Chapter 2 — Scope
Chapter 2 — Scope
2.1 Overview
This chapter provides an overview of the types of contracts and transactions that are within the scope of ASC 470-20 (see Section 2.2) and discusses specific scope considerations related to the following:
- Embedded derivatives (see Section 2.3).
- Share-settled redemption or indexation features (see Section 2.4).
- The fair value option (see Section 2.5).
- Temporary equity (see Section 2.6).
- Debt that can be exchanged for another entity’s stock (see Section 2.7).
- Convertible instruments issued to nonemployees for goods or services (see Section 2.8).
2.2 General Considerations
ASC 470-20
05-1 This Subtopic provides accounting and reporting guidance for debt (and certain preferred stock) with specific conversion features and other options as follows:
- Debt instruments with detachable warrants
- Convertible securities — general
- Beneficial conversion features
- Interest forfeiture
- Induced conversions
- Conversion upon issuer’s exercise of call option
- Convertible instruments issued to nonemployees for goods and services
- Own-share lending arrangements issued in contemplation of convertible debt issuance.
05-1A This Subtopic presents guidance in the following two Subsections:
- General
- Cash Conversion
15-1 The guidance in this Subtopic applies to all entities.
15-2 The guidance in this
Subtopic applies to all debt instruments. The guidance on
beneficial conversion features and conversion features that
reset applies also to convertible preferred stock. The
guidance in the General Subsections does not apply to those
instruments within the scope of the Cash Conversion
Subsections. The guidance on own-share lending arrangements
applies to an equity-classified share-lending arrangement on
an entity’s own shares when executed in contemplation of a
convertible debt offering or other financing.
The guidance in ASC 470-20 applies to both public business entities (including SEC registrants) and
private companies that are issuers of instruments within its scope.
ASC 470-20 provides guidance on the issuer’s accounting for the following financial instruments:
- Convertible debt (i.e., debt instruments that contain a feature that requires or permits conversion into the issuer’s equity shares), including:
- Convertible shares (i.e., shares that require or permit conversion into a different class of the issuer’s equity shares):
- Liability-classified shares with a CCF (see Section 6.2.2).
- Equity-classified shares with a BCF.1
- Own-share lending arrangements executed in contemplation of a convertible debt issuance (see Chapter 8).
- Debt issued with detachable warrants (or options) on the issuer’s equity shares (see Sections 3.4.2.3 and 4.5.2.3).
- Debt exchangeable for third-party stock (see Section 2.7).
- Convertible instruments issued to nonemployees for goods or services (see Section 2.8).
Although ASC 470-20-15-2 specifies that ASC 470-20 applies broadly to debt instruments, most of its
guidance only addresses debt instruments that are convertible into the issuer’s equity shares. However,
ASC 470-20 applies to certain aspects of the accounting for debt issued with detachable warrants (or
options) on the issuer’s equity shares (see Sections 3.4.2.3 and 4.5.2.3). In determining the appropriate
accounting for debt that does not contain a conversion feature, an entity considers other accounting
guidance, including ASC 470-10, ASC 470-50, ASC 470-60, ASC 825-10, and ASC 835-30.
The ASC master glossary and ASC 470-20-20 previously included a definition of
the term “debt” that specified that it involves “a contractual obligation to pay
money on demand or on fixed or determinable dates.” However, in ASU 2016-19, the FASB
removed the definition because the Board did not consider it “to be robust enough”
in contexts other than TDRs (e.g., part of the definition linked the term to
restructuring situations).
Although ASC 470-20 is in the liabilities area of the Codification and the titles of ASC 470 and ASC 470-20
suggest that they address debt, some of the guidance in ASC 470-20 also applies to instruments in
the form of shares as well as certain equity-classified share-lending arrangements. Thus, ASC 470-20
contains guidance on convertible shares that either (1) contain a CCF and are required to be classified
as liabilities under ASC 480-10-15-4 (see Section 6.2.2) or (2) contain a BCF even if they are classified as
equity. Further, ASC 470-20 contains accounting guidance that applies to equity-classified share-lending
arrangements on the entity’s own shares for arrangements that were entered into in contemplation
of a convertible debt offering or other financing (see Chapter 8). The issuer applies ASC 480-10 and
ASC 815-40 to evaluate whether the arrangement qualifies as equity.
Connecting the Dots
For a discussion of how an issuer evaluates whether a financial instrument
qualifies as equity, see Deloitte’s Roadmaps Contracts on an Entity’s Own
Equity, which addresses ASC 815-40, and Distinguishing Liabilities
From Equity, which addresses ASC 480-10.
This Roadmap only addresses accounting considerations for convertible instruments in the form of debt and convertible instruments issued in the form of a share that require classification as a liability (i.e., convertible instruments classified in permanent or temporary equity are not specifically addressed). Therefore, the term “convertible debt instruments” in this publication refers exclusively to those instruments.
Footnotes
1
As discussed below, this Roadmap
only addresses accounting considerations for
convertible instruments issued in the form of a
share that are classified as liabilities.
2.3 Embedded Derivatives
2.3.1 Interaction Between ASC 470-20 and ASC 815-15
ASC 470-20
25-1 The guidance in this Section shall be considered after consideration of the guidance in . . . Subtopic 815-15 on bifurcation of embedded derivatives . . . .
Many of the requirements in ASC 470-20 related to the accounting for convertible debt instruments (e.g., the CCF and BCF guidance) do not apply to a conversion feature that must be bifurcated and accounted for as derivative instrument under ASC 815-15. Therefore, an issuer needs to determine whether ASC 815-15 requires bifurcation of the conversion feature before it assesses whether ASC 470-20 applies. However, if a feature other than the conversion feature (e.g., a call or put option) must be bifurcated from a convertible debt instrument, the conversion feature is not exempt from analysis under ASC 470-20. For example, an entity may be required to separate a convertible debt instrument into liability and equity components under the CCF or BCF guidance in ASC 470-20 even if the instrument contains a bifurcated derivative other than the embedded conversion feature.
2.3.2 Bifurcation
2.3.2.1 Overall Framework
ASC Master Glossary
Embedded Derivative
Implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.
Hybrid Instrument
A contract that embodies both an embedded derivative and a host contract.
ASC 815-15
25-1 An embedded derivative shall be separated from the host contract and accounted for as a derivative
instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:
- The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
- The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
- A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
To determine whether any embedded feature in a convertible instrument must be bifurcated and
accounted for separately as a derivative instrument, an entity must evaluate the instrument’s terms,
which may include, for example, one or more of the following features:
- A right or obligation to convert the instrument into the issuer’s equity instruments (e.g., common or preferred stock), including a right or obligation that is contingent on the occurrence of a specified event (e.g., debt that is mandatorily convertible into the issuer’s equity shares upon an initial public offering [IPO]).
- The holder’s right to require the issuer to accelerate the repayment of the stated amount (i.e., a put or redemption option).
- The issuer’s right to prepay the stated amount (i.e., a call option).
- Terms that accelerate the repayment of principal or interest upon the occurrence or nonoccurrence of an event (e.g., a default or an IPO).
- Term-extension features.
- Indexed principal or interest payments (e.g., to benchmark interest rates, credit spreads, inflation rates, commodity prices, equity prices, revenues, or other underlyings).
- Interest payments that are leveraged or inversely related to market interest rates or subject to a collar, cap, or floor.
- Interest payments that are triggered upon the occurrence or nonoccurrence of an event that is unrelated to an interest rate index or the issuer’s credit risk.
- Foreign currency features.
Under ASC 815-15-25-1, an entity is required to separately account for a feature embedded within
another contract (the host contract) if the following three conditions are met:
- The embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related. For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to changes in the interest rates on a debt host contract.
- The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not remeasured at fair value, with changes in fair value recorded immediately through earnings (e.g., under the fair value option election in ASC 815-15-25-4 or ASC 825-10).
- The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers the definition of a derivative in ASC 815-10 and the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15.
There is no requirement to evaluate the three bifurcation conditions in any
particular order. Because all three must be met, the analysis can be
simplified if it is readily apparent that any one condition is not
satisfied. For example, if the instrument is accounted for at fair value,
with changes in fair value recognized in earnings (such as under the fair
value option in ASC 825-10), the feature would not be bifurcated
irrespective of whether the other two bifurcation conditions are met (see
Section
2.5). Therefore, evaluation of the other conditions might not be
necessary.2 Similarly, the analysis can be simplified if it is readily apparent
that the feature is clearly and closely related to the host contract or
would not be accounted for as a derivative instrument if it was a
freestanding contract.
