Chapter 4 — Traditional Convertible Debt

4.5 Derecognition

4.5.1 Overview

For traditional convertible debt, the issuer’s accounting for the conversion (or exchange) of the debt into equity shares in full satisfaction of the debt depends on the facts and circumstances, as follows:

Conversion in accordance with the instrument’s original terms — If the debt is converted into the issuer’s equity shares under the instrument’s original conversion terms (other than a share-settled redemption feature, which is discussed below) and the conversion was not triggered by the issuer’s exercise of a call option, the net carrying amount of the debt is credited to equity to reflect the shares issued, and no gain or loss is recognized (see Section 4.5.2).
Conversion upon the issuer’s exercise of a call option — If the debt is converted into the issuer’s equity shares under the instrument’s original conversion terms (other than a share-settled redemption feature) and the debt had become convertible because the issuer had exercised a call option embedded in the debt, the accounting for the conversion depends on whether the conversion option was substantive when the debt was issued. If the conversion option was substantive at issuance, the conversion is accounted for as a conversion in accordance with the instrument’s original terms (see Section 4.5.3). If the conversion option was nonsubstantive at issuance, the conversion of the instrument into the issuer’s equity shares is accounted for as a debt extinguishment.
Induced conversions — If the conversion of the debt into the issuer’s equity shares qualifies as an “induced conversion” as described in ASC 470-20, the issuer (1) recognizes “an expense equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of securities issuable [under] the original conversion terms” and (2) credits the excess amount and the net carrying amount of the debt to equity to reflect the shares issued (see Section 4.5.4).
Conversion in a TDR — If the debt is converted into the issuer’s equity shares under a TDR as defined in ASC 470-60 and the transaction is not a related-party transaction, the issuer (1) recognizes the difference between the fair value of the equity interest granted and the net carrying amount of the debt as a restructuring gain and (2) credits the fair value of the shares issued to equity (see Section 4.5.7). If the holder is a related party, the issuer should consider whether the transaction represents a capital transaction (see Section 4.5.5.3).
Other conversions and exchanges — If the debt is converted (or exchanged) into the issuer’s equity shares in accordance with a share-settled redemption feature or on different terms from those at issuance, and the transaction is not accounted for as an induced conversion or TDR and is not a related-party transaction, the conversion is accounted for as a debt extinguishment. In such a case, the issuer (1) recognizes an extinguishment gain or loss equal to the difference between the reacquisition price and the net carrying amount of the extinguished debt and (2) credits the reacquisition price to equity to reflect the shares issued (see Section 4.5.5). If the holder is a related party, the issuer should consider whether the transaction represents a capital transaction (see Section 4.5.5.3).

Like other debt, traditional convertible debt is derecognized when it is extinguished (e.g., through a repurchase or repayment of the debt in full satisfaction of the debt obligation). Upon a debt extinguishment, the issuer recognizes an extinguishment gain or loss equal to the difference between the reacquisition price and the net carrying amount of the extinguished debt (see Section 4.5.5). If the holder is a related party, the issuer should consider whether a debt extinguishment represents a capital transaction (see Section 4.5.5.3). Modifications and exchanges of debt instruments (see Section 4.5.6) and TDRs (see Section 4.5.7) are subject to specialized guidance.

4.5.2 Conversion in Accordance With the Instrument’s Original Terms

ASC 470-20

40-4 If a convertible debt instrument does not include a beneficial conversion feature, the carrying amount of the debt, including any unamortized premium or discount, shall be credited to the capital accounts upon conversion to reflect the stock issued and no gain or loss is recognized.

ASC 470-20-40-4 specifies the general approach to accounting for a conversion of traditional convertible debt into the issuer’s equity shares when the conversion occurs in accordance with the original terms of the debt. Under this approach, the carrying amount of the debt is credited to equity, and no gain or loss is recognized. For example, depending on the circumstances, the issuer may make the following accounting entry:

The carrying amount of the debt reflects any remaining unamortized discount or premium as of the date of conversion as well as any remaining unamortized debt issuance costs as of that date, in accordance with the definition of “net carrying amount of debt” in ASC 470-50. To recognize the appropriate carrying amount within equity, the issuer should amortize any premium or discount and debt issuance costs up to the date the instrument is converted. As indicated in ASC 470-20-40-11, the carrying amount also includes any “accrued interest from the last interest payment date, if applicable, to the date of conversion, net of related income tax effects, if any,” irrespective of whether accrued unpaid interest is forfeited upon conversion (see Section 4.5.2.1).

This accounting does not apply to any of the following transactions involving traditional convertible debt:

A conversion that occurs upon the issuer’s exercise of a call option if the instrument did not contain a substantive conversion feature as of its issuance date (see Section 4.5.3).
Induced conversions as described in ASC 470-20-40-13 (see Section 4.5.4).
A conversion in accordance with a TDR as defined in ASC 470-60 (see Section 4.5.7).
A conversion of a traditional convertible debt instrument with a separately recognized equity component that is not a BCF (see Section 4.5.2.2).

Further, this accounting does not apply to:

A conversion of a convertible debt instrument that contained a recognized BCF (see Section 7.6.1).
A conversion of a convertible debt instrument that contained a CCF (see Section 6.5).
A conversion that occurs in accordance with the terms of a share-settled redemption feature (see Sections 2.4 and 4.5.5.1).
An exchange of debt into the shares of a third party (see Section 2.7).

See Appendix B for a discussion of the accounting for a conversion of a convertible debt instrument for which the embedded conversion option has been separated as an embedded derivative liability.

4.5.2.1 Interest Forfeiture

ASC 470-20

05-9 When a convertible debt instrument is converted to equity securities, sometimes the terms of conversion provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder. This occurs either because the conversion date falls between interest payment dates or because there are no interest payment dates (a zero coupon convertible instrument).

35-11 If the terms of conversion of a convertible debt instrument provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder, that interest should be accrued or imputed to the date of conversion of the debt instrument.

40-11 If the terms of conversion of a convertible debt instrument provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder, accrued interest from the last interest payment date, if applicable, to the date of conversion, net of related income tax effects, if any, shall be charged to interest expense and credited to capital as part of the cost of securities issued. Thus, the accrued interest is accounted for in the same way as the principal amount of the debt converted and any unamortized issue premium or discount; the net carrying amount of the debt, including any unamortized premium or discount and the related accrual for interest to the date of conversion, net of any related income tax effects, is a credit to the entity’s capital.

Although the terms of a convertible debt instrument may specify that the holder forfeits any right to accrued unpaid interest upon a conversion (e.g., if the conversion date falls between interest payment dates or the convertible debt is a zero-coupon instrument), the issuer is nevertheless required to accrue interest cost to the date of conversion. The forfeiture of accrued interest is not treated as a forgiveness of the associated liability. The amount of interest is computed by using the interest method in ASC 835-30. The accrued interest cost, net of any related income tax effects, is credited to equity as part of the cost of the equity shares issued.

4.5.2.2 Conversion of Debt With a Separately Recognized Equity Component for Reasons Other Than a BCF or CCF

No separate equity component is recognized upon the initial issuance of a traditional convertible debt instrument. However, after the issuance of such an instrument, an equity component may be recognized if the issuer (1) reclassifies an embedded conversion feature that was previously classified as an embedded derivative liability to equity (see ASC 815-15-35-4) or (2) modifies or exchanges the convertible debt instrument in a transaction that does not result in extinguishment but includes an increase in the fair value of the embedded conversion option (see Section 4.5.6).

ASC 815-15-40-1 addresses the accounting in a scenario in which a convertible debt instrument with a separate equity component that resulted from a previous reclassification of the embedded conversion option from a liability to equity is converted in accordance with the instrument’s original terms. ASC 815-15-40-1 states:

If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

A traditional convertible debt instrument may contain an equity component that resulted from a previous modification or exchange that increased the conversion option’s fair value (see Section 4.5.6). The Codification does not specifically address the accounting for any unamortized discount that remains on the conversion date if such an instrument is converted into common stock in accordance with the instrument’s original conversion terms. However, given the similarities between the accounting for (1) a conversion of a convertible debt instrument with a BCF (see Section 7.6.1) and (2) a separately recognized equity component that resulted from a previous reclassification of the embedded conversion option from a liability to equity, an entity should immediately amortize any unamortized discount on the debt that remains on the instrument’s conversion date in accordance with its original conversion terms and recognize such amount as an expense.

4.5.2.3 Debt Tendered Upon Exercise of Detachable Warrants

ASC 470-50

40-5 The guidance in this Subtopic does not apply to debt tendered to exercise detachable warrants that were originally issued with that debt if the debt is permitted to be tendered towards the exercise price of the warrants under the terms of the securities at issuance. The tendering of the debt in such a case would be accounted for in the same manner as a conversion.

If debt is tendered for the exercise of detachable warrants, the transaction is accounted for as a conversion rather than as a debt extinguishment if both of the following conditions are met: (1) the warrants were originally issued with that debt and (2) the original terms permit the debt to be tendered toward the exercise price of the warrants (see also Section 3.4.2.3).

4.5.3 Conversion Upon Issuer’s Exercise of a Call Option

4.5.3.1 General Considerations

ASC 470-20

05-11 An entity may issue equity securities to settle a debt instrument that was not otherwise currently convertible but became convertible upon the issuer’s exercise of a call option when the issuance of equity securities is pursuant to the instrument’s original conversion terms. This Subtopic provides related guidance.

40-4A The guidance in paragraphs 470-20-40-5 through 40-10 does not apply to debt instruments that are within the scope of the Cash Conversion Subsections of Subtopic 470-20.

40-5 The following guidance addresses accounting for the issuance of equity securities to settle a debt instrument (pursuant to the instrument’s original conversion terms) that became convertible upon the issuer’s exercise of a call option:

Substantive conversion feature. If the debt instrument contained a substantive conversion feature as of its issuance date, the issuance of equity securities shall be accounted for as a conversion. That is, no gain or loss shall be recognized related to the equity securities issued to settle the instrument.
No substantive conversion feature. If the debt instrument did not contain a substantive conversion feature as of its issuance date (as defined in paragraphs 470-20-30-9 through 30-12), the issuance of equity securities shall be accounted for as a debt extinguishment. That is, the fair value of the equity securities issued should be considered a component of the reacquisition price of the debt.

Sometimes, the terms of a convertible debt instrument include both (1) an option for the issuer to call the instrument and (2) a right for the holder to exercise the conversion feature if the issuer calls the instrument. In this circumstance, the accounting for the conversion of the instrument into the issuer’s equity shares in accordance with the original terms of the debt depends on whether the conversion feature was (1) otherwise currently convertible and (2) substantive as of the instrument’s issuance date.

Convertibility of Debt Instrument	Conversion Feature Substantive at Inception	Conversion Feature Not Substantive at Inception
Convertible only upon the issuer’s exercise of a call option	N/A. (By definition, such a conversion option is not substantive as of the issuance date.)	Accounted for as an extinguishment.
Convertible upon the issuer’s exercise of a call option and could otherwise become convertible in the future	Accounted for as a conversion.	Accounted for as an extinguishment.
Currently convertible even if the issuer has not exercised its call option	Accounted for as a conversion. Because the instrument is convertible without the issuer’s exercise of a call option, the accounting does not depend on whether the conversion option was substantive on the issuance date.

If the conversion option is nonsubstantive at issuance and the instrument becomes convertible upon the issuer’s exercise of the call option, the conversion of the instrument into equity shares is accounted for as a debt extinguishment (see Section 4.5.5) and the holder’s election to convert the debt is analyzed as a debt settlement alternative instead of a conversion privilege. As long as the conversion feature is nonsubstantive at issuance, and provided that the holder does not currently have the ability to convert the instrument unless the issuer exercises its call option, extinguishment accounting applies even if the instrument would have become convertible upon the passage of time (e.g., a conversion option that becomes exercisable on the instrument’s maturity date or on specified prior dates).

The conversion of an instrument into the issuer’s equity shares is accounted for as a conversion as long as it otherwise qualifies for such accounting if either (1) the conversion feature is substantive at issuance or (2) the holder has the ability to exercise the conversion feature irrespective of the issuer’s exercise of its call option.

This guidance does not apply to any of the following transactions involving traditional convertible debt:

A conversion in accordance with a TDR as defined in ASC 470-60 (see Section 4.5.7).
Induced conversions as described in ASC 470-20 (see Section 4.5.4).

Further, this accounting does not apply to:

A conversion that occurs in accordance with the terms of a share-settled redemption feature (see Sections 2.4 and 4.5.5.1).
An exchange of debt into the shares of a third party (see Section 2.7).
A conversion of an instrument that was separated into liability and equity components in accordance with the CCF guidance in ASC 470-20 (see Section 6.5).

4.5.3.2 Determining Whether a Conversion Feature Is Substantive

ASC 470-20 — Glossary

Substantive Conversion Feature

A conversion feature that is at least reasonably possible of being exercisable in the future absent the issuer’s exercise of a call option.

ASC 470-20

40-6 The assessment of whether the conversion feature is substantive may be performed after the issuance date but shall be based only on assumptions, considerations, and marketplace information available as of the issuance date.

40-7 By definition, a substantive conversion feature is at least reasonably possible of being exercised in the future. If the conversion price of an instrument at issuance is extremely high so that conversion of the instrument is not deemed at least reasonably possible as of its issuance date, then the conversion feature would not be considered substantive.

40-8 For purposes of determining whether a conversion feature is reasonably possible of being exercised, the assessment of the holder’s intent is not necessary. Therefore, even if such an instrument included a conversion feature that provided for conversion due solely to the passage of time (for example, the instrument will become convertible at a date before its maturity date), it would be inappropriate to conclude that the conversion feature is substantive. Also, an instrument that became convertible only upon the issuer’s exercise of its call option does not possess a substantive conversion feature.

40-9 Methods that may be helpful in assessing whether a conversion feature is substantive include the following:

The fair value of the conversion feature relative to the fair value of the debt instrument. Comparing the fair value of a conversion feature to the fair value of the debt instrument (that is, the complete instrument as issued) may provide evidence that the conversion feature is substantive.
The effective annual interest rate per the terms of the debt instrument relative to the estimated effective annual rate of a nonconvertible debt instrument with an equivalent expected term and credit risk. Comparing the effective annual interest rate of the debt instrument to the effective annual rate the issuer estimates it could obtain on a similar nonconvertible instrument may provide evidence that a conversion feature is substantive.
The fair value of the debt instrument relative to an instrument that is identical except for which the conversion option is not contingent. Comparing the fair value of the debt instrument to the fair value of an identical instrument for which conversion is not contingent isolates the effect of the contingencies and may provide evidence about the substance of a conversion feature. If the fair value of the debt instrument is similar to the fair value of an identical convertible debt instrument for which conversion is not contingent, then it may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
Qualitative evaluation of the conversion provisions. The nature of the conditions under which the instrument may become convertible may provide evidence that the conversion feature is substantive. For example, if an instrument may become convertible upon the occurrence of a specified contingent event, the likelihood that the contingent event will occur before the instrument’s maturity date may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.

