4.3 Initial Accounting
Upon the initial recognition of traditional convertible debt, the issuer presents the entire amount attributable to the debt (see Section 3.5) as a liability; no amount is allocated to equity. If the issuer elects to account for the convertible debt at fair value on a recurring basis under the fair value option in ASC 825-10, any issuance costs are expensed at inception. If the fair value option is not elected, the issuer reduces the initial carrying amount of the debt by any direct and incremental issuance costs paid to third parties that are associated with the convertible debt issuance (see Section 3.5.3). The issuer should also determine whether the instrument contains any embedded features, other than the conversion feature, that must be bifurcated as derivatives under ASC 815-15-25-1 (e.g., a put option, a call option, or an interest rate adjustment feature).
In this chapter, it is assumed, unless otherwise stated, that the issuer is not required to separate any embedded derivative feature from the convertible debt instrument. Unless the issuer has elected to apply the fair value option, it should separately account for any bifurcated embedded derivative at fair value under ASC 815-15 (see Section 2.3 and Appendix A for further discussion of the evaluation of embedded derivatives).
Example 4-1
Issuance of Traditional Convertible Debt Instrument Without Any Other Instruments
Entity A issues a five-year convertible debt instrument at par for net cash proceeds of $8 million, which is its principal amount. The instrument has a stated interest rate of 1.5 percent per annum and an embedded conversion option that gives the holder the right to convert the debt on its maturity date into a fixed number of A’s shares of common stock subject to standard antidilution adjustments. The interest rate on the convertible debt is lower than that on similar nonconvertible debt issued by A, since investors are willing to accept a lower rate because of the value of the embedded conversion option. Entity A estimates that if the embedded conversion option had been issued separately as a freestanding financial instrument, its fair value at inception would have been $1 million, although the option is not in-the-money at issuance. Entity A has determined that the conversion option is not required to be bifurcated as a derivative under ASC 815-15 and that the convertible debt is within the scope of the accounting guidance in ASC 470-20-25-12. Therefore, A makes the following journal entry at issuance: