Appendix B — Accounting for Conversion of Convertible Debt Instrument With a Bifurcated Embedded Conversion Option

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. As a result, the instrument was not subject to the Cash Conversion subsections of ASC 470-20 or the BCF guidance in ASC 470-20 on the issuance date.
• 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.

Under View 1, 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:

Proponents of View 1 believe 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.

To support their position, proponents of View 1 observe that the pre-Codification guidance in paragraph 16 of APB Opinion 26 states that “the essential economics of the decision leading to the early extinguishment of outstanding debt are the same, regardless of whether such debt is extinguished via the use of the existing liquid assets, new equity securities, or new debt.” That reasoning was part of the FASB’s rationale for issuing guidance (which was ultimately codified in ASC 470-50-40-3) that requires the difference between the fair value of the shares and the carrying amount of the liability to be considered a gain or loss related to extinguishment of the existing debt.

Proponents of View 1 further support their position on the basis of an analogy to the pre-Codification guidance in EITF Issue 03-7 that required a gain or loss to be recorded for the liability portion of a conversion of a convertible debt instrument in the form of Instrument C. Although EITF Issue 03-7 was not codified because it was superseded by FSP APB 14-1, proponents of View 1 believe that the guidance in that Issue is relevant since (1) it was applied before the approach in FSP APB 14-1 (now the Cash Conversion subsections of ASC 470-20) was required and (2) FSP APB 14-1 does not address the accounting for a conversion of convertible debt with a bifurcated embedded conversion option.

Opponents of View 1 believe that it is not appropriate to record a gain for the forgone time value in the embedded conversion option. Some maintain that proponents’ analogy to EITF Issue 03-7 is improper because the distinguishing factor in EITF Issue 03-7 was the partial cash settlement of a conversion. Other opponents believe that under ASC 815-40, the embedded conversion option would be reclassified to equity at its then carrying amount immediately before accounting for the conversion.

Some opponents of View 1 also believe that recording a loss for the unamortized portion of the discount on the debt host is inconsistent with the guidance in ASC 470-20-40-4, which requires any unamortized discount or premium to be credited to the capital accounts when a convertible debt instrument is converted into common stock in accordance with its original conversion terms. These opponents believe that ASC 470-20-40-4 applies even though the embedded conversion option was classified as a derivative liability on the conversion date.

In addition, some opponents of View 1 believe that the analogy to the guidance in paragraph 16 of Opinion 26 is inappropriate because Opinion 26 did not ultimately require extinguishment accounting for convertible debt that is converted in accordance with its original terms. However, they acknowledge that at the time that guidance was written, GAAP did not require separation of the embedded conversion option as a derivative liability under any circumstances.

Under View 2, 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:

Proponents of View 2 believe 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 settlement of the debt host and bifurcated conversion option liability did not involve a transfer of cash. Proponents also note that 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 through the issuance of shares in accordance with the conversion privileges provided in the terms of the debt at issuance. Consequently, proponents of View 2 believe that it is the form of the instrument and the conversion terms, rather than the accounting classification, that determine the appropriate accounting for the conversion.

Some proponents of View 2 also believe that it represents the appropriate accounting under ASC 815-40 because the embedded conversion option should be reclassified to equity immediately before the settlement is accounted for.

However, opponents of View 2 point out that the guidance in ASC 470-20-40-4 and ASC 470-50-40-5 was written when GAAP did not require the conversion option to be separated from the debt host contract, and therefore they believe that the settlement should be accounted for under other GAAP (see Views 1 and 3).

Under View 3, 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:

Some proponents of View 3 point to the guidance in 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. Under that guidance, 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, some proponents of View 3 believe that ASC 815-15-40-1 applies to the settlement of the debt host and bifurcated 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.

Other proponents of View 3 believe that the situation in this example differs from that discussed in ASC 815-15-40-1 but that the application of ASC 815-15-40-1 (analogously) and ASC 815-40-40-2 would achieve the same result. Those proponents believe that ASC 815-15-40-1, by analogy, applies to the settlement of the debt host, and ASC 815-40-40-2 applies to the settlement of the bifurcated conversion option liability. ASC 815-40-40-2 states that “[i]f contracts classified as assets or liabilities are ultimately settled in shares, any gains or losses on those contracts shall continue to be included in earnings.” That is, prior gains and losses are not reclassified from earnings, and no additional gain or loss is recorded upon settlement (i.e., any remaining time value in the derivative is recorded to equity).

Proponents of View 3 believe that their view is consistent with the guidance in EITF Issue 03-7, which required the equity-derivative portion of the instrument to be recorded directly to equity, with no additional gain or loss recorded. They believe that this guidance can be applied analogously because EITF Issue 03-7 effectively treats the principal amount and conversion feature separately for settlement purposes, even though the two features had not been previously separated for accounting purposes. In other words, proponents of View 3 believe that the guidance in GAAP prohibits an entity from recording the forgone time value to earnings.

Opponents of View 3 believe that ASC 815-15-40-1 does not apply to this type of conversion and that the guidance in GAAP therefore does not require the immediate amortization of the unamortized discount on the debt host.