40-10 The guidance in paragraphs 470-20-40-7 through 40-9 does not address the treatment of an instrument for purposes of applying Subtopic 260-10.

An issuer’s evaluation of whether a conversion option is substantive as of the debt’s issuance date reflects the assumptions, considerations, and marketplace information available as of the issuance date even if the evaluation is performed on a subsequent date.

A conversion option may be deemed substantive if — as of the instrument’s issuance date — there is at least a reasonable possibility that it will become exercisable by the holder upon (1) the passage of time or (2) the occurrence or nonoccurrence of a specified event (other than the issuer’s exercise of the call option) that is likely to occur. However, in accordance with ASC 470-20-40-7, a conversion option that has a reasonable possibility of becoming exercisable would not be considered substantive if, as of the instrument’s issuance date, its exercise is not reasonably possible (e.g., because the conversion option is deeply out-of-the-money).

Under ASC 470-20, a conversion feature would not be considered substantive as of the instrument’s issuance date in any of the following circumstances:

The holder has no ability to exercise the conversion feature (i.e., it is not exercisable) unless the issuer exercises its call option.
It is not reasonably possible for the holder to obtain the ability to exercise the conversion feature (i.e., it is not reasonably possible that the feature will become exercisable) unless the issuer exercises its call option. For example, this would be the case if the only circumstance in which the holder can obtain a right to convert the instrument (other than the issuer’s exercise of the call option) is a specified event that does not have a reasonable possibility of occurring.
It is not reasonably possible that the holder will exercise the conversion feature (e.g., the conversion price is extremely high relative to the current share price as of the issuance date).

In evaluating whether a conversion option is substantive as of the issuance date in accordance with ASC 470-20-40-9 (e.g., when determining whether it is reasonably possible that the holder will exercise the conversion feature), entities should consider the following:

The smaller the fair value of the conversion feature relative to the fair value of the debt instrument, the more likely it is that the conversion option is not substantive.
The smaller the difference between the convertible debt’s effective interest rate and the effective interest rate on a hypothetical nonconvertible debt instrument with the same terms except for the conversion feature, the more likely it is that the conversion option is not substantive.
The smaller the difference between the fair value of the convertible debt and the fair value of a hypothetical convertible debt instrument with the same terms (except that the conversion feature is not contingent), the more likely it is that the conversion option is not substantive.
The smaller the likelihood of a contingent event that would make the conversion feature exercisable, the more likely it is that the conversion option is not substantive.

Connecting the Dots

Section 3.2 of Deloitte’s Roadmap Distinguishing Liabilities From Equity discusses the determination of whether a feature is substantive under ASC 480-10.

4.5.3.3 Illustrations

ASC 470-20

Example 9: Illustration of a Conversion of an Instrument That Becomes Convertible Upon the Issuer’s Exercise of a Call Option

55-67 This Example illustrates an instrument subject to the guidance in paragraphs 470-20-40-5 through 40-9.

55-68 An entity issues a contingently convertible instrument on January 1, 2006, with a market price trigger, a $1,000 par amount, and a maturity date of December 31, 2020. The debt instrument is convertible at the option of the holder if the share price of the issuer exceeds a specified amount. The issuer can call the debt at any time between 2009 and the maturity date of the debt. If the issuer calls the debt, the holder has the option to receive cash for the call amount or a fixed number of shares as specified in the terms of the instrument upon issuance, regardless of whether the market price trigger has been met. In 2010, the issuer calls the debt before the market price trigger being met and the holder elects to receive a fixed number of shares (as specified in the terms of the instrument).

Example 9 in ASC 470-20-55 describes a contingently convertible instrument (CoCo) and includes the following key assumptions:

The CoCo, which has a par amount of $1,000, was issued on January 1, 2006, and matures on December 31, 2020.
The issuer has the right to call the CoCo at any time between 2009 and its maturity date. If the CoCo is called, the issuer will settle the call amount of the CoCo (e.g., $1,000) in cash unless the holder elects to convert the debt into a fixed number of the issuer’s shares.
The holder has a contingent right to convert the CoCo into a fixed number of shares (e.g., 10 shares) that is exercisable only if either (1) a specified market price trigger is met (i.e., the issuer’s share price exceeds a specified amount) or (2) the issuer exercises its right to call the CoCo (in this case, the holder obtains the right to convert the CoCo irrespective of whether the market price trigger is met).
In 2010, the issuer calls the CoCo. At this time, the market price trigger has not been met. The holder elects to convert the CoCo into a fixed number of shares instead of receiving the call amount in cash.

In Example 9 in ASC 470-20-55, the holder did not have the ability to convert the CoCo debt before the issuer called it because the market price trigger had not been met. Therefore, the conversion would be evaluated on the basis of the accounting guidance on conversions upon an issuer’s exercise of a call option in ASC 470-20-40-5. If the conversion feature was substantive at issuance, the conversion would be accounted for as a conversion (see Section 4.5.2). If the feature was nonsubstantive at issuance, the conversion would be accounted for as an extinguishment (see Section 4.5.5).

If the facts were altered so that the market-price trigger had been met when the issuer exercised its call option, the accounting guidance on conversions upon the issuer’s exercise of a call option in ASC 470-20-40-5 would not apply because the holder already had an unconditional right to elect to convert the debt when the issuer elected to call it. In this case, the conversion would be accounted for as a conversion irrespective of whether the conversion feature was substantive at issuance.

When the EITF developed the guidance on accounting for the conversion of an instrument that became convertible upon the issuer’s exercise of a call option, the FASB staff prepared illustrations of the application of the guidance. Example 1 in EITF Issue 05-1, Issue Summary 1, Supplement 3 (March 3, 2006), states:

An entity issues a CoCo for par in the amount of $1,000 and a maturity date of December 31, 2025. The issuer can call the bond for its par amount at any time after December 31, 2008, and the holder may put back the bond to the issuer for its par value on the following dates: January 1, 2010, and January 1, 2020. The coupon rate of the bond is 3.5 percent. If the issuer calls the CoCo, the holder has 30 days to receive cash for the accreted value of the instrument or 10 shares of common stock. At the bond’s issuance date, the issuer’s stock price is $70 and the holder can convert the bond into 10 shares of common stock upon the occurrence of either of the following events:

The market price of the issuer’s stock exceeds $120 for a consecutive 30-day period
Consummation of a change in control of the issuer.