In determining whether bifurcation is required, the entity should not rely
solely on how terms are formally described in the contractual provisions but
also should consider the economic payoff profile of the various terms. For
example, a term that is described as a conversion option might more
appropriately be evaluated as a put option if it represents a right for the
investor to receive shares worth a fixed monetary amount upon exercise (see
Sections
2.4 and 3.3). It may also be appropriate to evaluate terms with
similar economic payoff profiles on a combined basis. For example, the
contractual terms might include multiple conversion features, such as
conversion features that are at the option of the issuer or holder or are
contingent on different events. If their economic payoff profiles are
similar (e.g., they all economically represent a feature that is convertible
into the issuer’s common stock), it may be appropriate to evaluate them for
bifurcation as a single embedded feature.
In its balance sheet, an entity typically presents a bifurcated embedded derivative on a combined basis with the host contract. In the SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006), the SEC staff stated that “[a]lthough bifurcated for measurement purposes, embedded derivatives should be presented on a combined basis with the host contract, except in circumstances where the embedded derivative is a liability and the host contract is equity.”
2.3.2.2 Condition 1 — Not Clearly and Closely Related
The first bifurcation condition in ASC 815-15-25-1 is that the embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related. In evaluating whether this condition is met, the entity must determine the nature of the host contract and identify the economic characteristics and risks of the embedded feature. A convertible instrument issued in the form of debt is considered to contain a debt host contract. A convertible instrument issued in the form of a share must be evaluated to determine whether it contains a debt or an equity host contract (see Section A.2).
The table below provides examples of embedded features that may or may not be
considered clearly and closely related to a debt host contract. The embedded
features are defined on the basis of the economic profile of the payment
rather than the form used for settlement (i.e., cash or shares). However,
the assessment could differ depending on the facts and circumstances and the
application of other specific requirements of ASC 815.
Host Contract
|
Clearly and Closely Related
|
Not Clearly and Closely Related
|
---|---|---|
Debt
|
|
|
2.3.2.3 Condition 2 — Hybrid-Instrument Accounting
The second bifurcation condition in ASC 815-15-25-1 is that the hybrid
instrument is not remeasured at fair value, with changes in fair value
recognized in earnings. If an issuer has applied the fair value option in
ASC 815-15-25-4 or ASC 825-10 to a convertible debt instrument (see
Sections
2.5 and 3.2), an embedded feature would not be bifurcated. However,
ASC 825 prohibits an entity from electing the fair value option for a
financial instrument that would be classified, in whole or in part, as
equity. Because ASC 470-20 requires the issuer of certain types of
convertible debt instruments to separate them into liability and equity
components at issuance (e.g., instruments with CCFs or noncontingent BCFs),
the issuer cannot elect the fair value option for such instruments.
Effectively, therefore, an issuer needs to consider whether ASC 470-20
requires the convertible debt instrument to be separated into liability and
equity components before it can determine whether the fair value option is
available for that instrument.
When assessing whether an embedded feature must be bifurcated, an entity should
not consider a liability that is measured at settlement value in accordance
with ASC 480-10-35-3 (see Sections 4.3.1.2 and 5.3.1.3 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity) to be accounted for at fair
value. Although the settlement value might approximate fair value, the
calculation of a liability’s settlement value does not take into account all
of the attributes of an instrument that are included in a fair value
estimate — for example, the time value of an option. Thus, an instrument
that is remeasured at settlement value may contain an embedded feature that
must be bifurcated.
2.3.2.4 Condition 3 — Derivative Instrument
The third bifurcation condition in ASC 815-15-25-1 is that the embedded feature would have been accounted for as a derivative instrument under ASC 815 if it were a separate freestanding instrument. To determine whether this condition has been satisfied, the entity evaluates whether the feature (1) would have met the definition of a derivative instrument in ASC 815-10 on a stand-alone basis and (2) meets any scope exception described in ASC 815-10 and ASC 815-15. An embedded feature would not be bifurcated if it does not meet the definition of a derivative instrument or it qualifies for a scope exception.
To determine whether the embedded feature would have met the definition of a derivative instrument on a freestanding basis, an entity considers whether the instrument possesses the three characteristics of a derivative instrument listed in ASC 815-10-15-83:
- It has one or more underlyings and one or more notional amounts or payment provisions or both — The settlement of a derivative depends on the interaction between (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both, defined as follows:
- An underlying is a variable whose changes affect the cash flows or fair value of the contract. Examples of underlyings include security prices, commodity prices, interest rates, exchange rates, or the occurrences or nonoccurrences of a specified event. For example, one underlying of an embedded conversion feature is the issuer’s stock price.
- A notional amount is a quantity specified in the contract. Examples of notional amounts include monetary amounts (e.g., principal or face amounts) or a number of equity shares.
- A payment provision is a clause that, as indicated in ASC 815-10-15-93, “specifies a fixed or determinable settlement [amount] if the underlying behaves in a specified manner.” Examples include fixed payments that are contingent on the occurrence or nonoccurrence of an event.
- It requires no initial net investment or one that is smaller than that required under comparable contracts — Under ASC 815-10-15-83(b), a derivative “requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.” In accordance with ASC 815-15-25-1(c), the initial investment in a hybrid instrument is not considered the initial net investment for an embedded feature in that instrument. Instead, the initial net investment in the embedded feature is the amount an entity would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature. For example, the initial net investment in a conversion feature embedded in a debt instrument is the fair value of that feature, rather than the fair value of the convertible debt or the shares that would be delivered upon exercise of the conversion feature. Thus, the initial net investment characteristic is generally met for an embedded derivative.
- Net settlement is permitted — Under ASC 815, a contract or feature is not considered a derivative unless it can be settled net. The net settlement characteristic is met in any of the following circumstances:
- The contractual terms require or permit net settlement. In a contractual net settlement, neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the notional amount. One form of contractual net settlement is a one-way transfer of cash or assets, such as a net amount of cash or a net number of shares (“cashless exercise”). If the contractual terms require or permit either party to elect net settlement, the net settlement characteristic is met even if the item delivered upon settlement is not readily convertible to cash (e.g., private-company shares). In accordance with ASC 815-10-15-107, the exercise of an embedded put, call option, or prepayment option in a debt host contract is considered a contractual net settlement “because neither party is required to deliver an asset that is associated with the underlying.”
- An established market mechanism exists that facilitates net settlement outside of the contract, such as the ability to sell the derivative on an exchange. This condition is typically not met for an embedded feature.
- The contract is settled in a manner in which the recipient’s position is not substantially different from that in a net settlement. For example, if a contract is settled by a two-way (gross) exchange of items that are readily convertible to cash or are derivatives, the net settlement characteristic is met. According to the ASC master glossary, the term “readily convertible to cash” means that an asset has both “[i]nterchangeable (fungible) units” and “[q]uoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.” For example, an embedded conversion feature that must be settled by the physical delivery of the shares underlying the feature in exchange for the extinguishment of the host debt contract would meet the net settlement characteristic if the shares are readily convertible to cash.
In addition, to determine whether the embedded feature would have been accounted for as a derivative
under ASC 815 if it had been a freestanding contract, the entity should consider whether any of the
scope exceptions in ASC 815-10-15 and ASC 815-15-15 apply to the feature. Examples of exceptions
that may be relevant for embedded features in convertible debt instruments include those related to:
- Contracts that are both indexed to the entity’s own stock and classified in stockholders’ equity (see ASC 815-10-15-74(a) and Section 2.3.3). For example, an entity would evaluate an embedded conversion feature to determine whether it meets this scope exception.
- Certain loan commitments (see ASC 815-10-15-69 through 15-71). For example, an entity may evaluate a term extension option embedded in a debt instrument to determine whether it meets this scope exception.
- Certain contracts traded on an exchange if, as indicated in ASC 815-10-15-59(d), the underlying on which the settlement is based is “[s]pecified volumes of sales or service revenues of one of the parties to the contract.” For example, an entity would evaluate interest payments indexed to sales revenue to determine whether they meet this scope exception.
