2.7 Debt Exchangeable Into the Stock of Another Entity
ASC 470-20 — SEC Materials — SEC Staff Guidance
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 those of the issuer. For example, the terms of a debt instrument may give the holder the option to require that the issuer deliver a fixed number of shares of a third party’s common stock in lieu of repaying the debt’s principal amount at maturity. Although from the holder’s perspective, the economic characteristics and risks of an investment in such a debt instrument are somewhat similar to those of an investment in convertible debt, the issuer should not analyze the instrument as convertible debt under ASC 470-20 since it is not settled in the issuer’s equity shares. Instead, the issuer should apply the SEC guidance above and account for the exchange feature in accordance with ASC 815-15 if the issuer does not elect to account for the debt instrument under the fair value option in ASC 825-10 (see Section 2.5).
In consolidated financial statements, a contract that is exchangeable into a
consolidated subsidiary’s equity shares is analyzed in a manner similar to a
contract that is 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 true irrespective of whether the instrument
is issued by the parent or subsidiary. Therefore, if a parent issues a debt
instrument that is exchangeable into a consolidated subsidiary’s equity shares and
the subsidiary is a substantive entity, the exchange feature would be analyzed as a
conversion feature under ASC 470-20 unless it must be accounted for as a derivative
instrument under ASC 815-15 (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).
In the subsidiary’s separate financial statements, the parent’s equity 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 as a convertible debt instrument under ASC 470-20 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.
Equity shares issued by an equity method investee are not considered part of the entity’s own equity. Therefore, debt instruments that are exchangeable into the shares of an equity method investee are not analyzed as convertible debt under ASC 470-20.