The FASB staff analyzed three different scenarios related to Example 1 and indicated whether they should be evaluated under the guidance that was subsequently incorporated into ASC 470-20-40-5:

Scenario	Subject to an Evaluation Under ASC 470-20-40-5	Accounting
Scenario 1 “The issuer’s stock price exceeds $120 for 30 consecutive trading days from May 1 to May 30, 2009, and, on May 30, 2009, when its share price is $121, the issuer calls the CoCo. On June 29, 2009, the issuer’s share price is $110 and the holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,100.”	No. “Because the CoCo was convertible at the discretion of the holder immediately prior to the issuer’s exercise of its call option, the conversion is not within the scope of [ASC 470-20-40-5].”	“The carrying amount of the debt is credited to equity, and no gain or loss is recognized.”
Scenario 2 “The issuer’s stock price exceeds $120 for 29 consecutive trading days from May 1 to May 29, 2009, and on May 29, 2009, the issuer calls the CoCo. The stock price on the call date is $150 per share. The value of the CoCo immediately prior to the call is $1,500. On June 28, 2009, the stock price is $140 and the holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,400.” “Based on an analysis of the effective annual interest rate per the terms of the CoCo relative to the effective annual rate that the issuer estimates it could have obtained on a similar non-convertible instrument of an equivalent term, the issuer concludes that, upon issuance, the embedded conversion feature is substantive (that is, it is reasonably possible that the conversion feature will affect the settlement of the instrument).”	Yes. “This scenario is within the scope of [ASC 470-20-40-5]. The holder did not have the legal right to convert based on the CoCo’s market price trigger prior to the issuer’s exercise of its call option on May 29, 2009.”	Because the conversion feature was substantive at issuance, “the subsequent conversion of the instrument is deemed to have occurred pursuant to the instrument’s original terms and no gain or loss is recognized. The carrying value of the CoCo is credited to equity.”
Scenario 3 “As of January 1, 2024, the instrument is not convertible at the discretion of the investor, the stock price is $110 and the issuer exercises its call option. The holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,100. The fair value of the CoCo immediately prior to the call is $1,045.” “Based on an analysis of the effective annual interest rate per the terms of the CoCo relative to the effective annual rate that the issuer estimates it could have obtained on a similar nonconvertible instrument of an equivalent term, the issuer concludes that, upon issuance, the embedded conversion feature is substantive (that is, it is reasonably possible that the conversion feature will affect the settlement of the instrument).”	Yes. “When the issuer exercised its call option on January 1, 2025, the holder did not have the legal right to convert based on the CoCo’s stated contingent triggers. This scenario is within the scope of [ASC 470-20-40-5] because the issuer provides the holder with the opportunity to convert, which it did not have otherwise.”	Because the conversion feature was substantive at issuance, “the subsequent conversion of the instrument after conversion is deemed to have occurred pursuant to the instrument’s original terms and no gain or loss is recognized.”

Further, EITF Issue 05-1, Issue Summary 1, Supplement 1 (May 27, 2005), contains the examples below.

Example	Subject to an Evaluation Under ASC 470-20-40-5
Example 1, Convertible Debt Security “An entity issues a convertible bond for par in the amount of $1,000 and a maturity date of December 31, 2025. The issuer can call the bond for its par amount at any time after December 31, 2008, and the holder may put back the bond to the issuer for its par value on the following dates: January 1, 2010, and January 1, 2020. At the bond’s issuance date, the issuer’s stock price is $70 and the holder can convert the bond into 10 shares at any time. If the issuer calls the debt, the holder has the option of receiving cash for the par amount or 10 shares. On January 1, 2009, the issuer calls the bond when its stock price is $110. The holder has the option of receiving cash for the par amount ($1,000) or 10 shares of stock with a market value of $1,110. The holder elects to convert the bond and receive 10 shares of stock.”	No. “The issuer’s exercise of the call option resulted in the holder converting the bond into shares on January 1, 2009. However, because in this fact pattern the holder has the ability to convert the bond into 10 shares at anytime, the conversion does not fall within the scope of [ASC 470-20-40-5].”
Example 2, Contingently Convertible Debt “An entity issues a CoCo for par in the amount of $1,000 and a maturity date of December 31, 2025. The issuer can call the bond for its par amount at any time after December 31, 2008, and the holder may put back the bond to the issuer for its par value on the following dates: January 1, 2010, and January 1, 2020. At the bond’s issuance date, the issuer’s stock price is $70 and the holder can convert the bond into 10 shares of common stock upon the occurrence of any one of the following three events: If the issuer calls the CoCo, the holder has the option to receive cash for the par amount of the instrument or exercise its conversion option and receive 10 shares of common stock. If the market price of the issuer’s stock exceeds $120 for a consecutive 30-day period (market price trigger), the CoCo becomes convertible at the holder’s option during the subsequent calendar quarter. Upon the consummation of a change in control of the issuer, the holder of the CoCo can exercise its conversion option.”	See individual scenarios below.
Example 2, Scenario 1 “The issuer’s stock price exceeds $120 for 30 consecutive trading days from May 1 to May 30, 2009, which pursuant to the original terms of the CoCo provides the holder with the option to convert anytime from July 1 through September 30, 2009. On September 30, 2009, the issuer’s share price is $110 and the holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,100.”	No. Because the CoCo could be converted at the holder’s discretion immediately before the issuer exercised its call option, the conversion is not within the scope of ASC 470-20-40-5.
Example 2, Scenario 2 “The issuer’s stock price exceeds $120 for 29 consecutive trading days from May 1 to May 29, 2009, and on May 29, 2009, the issuer calls the CoCo when the stock price is $150 per share. The holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,500.”	Yes. “When the issuer exercised its call option on May 29, 2009, the holder did not have the legal right to convert based on the CoCo’s market price trigger contingency provision because the market price trigger was only satisfied for 29 days and, therefore, falls one day short of the 30 day requirement stipulated in the original terms of the CoCo. This scenario is within the scope of [ASC 470-20-40-5] because the issuer provides the holder with the opportunity to convert, which it would not have had otherwise.”
Example 2, Scenario 3 “On January 1, 2009, the issuer announces that it is selling 100 percent of its outstanding shares for $110 per share and that the transaction will be consummated on February 1, 2009. In contemplation of the transaction, the issuer’s stock price increases to $110. On February 1, 2009, the holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,100 and those shares are tendered to the acquiring company in exchange for $1,100.”	No. The holder obtained a right to convert the CoCo through a change-of-control contingency, so this scenario is not within the scope of ASC 470-20-40-5.
Example 2, Scenario 4 “On January 1, 2009, the issuer announces that it is selling 100 percent of its outstanding shares for $110 per share and the transaction will be consummated on February 1, 2009. The issuer’s stock price increases to $110 in contemplation of the transaction. On January 29, 2009, the issuer calls the CoCo when its stock price is $110. On January 29, 2009, the holder elects to convert the CoCo and receives 10 shares of common stock valued at $1,100.”	Yes. “When the issuer exercised its call option on January 29, 2009, the holder did not have the ability to convert based on the change of control contingency. This scenario is within the scope of [ASC 470-20-40-5] because the issuer provides the holder with the opportunity to convert, which it would not have had otherwise.”

4.5.4 Induced Conversions

4.5.4.1 Scope

ASC 470-20

05-10 Some convertible debt instruments include provisions allowing the debtor to alter terms of the debt to the benefit of debt holders. In some circumstances, conversion privileges for a convertible debt instrument are changed or additional consideration is paid to debt holders for the purpose of inducing prompt conversion of the debt to equity securities (sometimes referred to as a convertible debt sweetener). Such provisions may be general in nature, permitting the debtor or trustee to take actions to protect the interests of the debt holders, or they may be specific, for example, specifically authorizing the debtor to temporarily reduce the conversion price for the purpose of inducing conversion.

40-13 The guidance in paragraph 470-20-40-16 applies to conversions of convertible debt to equity securities pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the terms of the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. That guidance applies only to conversions that both:

Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.

40-14 A conversion includes an exchange of a convertible debt instrument for equity securities or a combination of equity securities and other consideration, whether or not the exchange involves legal exercise of the contractual conversion privileges included in terms of the debt. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.

40-15 The changed terms may involve any of the following:

A reduction of the original conversion price thereby resulting in the issuance of additional shares of stock
An issuance of warrants or other securities not provided for in the original conversion terms
A payment of cash or other consideration to those debt holders that convert during the specified time period.

The guidance in the following paragraph does not apply to conversions pursuant to other changes in conversion privileges or to changes in terms of convertible debt instruments that are different from those described in this paragraph.

Sometimes, convertible debt is converted into the issuer’s equity shares in accordance with changed conversion terms that are effective for a limited period, involve additional consideration, and are designed to induce conversion (also known as an “inducement offer”). Paragraph 16 of FASB Statement 84 (this paragraph was not codified) provides the following background information about such transactions:

A debtor sometimes wishes to induce prompt conversion of its convertible debt to equity securities to reduce interest costs, to improve its debt-equity ratio, or for other reasons. Thus, the debtor may offer additional consideration as an inducement for debt holders to convert promptly. This additional consideration can take many forms, including a temporary improvement of the conversion ratio (effected by a reduction of the conversion price), the issuance of warrants or other securities, or the payment of a cash incentive or other assets to debt holders who convert by a specified date.

If traditional convertible debt is converted in accordance with an inducement offer that meets certain conditions, neither conversion accounting (as described in Section 4.5.2) nor extinguishment accounting (as described in Section 4.5.5) applies. Instead, the issuer must recognize an inducement expense upon conversion. Such accounting applies to conversions that have all of the following characteristics:

The original terms of the debt contained conversion privileges (i.e., the debt was convertible into the issuer’s equity shares).
Either the debtor or the holder offered revised conversion terms that gave the holder an economic incentive to convert. For example, a debtor might offer each holder that elects to accept the inducement offer a reduced conversion price, additional instruments (e.g., warrants), or cash or other consideration in addition to the shares that would have been issued under the original conversion terms (“sweeteners”).
The inducement offer had a restrictive time limit on its exercisability that is intended to induce a prompt conversion. In paragraph 34 of the Basis for Conclusions of Statement 84, the FASB justifies this requirement by noting that “inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion.” Although ASC 470-20-40-13(a) does not address the extent of the time limit, the examples in ASC 470-20-55 imply that 30 or 60 days could qualify as “a limited period of time.” In paragraph 34, the FASB justifies the absence of a maximum time period by indicating that “any period so specified would be arbitrary and . . . the terms of conversion inducement offers may vary according to the circumstances.” When the conversion terms are altered for the remaining term of the convertible debt instrument, a modification of the convertible debt instrument has occurred (see Section 4.5.6).
The convertible debt was converted under the revised conversion terms.
For each converted instrument, all equity securities that were issuable in accordance with the original terms of the convertible debt were issued (i.e., the conversion might result in the issuance of additional but not fewer shares than contemplated in the original conversion terms of each converted instrument). In paragraph 33 of the Basis for Conclusions of Statement 84, the FASB explains this requirement, stating that “a transaction that does not include the issuance of all of the equity securities issuable pursuant to the conversion privileges should not be characterized as a conversion transaction.”

Therefore, induced conversion accounting does not apply in any of the following circumstances:

The original debt instrument did not contain a conversion feature.
The instrument was converted under the original conversion terms.
The terms were adjusted for some purpose other than to induce conversion (e.g., to settle a legal dispute about the correct interpretation of the conversion terms).
The offer was not for a limited period.
The changed conversion privileges have no stated expiration date or are available for the remaining term of the convertible debt.
The inducement offer involves the issuance of fewer equity securities than were issuable under the original conversion terms.
The inducement offer involves the issuance of different equity securities than those that were issuable under the original conversion terms (e.g., preferred stock instead of common stock).
The fair value of the consideration transferred is equal to or less than the fair value of the securities issuable under the original conversion terms.

In the evaluation of whether inducement accounting applies, it does not matter whether:

The inducement offer is initiated by the debtor or the holder.
The inducement offer is provided to all holders, some holders, or only one holder of the debt.
The inducement transaction involves the legal exercise of contractual conversion privileges (i.e., the legal form of the inducement transaction does not matter; a repurchase of convertible bonds in exchange for the issuer’s equity shares might need to be accounted for as an induced conversion).
The ability to modify the conversion terms to induce conversion was contemplated in the original terms of the debt instrument.
The inducement offer involves the issuance of equity securities only or a combination of equity securities and cash or other consideration (as long as the inducement offer does not reduce the number of equity shares issuable).
The original conversion terms did not permit conversion during the period of the inducement offer.

Paragraph 29 of the Basis for Conclusions of FASB Statement 84 explains why inducement accounting might apply even if the original terms of the debt instrument permit contractual revisions to induce conversion (e.g., a subjective modification provision; see Section 4.3.9.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity):

The Board is aware that some convertible debt instruments include provisions allowing the debtor to alter terms of the debt to the benefit of debt holders in a manner similar to transactions described in [ASC 470-20-40-13 through 40-15]. Such provisions may be general in nature, permitting the debtor or trustee to take actions to protect the interests of the debt holders, or they may be specific, for example, specifically authorizing the debtor to temporarily reduce the conversion price for the purpose of inducing conversion. The Board concluded that conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally “provided in the terms of the debt at issuance,” should be included within the scope of [induced conversion accounting]. The Board concluded that the substantive nature of the transaction should govern. The Board believes that the existence of provisions in terms of the debt permitting changes to the conversion privileges should not influence the accounting.

Example 4-2

Evaluation of Conversion as an Induced Conversion

As noted above, the determination of whether inducement accounting applies does not depend on (1) the party that initiates the offer (i.e., the debtor or the debt holder) or (2) whether the offer is related to all debt holders or extends to one or more specific debt holders. EITF Issue 02-15 contains the following example (not codified) that illustrates these points:

Company A issued publicly traded convertible bonds (the Bonds) during a prior period. Currently, the Bonds are trading at a price that is significantly less than the carrying value (possibly due to a decline in Company A’s stock price or credit rating or both). The original conversion price of the Bonds is $50 (20 shares of common stock per bond), and Company A’s common stock is currently trading at $25 per share. On an individual basis, bondholders approach Company A with an offer for Company A to purchase the Bonds by providing consideration in excess of the conversion terms. Assume that on the date of the exchange, each Bond has the following values:

Company A’s carrying value of the Bonds	$ 1,000
Current fair market value of the Bonds	$ 750

A bondholder approaches Company A with the following two independent offers that are exercisable by Company A for a limited period of time:

Company A may purchase the Bonds in exchange for the Bonds’ original conversion of 20 shares of Company A common stock ($500 fair market value) and $300 cash.
Company A may purchase the Bonds in exchange for 32 shares of Company A common stock ($800 fair market value).

In this example, if the debtor accepts one of the offers, induced conversion accounting is required even though (1) the offers are made by individual debt holders rather than the debtor, (2) the offers do not involve all debt holders, and (3) the net carrying amount of the debt exceeds the fair value of the consideration issuable under the offers. Thus, as indicated in paragraph 5 of EITF Issue 02-15, induced conversion accounting might apply to a conversion for consideration in excess of the original conversion terms after “a third party purchases debt securities in the open market (at a significant discount from face value) and approaches the debtor to increase the conversion terms.”

The guidance in ASC 470-20-40-14 implies that the induced conversion guidance for traditional convertible debt applies to an exchange of a convertible debt instrument for shares (or cash and shares) that meets the conditions in ASC 470-20-40-13, even if the exchange does not involve the legal exercise of the contractual conversion privileges included in the terms of the debt. Therefore, induced conversion accounting applies if an issuer, in accordance with an offer that is available for a limited period, repurchases convertible debt in exchange for consideration that includes (1) all of the equity shares that would have been issuable under the original conversion terms and (2) additional consideration (e.g., cash, additional shares, or both, with a fair value equal to the time value of the conversion feature). For example, induced conversion accounting applies if an entity repurchases convertible debt that is convertible into 100 million shares in exchange for 100 million shares plus $5 million of cash.