- Registration payment arrangements (see ASC 815-10-15-82 and Section 3.4.3).
2.3.3 Bifurcation Analysis for Embedded Conversion Features
The application of the bifurcation conditions to an equity conversion feature embedded in a debt instrument is multifaceted and often complex. Although there are additional factors that should be considered (see Appendix A), the analysis of whether an equity conversion feature should be bifurcated from a debt host contract under ASC 815-15 often centers on whether the feature meets (1) the net settlement characteristic in the definition of a derivative and, if so, (2) the scope exception in ASC 815-10-15-74(a) for certain contracts issued by the reporting entity that are both indexed to its own stock and classified in stockholders’ equity in its statement of financial position. If an equity conversion feature is embedded in a contract in the legal form of a share (e.g., convertible preferred stock) but the hybrid financial instrument is classified as a liability for accounting purposes, the host contract is generally a debt host (see Section A.2). Therefore, the analysis is similar to that of an equity conversion feature embedded in a legal-form debt instrument (i.e., the equity conversion feature is not clearly and closely related to the host contract).
For equity conversion features that require physical settlement into a fixed number of shares, whether the conversion option meets the net settlement characteristic in the definition of a derivative often depends on whether the underlying shares are readily convertible to cash. The net settlement criterion would be met if the instruments require or permit explicit net settlement (either in net cash or net shares). In evaluating whether a conversion feature meets the net settlement characteristic, the entity should consider all of the convertible instrument’s terms (e.g., redemption and liquidation features). Sometimes, a conversion feature stipulates that rather than having shares delivered, the issuer or investor may choose to have the instrument settle in a cash amount equal to the value of the shares that would have been received in exchange for the convertible instrument. In this case, the terms of the conversion feature explicitly permit net settlement. Other times, the instrument may be redeemable by the holder and, upon redemption, the holder receives a cash amount equal to the greater of (1) the face value plus accrued interest or (2) the value of the shares that would be received had the holder exercised the conversion option. While the conversion feature, according to its terms, may only be settled physically, the redemption feature effectively permits the conversion feature’s net cash settlement.
The determination of whether an embedded equity conversion feature meets the scope exception for certain contracts on the entity’s own equity includes an evaluation of whether the feature is considered indexed to own equity under ASC 815-40-15 and, if so, whether the feature meets additional equity classification conditions in ASC 815-40-25. Common convertible debt terms that should be considered as part of this analysis include:
- Exercise contingencies (e.g., conversion rights that are contingent on (1) the satisfaction of a share price condition or a convertible debt trading price condition or (2) specified corporate events); see Section 4.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
- Conversion rate adjustments (e.g., antidilution adjustments, down-round protection, and fundamental change make-whole features); see Section 4.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
- Settlement provisions (e.g., contingent cash settlement provisions); see Chapter 5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
A convertible debt instrument might qualify as conventional convertible debt
under ASC 815-40-25-39 if the holder can realize the value of the conversion
option only by exercising it and receiving the entire proceeds in a fixed number
of shares or the equivalent amount of cash at the issuer’s discretion. In that
case, some of the equity classification conditions in ASC 815-40-25 would not
apply (see Section
5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
A conversion feature might begin or cease to meet the bifurcation criteria under
ASC 815-15 after the initial recognition of the instrument in which it is
embedded. For instance, the assessment of whether a feature meets the equity
classification conditions in ASC 815-40-25 may change if the entity authorizes
the issuance of additional shares. The accounting analysis might also change if
a conversion feature becomes readily convertible to cash because a market
develops for the underlying shares. In these circumstances, the applicability of
ASC 470-20 to the instrument may be affected. To ensure that the accounting for
an instrument remains appropriate, the issuer should monitor such changes (see
Section 5.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
If separation of the conversion feature is required after the initial recognition of the convertible
instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the
bifurcation criteria. If no amount was previously allocated to equity, a portion of the current carrying
amount of the convertible instrument equal to the current fair value of the feature is allocated to the
embedded derivative (in accordance with ASC 815-15-30-2). However, if an amount attributable to the
equity feature was previously allocated to equity under the CCF guidance in ASC 470-20, the difference
between that amount and the fair value of the conversion option as of the date of reclassification is
accounted for under ASC 470-20-35-19 as an adjustment to equity.
If a conversion feature that was bifurcated from its host contract subsequently
meets the conditions for equity classification in ASC 815-40, it would no longer
meet the bifurcation criteria in ASC 815-15 and therefore should no longer be
classified as an asset or a liability. However, any previously recognized gains
and losses should not be reversed. Instead, the carrying amount of the embedded
derivative (i.e., the feature’s fair value as of the date of the
reclassification) should be reclassified to shareholders’ equity (see Section 6.4.2 of this
Roadmap and Section
6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity). Any remaining debt discount (that arose from the
original bifurcation) should continue to be amortized. The entity also should
provide the disclosures required by ASC 815-15-50-3, as applicable.
Appendix A of this publication includes additional guidance on key aspects of the embedded derivative
analysis that an issuer performs for a convertible debt instrument.
Footnotes
2
In some cases, an entity will need to determine
whether the embedded conversion feature would require bifurcation
before the entity can apply the fair value option. This is because
ASC 825-10-15-5(f) precludes application of the fair value option to
any financial instrument that is, in whole or in part, classified by
the issuer as a component of shareholders’ equity (including
temporary equity) (e.g., a convertible debt instrument within the
scope of the Cash Conversion subsections of ASC 470-20 or a
convertible debt instrument that contains a noncontingent BCF). See
Sections
2.5 and 3.2.
2.4 Share-Settled Redemption or Indexation Features
A financial instrument may contain a term that is described as a “conversion” feature but economically
represents a share-settled redemption provision. That is, the number of equity shares to be delivered is
variable and is calculated to be equal in value to a fixed or specified monetary amount (e.g., the principal
amount plus accrued and unpaid interest) or a monetary amount that is indexed to an unrelated
underlying (e.g., the price of gold).
Even if the terms of the instrument refer to the share-settled feature as a
conversion feature, the issuer should not analyze it as such under ASC 470-20 since
a share-settled feature does not have the economic payoff profile of an equity
conversion feature. Instead, the issuer should (1) evaluate the feature as a put,
call, redemption, or other indexed feature, as applicable, and (2) determine whether
the feature must be separated as a derivative instrument under ASC 815-15 (see
Section 2.3 and
Appendix A). (If
the instrument is issued in the form of an equity share such as preferred stock, the
issuer should also evaluate whether it must be classified as a liability under ASC
480-10.) This view is consistent with the guidance in ASC 470-20-25-8 as well as
with ASC 470-20-55-19, which exempts “a convertible instrument [that] 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” from the application of the accounting guidance on contingent BCFs
in ASC 470-20 when those resets subsequently occur (see Section 7.2.3).
Example 2-1
Share-Settled Redemption Feature in Preferred Stock
A liability-classified instrument issued in the form of preferred stock with a liquidation preference amount of $1 million contains a contingent conversion feature that requires the issuer to settle the instrument in a variable number of common shares when a qualified financing occurs. The conversion price is defined as $1.2 million divided by the market price of the common stock on the conversion date. The issuer would not analyze the instrument as a convertible instrument under ASC 470-20. Instead, it should analyze the feature as a contingent redemption provision and evaluate whether the feature must be separated as a derivative instrument under ASC 815-15.
Example 2-2
Share-Settled Indexation Feature in Debt Instrument
A debt instrument with a principal amount of $1 million contains a conversion feature that gives the holder the option to require the issuer to settle the instrument in a variable number of common shares worth $1 million, adjusted for changes in the S&P 500 Index, as of the conversion date. The issuer should not analyze the debt instrument as a convertible debt instrument under ASC 470-20. Instead, it should analyze the feature as indexed to the S&P 500 Index and evaluate whether it must be separated as a derivative instrument under ASC 815-15.
2.5 Fair Value Option
ASC 470-20
25-1 The guidance in this Section shall be considered after consideration of the guidance in the Fair Value Options Subsections of Subtopic 825-10 . . . .
ASC 825-10
15-4 All entities may elect the fair value option for any of the following eligible items:
a. A recognized financial asset and financial liability, except any listed in the following paragraph . . .
