. Unlike its application to other redeemable equity instruments, the guidance on classifying a convertible debt instrument with a separately recognized equity component as temporary equity must be applied only at the ends of reporting periods in which the instrument is currently redeemable for cash or other assets. Thus, the guidance does not apply in reporting periods in which the instrument will become redeemable or convertible only on a future date. As a result of this guidance, an entity that has an outstanding convertible debt instrument with a separately recognized equity component must assess, in each financial reporting period, whether the equity component (or a portion thereof) must be classified in temporary equity. As indicated in ASC 480-10-S99-3A(12)(d) and ASC 480-10-S99-3A(16)(d), the amount that must be classified in temporary equity is limited to the excess (if any) of “(1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion . . . over (2) the carrying amount of the liability-classified component of the convertible debt instrument” both at initial measurement and on subsequent balance sheet dates.

For a comprehensive discussion of the SEC’s temporary equity guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

Example 7-15

Convertible Debt With Separated Equity Component

Entity A issued a convertible debt instrument for net proceeds of $100. Upon the instrument’s issuance, A was required to separate the conversion feature as a derivative under ASC 815-15. After issuance, however, the conversion feature no longer met the bifurcation criteria in ASC 815-15-25-1. Accordingly, A reclassified the carrying amount of the conversion feature as equity under ASC 815-15-35-4.

As of the reporting date, the current carrying amount of the debt is $90 and the carrying amount of the equity-classified conversion feature is $10. The instrument also includes a cash-settled put option that permits the investor to put the instrument back to A at any time for $97. Entity A is not required to bifurcate the put option and account for it as a derivative under ASC 815-15. In this case, A would present $3 of the equity component in permanent equity and $7 in temporary equity because $7 of the equity component is currently redeemable (i.e., the excess of the current redemption amount over the carrying amount of the debt’s liability component).

If, instead, the put option was contingent and the contingency was not met as of the reporting date, no amount would be presented in temporary equity (irrespective of whether it was probable that the contingency would be met in the future) because the SEC’s guidance on redeemable securities in ASC 480-10-S99-3A only applies to convertible debt instruments with a separately classified equity component if the instrument is currently redeemable or convertible as of the reporting date.

Footnotes

The fair value option cannot be applied to a convertible debt instrument issued at a substantial premium. Such an instrument must be accounted for in accordance with the guidance in Section 7.6.3.

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