However, induced conversion accounting does not apply if the repurchase involves fewer equity shares than were issuable under the original conversion terms, even if the total consideration is in excess of the fair value of the equity shares that would have been issuable under the original terms. For example, induced conversion accounting does not apply if an entity repurchases convertible debt that is convertible into 100 million shares in exchange for 95 million shares plus $20 million of cash, even if the total consideration exceeds the fair value of 100 million shares. An entity applies extinguishment accounting (see Section 4.5.5) if (1) an exchange of a convertible debt instrument for shares (or cash and shares) occurs under terms that are different from the original conversion terms and (2) the exchange is outside the scope of the accounting requirements for induced conversions.

The guidance in U.S. GAAP does not clearly address whether inducement accounting applies to a conversion that meets the conditions in ASC 470-20-40-13 in situations in which the conversion feature has been bifurcated as a derivative instrument under ASC 815-15. In such circumstances, it may be acceptable to apply either inducement accounting (because of the lack of an explicit scope exception) or extinguishment accounting.

4.5.4.2 Recognition and Measurement

ASC 470-20

40-16 If a convertible debt instrument is converted to equity securities of the debtor pursuant to an inducement offer (see paragraph 470-20-40-13), the debtor shall recognize an expense equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of securities issuable pursuant to the original conversion terms. The fair value of the securities or other consideration shall be measured as of the date the inducement offer is accepted by the convertible debt holder. That date normally will be the date the debt holder converts the convertible debt into equity securities or enters into a binding agreement to do so. Until the debt holder accepts the offer, no exchange has been made between the debtor and the debt holder. Example 1 (see paragraph 470-20-55-1) illustrates the application of this guidance.

40-17 The guidance in the preceding paragraph does not require recognition of gain or loss with respect to the shares issuable pursuant to the original conversion privileges of the convertible debt when additional securities or assets are transferred to a debt holder to induce prompt conversion of the debt to equity securities. In a conversion pursuant to original conversion terms, debt is extinguished in exchange for equity pursuant to a preexisting contract that is already recognized in the financial statements, and no gain or loss is recognized upon conversion.

Under ASC 470-20, when a conversion must be accounted for as an induced conversion, the issuer should recognize an inducement expense equal to the fair value of the consideration transferred (including the fair value of the additional securities issued and that of any other sweetener, such as cash, warrants, or other securities issued) in excess of the fair value of the securities issuable under the original conversion terms. No gain or loss is recognized for the securities that were issuable under the original conversion terms. Thus, in an induced conversion that involves only the issuance of additional shares, for example, the issuer may make the following accounting entry:

Although conversions in accordance with changed conversion terms are otherwise accounted for as debt extinguishments (see Section 4.5.5), paragraphs 22 and 25 of the Basis for Conclusions of FASB Statement 84 indicate that it would be inappropriate to record a debt extinguishment gain or loss related to the shares issuable under the original conversion terms in an induced conversion subject to ASC 470-20-40-13. Those paragraphs state, in part:

[ASC 470-20-25-12] states that no portion of the proceeds from the issuance of [traditional] convertible debt should be accounted for as attributable to the conversion feature. The amount recognized as a liability relating to convertible debt represents an obligation either to pay a stated amount of cash or to issue a stated number of shares of equity securities. The Board believes that the nature of that obligation does not change if an incentive is paid to a debt holder to induce the holder to exercise a right already held. Therefore, [ASC 470-20-40-13] requires no recognition of gain or loss with respect to the shares issuable pursuant to the original conversion privileges of the convertible debt when additional securities or assets are transferred to a debt holder to induce prompt conversion of the debt to equity securities. . . . The Board believes that an induced conversion transaction is . . . different from an extinguishment of debt transaction as described in [ASC 470-50-40-2], in which any preexisting contract between the debtor and the debt holder is effectively voided and the debt is extinguished pursuant to newly negotiated terms.

In paragraphs 23 and 28 of the Basis for Conclusions of Statement 84, the FASB explains the reason it included the requirement to recognize a cost for the additional consideration issued as follows:

Unlike a conversion pursuant to original terms, in an induced conversion transaction the enterprise issues securities or pays assets in excess of those provided in the preexisting contract between the parties. The Board believes that the enterprise incurs a cost when it gives up securities or assets not pursuant to a previous obligation and that the cost of those securities or assets should be recognized. . . . The Board . . . noted that, in all induced conversions of convertible debt described herein, the debtor corporation gives debt holders equity securities (or a combination of equity securities and other consideration) whose total fair value exceeds the value of the securities it was previously obligated to give upon conversion. The Board believes that a debtor’s election to induce conversion, causing additional value to be given up, should result in recognition of the cost of that inducement.

The inducement expense is recognized as of the date the inducement offer is accepted by the convertible debt holder (i.e., generally the earlier of (1) the conversion date and (2) the date the holder enters into a binding agreement to convert), not as of the date the inducement offer is made. Paragraph 30 of the Basis for Conclusions of FASB Statement 84 states, in part:

The Board . . . considered whether a change in conversion privileges of a convertible debt instrument to induce prompt conversion should be recognized when the change is made, that is, when the inducement is offered to debt holders. The Board rejected that approach. Until the debt holder accepts the offer, no exchange has been made between the debtor and the debt holder. The Board concluded that the transaction should not be recognized until the inducement offer has been accepted by the debt holder.

Similarly, in the calculation of the inducement cost, the fair value of the securities or other consideration transferred as part of the inducement transaction is measured as of the date the inducement offer is accepted by the holder, not as of the date the inducement offer is made. If different holders accept the same offer on different dates, there may be multiple measurement dates. Paragraphs 31 and 32 of the Basis for Conclusions of FASB Statement 84 state, in part:

Some respondents stated that the fair value of a change in conversion privileges should be measured (but not recognized) as of the date the conversion inducement is offered. They reasoned that the fair value of the conversion inducement at the offer date is the basis for management’s decision to make the offer and that the value as of that date is the best measure of the consideration paid.

The Board did not adopt that approach. The Board believes that the transaction should not be measured until the parties agree, that is, until the inducement offer has been accepted by the debt holder. The Board notes that in many cases the difference between the measurements of value of the inducement offer at the offer date and the acceptance date will be minimal due to the normal structure of conversion inducement offers and the requirement in [ASC 470-20-40-13] that the inducement be offered for a limited period of time. However, in circumstances involving differences in values, the Board believes the fair value as of the acceptance date is the appropriate measure because that is the value of the inducement which presumably causes the transaction to occur.

Because the inducement expense recognized must equal the fair value of the additional securities issued upon conversion regardless of the convertible debt’s net carrying amount and the total fair value of the consideration paid on conversion, some accounting outcomes may be economically counterintuitive. For example, an offer that is settled entirely in cash might result in the recognition of a debt extinguishment gain, whereas an offer of equal economical value that is settled in shares might result in the recognition of an inducement loss. Further, the amount credited to equity to reflect the shares issued may exceed their fair value. As noted in Robert Sprouse’s dissent to FASB Statement 84, the requirement to recognize and measure an inducement expense does not “distinguish between induced conversions made under [the following two] sets of facts and circumstances: (a) debt convertible into equity securities whose market values are greater than the conversion price (refer to [ASC 470-20- 55-3 and 55-4]) and (b) debt convertible into equity securities whose market values are less than the conversion price (refer to [ASC 470-20-55-6 and 55-7]).”