15-5 No entity may elect the fair value option for any of the following financial assets and financial liabilities: . . .
f. Financial instruments that are, in whole or in part, classified by the issuer as a component
of shareholders’ equity (including temporary equity)
(for example, a convertible debt instrument within
the scope of the Cash Conversion Subsections of
Subtopic 470-20 or a convertible debt security with
a noncontingent beneficial conversion
feature).
On specified election dates (such as when an entity first recognizes an item or when it undergoes a business combination or upon a significant modification of debt as defined in ASC 470-50), ASC 825-10 permits an entity to irrevocably elect to measure an eligible item at fair value (“the fair value option”). An example of an eligible item is a recognized financial liability (such as convertible debt) that is not otherwise excluded from the scope of ASC 825-10 (see the next paragraph). An entity that has elected the fair value option for a financial liability recognizes (1) the portion of the change in the liability’s
fair value that is attributable to a change in instrument-specific credit risk in other comprehensive
income and (2) the remaining change in the liability’s fair value in net income. Upon derecognition, the
cumulative amount recognized in other comprehensive income is included in net income.
Under ASC 825-10-15-5(f), “[f]inancial instruments that are, in whole or in
part, classified by the issuer as a component of shareholders’ equity” are excluded
from the scope of the fair value option in ASC 825-10. Because ASC 470-20 requires
the issuer of certain types of convertible debt instruments to separate them into
liability and equity components at issuance (e.g., instruments with CCFs or
noncontingent BCFs), the issuer cannot elect the fair value option in ASC 825-10 for
such instruments. Therefore, an issuer needs to consider whether ASC 470-20 applies
to a convertible debt instrument before it can determine whether the fair value
option in ASC 825-10 is available (see Section 3.2). Since no part of the instrument
is classified in shareholders’ equity at issuance, election of the fair value option
in ASC 825-10 is not precluded for a traditional convertible debt instrument with a
contingent BCF (see Section
7.2.4 for further discussion).
In addition to the fair value option in ASC 825-10, ASC 815-15-25-4 provides a
fair value option for hybrid financial instruments that otherwise require
bifurcation into a host contract and a derivative instrument under ASC 815-15-25-1.
Unlike that in ASC 825-10, the fair value option in ASC 815-15 contains no explicit
scope exception for financial instruments that are, in whole or in part, classified
by the issuer as a component of shareholders’ equity. Therefore, stakeholders have
questioned whether an issuer is permitted to elect the fair value option in ASC
815-15 for a convertible debt instrument that (1) has an embedded feature other than
the conversion feature (such as a put or call option) that requires bifurcation
under ASC 815-15-25-1 and (2) is not eligible for the fair value option in ASC
825-10 because the instrument must be separated into liability and equity components
under ASC 470-20 (e.g., it contains a CCF or noncontingent BCF). (If the conversion
feature must be bifurcated as an embedded derivative, it is not separated as an
equity component under ASC 470-20; see Section 2.3.) Because the fair value option in
ASC 825-10 is not available for such a convertible debt instrument (as discussed
above), the issuer also cannot elect the fair value option in ASC 815-15 for the
instrument.
2.6 The SEC’s Guidance on 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.
FN8 See Subtopics 470-20 and 470-50; and Paragraph 815-15-35-4.
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
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.
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.
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 separated into a liability and equity component under the Cash Conversion subsections of ASC 470-20 (i.e., CCF convertible debt instruments; see Chapter 6).
- Convertible debt instruments that contain a separately recognized BCF (see Chapter 7).
- 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 ASC 470-50-40-15 and Section 4.5.6).
- Convertible debt instruments that contain a separately recognized equity component as a result of a reclassification of a previously bifurcated embedded conversion feature (see ASC 815-15-35-4).
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 (e.g., equity-classified
redeemable convertible preferred stock with a BCF), 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.3 Thus, the guidance does not need to be applied at the ends of 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.
Connecting the Dots
For further discussion of the application of the SEC’s guidance on temporary
equity, see Chapter
9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Footnotes
3
A convertible debt instrument that is only currently
convertible would meet this condition if the issuer does not control the
ability to settle the entire conversion value in shares. See Section 9.4.6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity.
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.
