Chapter 7 — Special Accounting Models for Certain Types of Debt

7.7 Debt Exchangeable Into the Stock of Another Entity

ASC 470-20 — SEC Materials — SEC Staff Guidance

Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings

SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity

S99-1 The following is the text of the SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity.

An issue has been discussed involving an enterprise that holds investments in common stock of other enterprises and issues debt securities that permit the holder to acquire a fixed number of shares of such common stock. These types of transactions are commonly affected through the sale of either debt with detachable warrants that can be exchanged for the stock investment or debt without detachable warrants (the debt itself must be exchanged for the stock investment — also referred to as “exchangeable” debt). Those debt issues differ from traditional warrants or convertible instruments because the traditional instruments involve exchanges for the equity securities of the issuer. There have been questions as to whether the exchangeable debt should be treated similar to traditional convertibles as specified in Subtopic 470-20 or whether the transaction requires separate accounting for the exchangeability feature. The SEC staff believes that Subtopic 470-20 does not apply to the accounting for debt that is exchangeable for the stock of another entity and therefore separation of the debt element and exchangeability feature is required.

A debt instrument may contain a feature that requires or permits its exchange into the shares of a third party rather than the issuer’s equity shares (“exchangeable debt”). For example, the terms of a debt instrument may include an option for the holder to require the issuer to deliver a fixed number of shares of common stock of a third party in lieu of repaying the debt’s principal amount at maturity. From the issuer’s perspective, exchangeable debt is substantially different from convertible debt because the embedded exchange feature is not settled in the issuer’s equity shares but in third-party stock.

Accordingly, the issuer of exchangeable debt should not analyze such debt as convertible debt under ASC 470-20. Instead the issuer should evaluate whether the exchange feature must be separated as a derivative under ASC 815-15 (see Section 8.4.7) and, if not, whether the SEC staff observer comments in ASC 470-20-S99-1 apply. Under ASC 470-20-S99-1, the exchange feature would be accounted for separately from the debt even if it is not required to be separated as a derivative under ASC 815 (e.g., the feature might not need to be separated as a derivative if it does not meet the net settlement characteristic in the definition of a derivative; see Section 8.4.7).

ASC 470-20-S99-1 does not address the measurement of an exchange feature that does not have to be accounted for as a derivative. An entity might analogize to the guidance on embedded features that are accounted for as derivatives and account for the exchange feature at fair value, with changes in fair value recognized in net income. Alternatively, an entity might look to the indexed-debt guidance in ASC 470-10 and account for the exchange feature on the basis of an intrinsic value approach under which changes in intrinsic value are recognized in net income. Under that approach, the exchange feature is measured on the basis of the excess, if any, of the current value of the third-party stock over the debt’s net carrying amount, without regard to the time value inherent in the option to exchange the debt for third-party stock (see Section 7.4.5).

In consolidated financial statements, a contract exchangeable into the equity shares of a consolidated subsidiary is analyzed in a manner similar to a contract convertible into the parent’s equity shares provided that the subsidiary is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). This is the case irrespective of whether the debt instrument is issued by the parent or subsidiary. Accordingly, if a parent issues a debt instrument that is exchangeable into the equity shares of a consolidated subsidiary and the subsidiary is a substantive entity, the exchange feature would be analyzed as a conversion feature under ASC 470-20 unless it has to be accounted for as a derivative instrument under ASC 815 (e.g., if it can be net settled and does not qualify for the scope exception in ASC 815-10-15-74(a) for certain contracts on the entity’s own equity). Equity shares issued by an equity-method investee, however, are not considered part of the entity’s own equity.

In the subsidiary’s separate financial statements, the equity of its parent is not considered part of the subsidiary’s equity. Therefore, a debt instrument that is issued by a subsidiary and exchangeable into the parent’s equity shares would not be analyzed in a manner similar to a contract that is convertible into the subsidiary’s equity shares in the subsidiary’s separate financial statements (see Section 2.6.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). In the parent’s consolidated financial statements, however, the same debt instrument would be analyzed as a debt instrument that is convertible into the issuer’s equity shares.

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