Example 4-3

Induced Conversion of Convertible Debt for Total Consideration Less Than the Debt’s Carrying Amount

Issuer A has outstanding convertible bonds that it accounts for as traditional convertible debt under ASC 470-20. Their net carrying amount is $1 million. The original conversion price was $20 (i.e., the issuer would deliver 50,000 shares upon conversion). To induce prompt conversion, A reduces the conversion price to $16 for a limited period (i.e., 62,500 shares), and the holders accept the offer. The current stock price is $15. Accordingly, the fair value of the securities issuable under the original conversion terms was $750,000 (i.e., 50,000 × $15) and the fair value of the securities issuable under the revised conversion terms is $937,500 (i.e., 62,500 × $15). Because the consideration issuable under the changed conversion privileges exceeds the consideration under the original terms, A recognizes an inducement loss under ASC 470-20 equal to the fair value of the additional shares, $187,500 (i.e., 12,500 × $15). However, if A had repurchased the shares for a cash payment of $937,500 instead of issuing shares worth $937,500, it would have recognized a debt extinguishment gain of $62,500 (i.e., $1,000,000 – $937,500).

4.5.4.3 Illustrations

ASC 470-20

Example 1: Induced Conversions of Convertible Securities

55-1 The following Cases illustrate application of the guidance in paragraph 470-20-40-16 to induced conversions of convertible securities:

Reduced conversion price for conversion before determination date, increase in bond fair value (Case A)
Reduced conversion price for conversion before determination date, decrease in bond fair value (Case B).

55-2 For simplicity, the face amount of each security is assumed to be equal to its carrying amount in the financial statements (that is, no original issue premium or discount exists).

Case A: Reduced Conversion Price for Conversion Before Determination Date — Bond Fair Value Increased

55-3 On January 1, 19X4, Entity A issues a $1,000 face amount 10 percent convertible bond maturing December 31, 20X3. The carrying amount of the bond in the financial statements of Entity A is $1,000, and it is convertible into common shares of Entity A at a conversion price of $25 per share. On January 1, 19X6, the convertible bond has a fair value of $1,700. To induce convertible bondholders to convert their bonds promptly, Entity A reduces the conversion price to $20 for bondholders that convert before February 29, 19X6 (within 60 days).

55-4 Assuming the market price of Entity A’s common stock on the date of conversion is $40 per share, the fair value of the incremental consideration paid by Entity A upon conversion is calculated as follows for each $1,000 bond that is converted before February 29, 19X6.

55-5 Therefore, Entity A records debt conversion expense equal to the fair value of the incremental consideration paid as follows.

Case B: Reduced Conversion Price for Conversion Before Determination Date — Bond Fair Value Decreased

55-6 On January 1, 19X1, Entity B issues a $1,000 face amount 4 percent convertible bond maturing December 31, 20X0. The carrying amount of the bond in the financial statements of Entity B is $1,000, and it is convertible into common shares of Entity B at a conversion price of $25. On June 1, 19X4, the convertible bond has a fair value of $500. To induce convertible bondholders to convert their bonds promptly, Entity B reduces the conversion price to $20 for bondholders that convert before July 1, 19X4 (within 30 days).

55-7 Assuming the market price of Entity B’s common stock on the date of conversion is $12 per share, the fair value of the incremental consideration paid by Entity B upon conversion is calculated as follows for each $1,000 bond that is converted before July 1, 19X4.

55-8 Therefore, Entity B records debt conversion expense equal to the fair value of the incremental consideration paid as follows.

55-9 The same accounting would apply if, instead of reducing the conversion price, Entity B issued shares pursuant to a tender offer of 50 shares of its common stock for each $1,000 bond surrendered to the entity before July 1, 19X4. See paragraph 470-20-40-14.

4.5.5 Extinguishments

ASC 405-20 and ASC 470-50 provide the accounting requirements related to debt extinguishments. While a detailed discussion of that guidance is beyond the scope of this Roadmap, the sections below briefly summarize its application to convertible debt.

4.5.5.1 Scope

ASC 405-20

40-1 Unless addressed by other guidance (for example, paragraphs 405-20-40-3 through 40-4 or paragraphs 606-10-55-46 through 55-49), a debtor shall derecognize a liability if and only if it has been extinguished. A liability has been extinguished if either of the following conditions is met:

The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
1. Delivery of cash
2. Delivery of other financial assets
3. Delivery of goods or services
4. Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. For purposes of applying this Subtopic, a sale and related assumption effectively accomplish a legal release if nonrecourse debt (such as certain mortgage loans) is assumed by a third party in conjunction with the sale of an asset that serves as sole collateral for that debt.

ASC 470-50

05-1 This Subtopic discusses the accounting for all extinguishments of debt instruments, except debt that is extinguished through a troubled debt restructuring (see Subtopic 470-60) or a conversion of debt to equity securities of the debtor pursuant to conversion privileges provided in terms of the debt at issuance (see Subtopic 470-20).

15-2 The guidance in this Subtopic applies, in part, to the following transactions and activities:

Extinguishments of debt effected by issuance of common or preferred stock, including redeemable and fixed-maturity preferred stock, that do not represent the exercise of a conversion right contained in the terms of the debt at issuance.

15-3 The guidance in this Subtopic does not apply to the following transactions and activities:

Conversions of debt into equity securities of the debtor pursuant to conversion privileges provided in the terms of the debt at issuance. Additionally, the guidance in this Subtopic does not apply to conversions of convertible debt instruments pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. Guidance on conversions of debt instruments (including induced conversions) is contained in paragraphs 470-20-40-13 and 470-20- 40-15.
Extinguishments of debt through a troubled debt restructuring. (See Section 470-60-15 for guidance on determining whether a modification or exchange of debt instruments is a troubled debt restructuring. If it is determined that the modification or exchange does not result in a troubled debt restructuring, the guidance in this Subtopic shall be applied.)
Transactions entered into between a debtor or a debtor’s agent and a third party that is not the creditor.

Extinguished debt should be derecognized (i.e., removed from the statement of financial position). In a manner similar to other debt instruments, a convertible debt instrument is considered extinguished when either of the two conditions in ASC 405-20-40-1 is met; that is, it would be considered extinguished if the issuer (1) “pays the creditor and is relieved of its obligation for the liability” or (2) “is legally released from being the primary obligor under the liability.” In cases in which the debtor has been relieved of its obligation, examples of debt extinguishment transactions include:

The debtor repays the principal amount and any accrued interest on the debt’s contractual maturity date.
The debtor settles the debt after exercising a call or prepayment feature embedded in the debt.
The debtor settles the debt after the investor exercises a put feature embedded in the debt.
The debtor repurchases outstanding debt securities in a public market for the debt.

Debt is considered to be extinguished if the issuer buys it back even if the issuer intends or expects to reissue the debt (such as treasury bonds). Conversely, debt is not considered to be extinguished solely because the issuer intends, expects, or has committed to settling it by paying the creditor at a future date. For example, debt would not be considered extinguished before settlement even if the issuer had provided the holder with an irrevocable notice that it is exercising a call or prepayment feature embedded in the debt. However, an irrevocable notice to repay debt before its maturity could affect its current versus noncurrent classification.