2.8 Convertible Debt Instrument Issued to Nonemployees in Share-Based Payment Transactions
ASC 470-20
05-12 A convertible instrument that is issued to a nonemployee in exchange for goods or services or a
combination of goods or services and cash and may contain a nondetachable conversion option that permits
the holder to convert the instrument into the issuer’s stock. This Subtopic provides related guidance.
25-17 The guidance in the following paragraph and paragraph 470-20-25-19 addresses a convertible
instrument that is issued or granted to a nonemployee in exchange for goods or services or a combination
of goods or services and cash. The convertible instrument contains a nondetachable conversion option that
permits the holder to convert the instrument into the issuer’s stock.
25-18 Once the instrument is
considered issued for accounting purposes pursuant to
Subtopic 718-10, distributions paid or payable shall be
characterized as financing costs (that is, interest expense
or dividends). Before that time, distributions paid or
payable under the instrument shall be characterized as a
cost of the underlying goods or services.
25-19 If the
convertible instrument is issued for cash proceeds that
indicate that the instrument includes a beneficial
conversion feature and the purchaser of the instrument also
provides (receives) goods or services to (from) the issuer
that are the subject of a separate contract, the convertible
instrument shall be recognized with a corresponding increase
or decrease in the purchase or sales price of the goods or
services.
30-22 To determine the fair
value of a convertible instrument granted as part of a
share-based payment transaction to a nonemployee in exchange
for goods or services or as consideration payable to a
customer that is equity in form or, if debt in form, that
can be converted into equity instruments of the issuer, the
entity shall first apply Topic 718 on stock compensation.
ASC 718-10
35-9A A convertible instrument
award granted to a nonemployee in exchange for goods or
services to be used or consumed in a grantor’s own
operations is subject to recognition and measurement
guidance in this Topic until the award is fully vested. Once
vested, a convertible instrument award that is equity in
form, or debt in form, that can be converted into equity
instruments of the grantor, shall follow recognition and
measurement through reference to other applicable generally
accepted accounting principles (GAAP), including Subtopic
470-20 on debt with conversion and other options.
ASC 718 generally aligns the issuer’s accounting for share-based
payments granted to employees and nonemployees, including the classification of
employee and nonemployee awards. Accordingly, such awards generally remain within
the scope of ASC 718 throughout their lives provided that they are not modified
after they are issued to grantees. However, ASC 718-10-35-9A provides an exception
that specifies that convertible debt instruments granted to nonemployees in a
share-based payment transaction become subject to other GAAP for financial
instruments once vesting has occurred.
After the vesting of convertible debt instruments that were
originally granted or issued to nonemployees for goods or services, or as
consideration payable to a customer, such instruments become subject to the guidance
in ASC 470-20 that applies to CCFs and to the evaluation of BCFs in convertible debt
instruments that are not subject to the CCF guidance unless the embedded conversion
option is bifurcated as an embedded derivative under ASC 815-15 (see Section 2.3). ASC 470-20
contains special guidance on the recognition and measurement of BCFs for convertible
debt instruments that became subject to other GAAP for financial instruments (see
Section 7.3.5). Any
interest that is paid or payable on such instruments is treated as a cost of the
underlying goods or services received or receivable (rather than a financing cost)
until the instruments are considered issued for accounting purposes. Under ASC
505-50-S99-1, “if the issuer receives a right to receive future services in exchange
for unvested, forfeitable equity instruments, those equity instruments should be
treated as unissued for accounting purposes until the future services are received
(that is, the instruments are not considered issued until they vest).” By analogy to
this guidance, convertible debt instruments granted to nonemployees in exchange for
goods and services should be treated as unissued for accounting purposes until those
goods or services have been received.
ASC 470-20-30-23 through 30-26 contain guidance on the treatment of
proceeds in the measurement of any initial BCF in convertible debt instruments
issued to nonemployees for goods and services. Although discussed in the context of
BCF accounting, that guidance also addresses the initial fair value measurement of
the convertible debt instruments, which may be relevant once the instruments become
subject to other GAAP for financial instruments, including ASC 470-20 (see further
discussion in Section 7.3.5).
See Deloitte’s Roadmap Share-Based Payment Awards for further
information about the accounting for convertible debt instruments issued as
share-based payments.