4.2 Scope
ASC 470-20
25-10 The guidance in paragraph 470-20-25-12 addresses debt instruments that have both of the following characteristics:
- The debt instrument is convertible into common stock of the issuer or an affiliated entity at a specified price at the option of the holder.
- The debt instrument is sold at a price or has a value at issuance not significantly in excess of the face amount.
25-11 The terms of convertible debt instruments addressed by the guidance in the following paragraph generally include all of the following:
- An interest rate that is lower than the issuer could establish for nonconvertible debt
- An initial conversion price that is greater than the fair value of the common stock at time of issuance
- A conversion price that does not decrease except pursuant to antidilution provisions.
In most circumstances, convertible debt instruments also are callable at the option of the issuer and are subordinated to nonconvertible debt.
25-12 No portion of the proceeds from the issuance of the types of convertible debt instruments described in the preceding two paragraphs shall be accounted for as attributable to the conversion feature.
25-16 The guidance in paragraphs 470-20-25-10 through 25-15 only addresses the accounting at issuance for convertible debt instruments and does not address accounting for changes to convertible debt instruments after issuance.
The issuer of a convertible debt instrument to which ASC 470-20-25-12 applies (i.e., traditional
convertible debt) is precluded from allocating any of the proceeds to equity. The application of this
prohibition, which was in APB Opinion 14 before the FASB’s codification of U.S. GAAP (the “Codification”),
is limited to convertible debt instruments that have the characteristics described in ASC 470-20-05-4
and ASC 470-20-25-10 and 25-11. For example:
- The holder has an option to convert the debt into the common stock of the issuer (or one of its substantive subsidiaries; see Section 2.7) at a specified price.
- The holder cannot both exercise the conversion option and settle the debt in cash (i.e., the alternatives are mutually exclusive; see Section 3.4.2.2).
- The initial effective conversion price is greater than the fair value of the common stock at the time of issuance (i.e., the conversion feature was not in-the-money at inception).
- Except for standard antidilution provisions, the contractual terms do not specify any adjustments to the conversion price.
- The proceeds or value of the instrument at inception was “not significantly in excess of the face amount.”
GAAP contain several important exceptions to the prohibition in ASC 470-20-25-12 against giving
separate accounting recognition to a conversion feature embedded in a convertible debt instrument:
- If the conversion feature meets the bifurcation criteria in ASC 815-15-25-1, it is accounted for separately from the debt host contract as a derivative at fair value, with changes in fair value recognized in earnings (see Section 2.3). In paragraph 293 of FASB Statement 133, the Board noted that it is “important that an entity not be able to avoid the recognition and measurement requirements of [ASC 815] merely by embedding a derivative instrument in a nonderivative financial instrument or other contract.”
- If the conversion feature was bifurcated as a derivative but no longer meets the bifurcation criteria in ASC 815-15, ASC 815-15-35-4 requires the issuer to reclassify the previously bifurcated conversion option into equity. As indicated in paragraph 5 of EITF Issue 06-7, when the EITF developed this requirement, it concluded that APB Opinion 14 “only addresses the accounting at issuance for convertible debt instruments and does not address accounting for changes to convertible debt instruments subsequent to issuance.”
- If the convertible debt can be settled in full or in part in cash upon conversion, the CCF guidance in ASC 470-20 (see Chapter 6) requires the issuer to separate an equity component unless the feature must be bifurcated as a derivative under ASC 815-15. Because the APB’s decision to preclude separation of the conversion option was based on the mutual exclusivity of the alternatives to convert the debt into equity shares or redeem the debt for cash (see Section 3.4.2.2), the FASB decided that ASC 470-20-25-12 should not apply if the convertible debt may be settled in whole or in part in cash upon conversion since the alternatives are not mutually exclusive.
- If the conversion feature is beneficial to the holder (i.e., it has intrinsic value on its commitment date), the BCF guidance in ASC 470-20 requires the separation of an equity component either at inception or upon the occurrence or nonoccurrence of a contingent event (see Chapter 7) unless either (1) the conversion feature must be bifurcated as a derivative under ASC 815-15 or (2) the convertible debt is subject to the CCF guidance in ASC 470-20. In paragraphs 1 and 2 of EITF Issue 98-5, which was the basis for the BCF guidance that was later codified in ASC 470-20, the EITF noted that APB Opinion 14 “does not explicitly address situations in which the embedded conversion feature is in-the-money at issuance [or] the conversion terms are contingently adjustable.”
- 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 4.5.6). Regarding the development of this guidance, the EITF noted in its November 16, 2006, meeting minutes that APB Opinion 14 “only pertains to the accounting at issuance for convertible debt instruments and does not address the accounting for modifications to convertible debt instruments.”
- 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 Chapter 5) unless the conversion feature requires bifurcation as a derivative under ASC 815-15-25-1 or an equity component has been separated under the CCF or BCF guidance in ASC 470-20. Paragraph 18 of APB Opinion 14 provided this exception, noting that “[s]ecurities not explicitly discussed in [the] Opinion should be dealt with in accordance with the substance of the transaction.”