The general approach to accounting for debt extinguishments is to recognize currently any difference between the reacquisition price of the debt and its net carrying amount as a gain or loss in net earnings (see Section 4.5.5.2). This approach applies not just to circumstances in which the issuer either (1) repays the debt by transferring cash or other assets or (2) is otherwise legally released from being the primary obligor but also to situations in which the terms have been modified and the new terms are substantially different from those of the original (see Section 4.5.6). Further, in certain circumstances, debt extinguishment accounting applies to conversions or exchanges of debt into the issuer’s equity shares. Examples include:

A conversion that occurs upon the issuer’s exercise of a call option if the instrument did not contain a substantive conversion feature as of its issuance date (see Section 4.5.3).
A conversion that occurs in accordance with changed conversion privileges that does not meet the criteria for induced conversion accounting (see Section 4.5.4).
A conversion that occurs in accordance with the original terms of a conversion feature that represents a share-settled redemption option (see Section 2.4).

Paragraph 19 of APB Opinion 26 (this paragraph was not codified) notes that the “accounting for [debt extinguishment] transactions should be the same regardless of the means used to achieve the extinguishment.” Therefore, in accordance with ASC 470-50-15-2(a), a share settlement should be accounted for as a debt extinguishment, rather than a conversion, if the issuance of shares economically represents a payment to the creditor in full settlement of the debt in a manner similar to the delivery of financial assets under ASC 405-20-40-1(a). Accordingly, debt extinguishment accounting applies to:

The settlement of debt through the issuance of shares if the issuer is using its own shares as a means of currency to settle the debt’s value (e.g., the number of shares delivered is determined to have a value equal to the monetary amount of the debt obligation).
The conversion of debt into a variable number of shares in accordance with a share-settled redemption or indexation feature (see Section 2.4).

Further, it may be appropriate to apply debt extinguishment accounting to conversions of convertible debt for which the conversion feature was separated as a derivative instrument under ASC 815-15. See further discussion in Appendix B.

The general approach to accounting for debt extinguishments does not apply to traditional convertible debt in the following circumstances:

A conversion that occurs under the conversion privileges contained in the original terms of the instrument (see Section 4.5.2), unless other guidance takes precedence. A conversion that occurs upon the issuer’s exercise of a call option if the instrument contained a substantive conversion feature as of its issuance date (see Section 4.5.3), unless other guidance takes precedence.
A conversion that reflects changes to the conversion privileges contained in the terms at inception if the criteria for induced conversion accounting are met (see Section 4.5.4).
A TDR as defined in ASC 470-60 (see Section 4.5.7).
An exchange of debt instruments (including an exchange involving contemporaneous exchanges of cash between the same debtor and creditor) if the terms are not substantially different (see Section 4.5.6).
Certain debt extinguishment transactions involving related parties (see Section 4.5.5.3).

Further, the general approach to accounting for debt extinguishments does not apply to:

A conversion or extinguishment of convertible debt with a BCF that was separated in accordance with the guidance in ASC 470-20 (see Section 7.6).
A conversion or extinguishment of convertible debt that was separated into liability and equity components under the CCF guidance in ASC 470-20 (see Section 6.5).

Although a traditional convertible debt instrument does not contain any equity component on the issuance date, the issuer may be required to subsequently recognize a separate component within equity if it (1) modifies or exchanges the convertible debt instrument in a transaction that does not result in extinguishment but includes an increase in the fair value of the embedded conversion option (see Section 4.5.6) or (2) reclassifies an embedded conversion feature that was previously classified as an embedded derivative liability to equity (see Section 6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). In these circumstances, any subsequent extinguishment of the convertible debt instrument includes extinguishment of both the liability for the convertible debt instrument and the conversion option for which an amount is classified in equity. It is therefore appropriate to allocate the total reacquisition price of the debt to the two components (to calculate the extinguishment gain or loss on the liability component). This treatment is similar to how an issuer accounts for the extinguishment of a convertible debt instrument that contained a BCF (see Section 7.6.2); however, the amount that an issuer allocates from the reacquisition price to the equity component would not be the intrinsic value of the conversion option on the date of extinguishment. Rather, if the equity component resulted from the reclassification of an embedded conversion feature from a derivative liability to equity, the amount allocated to the reacquisition of the equity component would be equal to the fair value of the conversion option on the date of the extinguishment in accordance with ASC 815-15-40-4.

The Codification does not specifically address how to allocate the reacquisition price for traditional convertible debt if the equity component resulted from a modification or exchange that increased the fair value of the conversion feature. Generally, the amount that was previously recognized for that equity component would be allocated to its reacquisition. Regardless of the approach applied, the amount allocated to the equity component should not result in a gain or loss. (ASC 260-10-S99-2 does not apply to the settlement of the equity component if the convertible debt instrument provided for conversion into the issuer’s common stock.)

4.5.5.2 Recognition and Measurement

ASC 470-50

40-2 A difference between the reacquisition price of debt and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. If upon extinguishment of debt the parties also exchange unstated (or stated) rights or privileges, the portion of the consideration exchanged allocable to such unstated (or stated) rights or privileges shall be given appropriate accounting recognition. Moreover, extinguishment transactions between related entities may be in essence capital transactions.

40-2A In an early extinguishment of debt for which the fair value option has been elected in accordance with Subtopic 815-15 on embedded derivatives or Subtopic 825-10 on financial instruments, the net carrying amount of the extinguished debt shall be equal to its fair value at the reacquisition date. In accordance with paragraph 825-10-45-6, upon extinguishment an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive income for the extinguished debt that resulted from changes in instrument-specific credit risk.

40-3 In an early extinguishment of debt through exchange for common or preferred stock, the reacquisition price of the extinguished debt shall be determined by the value of the common or preferred stock issued or the value of the debt — whichever is more clearly evident.

Extinguishment of Convertible Debt

40-4 The extinguishment of convertible debt does not change the character of the security as between debt and equity at that time. Therefore, a difference between the cash acquisition price of the debt and its net carrying amount shall be recognized currently in income in the period of extinguishment as losses or gains.

ASC 470-50 — Glossary

Net Carrying Amount of Debt

Net carrying amount of debt is the amount due at maturity, adjusted for unamortized premium, discount, and cost of issuance.

Reacquisition Price of Debt

The amount paid on extinguishment, including a call premium and miscellaneous costs of reacquisition. If extinguishment is achieved by a direct exchange of new securities, the reacquisition price is the total present value of the new securities.

Under the general approach to debt extinguishment accounting, any difference between the reacquisition price of debt and its net carrying amount is recognized in net earnings as a debt extinguishment gain or loss. Thus, for example, the issuer may make the following accounting entry if the cash reacquisition price exceeds the net carrying amount:

The reacquisition price is the monetary amount of consideration paid to extinguish the debt (e.g., the amount of cash paid or the fair value of the instruments, goods, or services transferred). When a conversion or exchange of debt for the issuer’s equity shares is accounted for as a debt extinguishment, the reacquisition price is the amount that is a more clearly evident measure of the fair value of either (1) the shares issued or (2) the debt extinguished (see ASC 470-20-40-3). However, if the issuer delivers a variable number of shares whose value is computed to equal a fixed monetary amount based on an average stock price (e.g., the most recent 20-day volume-weighted average price on the conversion date) rather than the stock price on the conversion date, by analogy to ASC 480-10-55-22, no gain or loss should be recognized for a difference between (1) the conversion-date fair value of the shares delivered and (2) the fixed monetary amount, irrespective of whether the convertible instrument is within the scope of ASC 480-10.

The net carrying amount of the debt accounted for by using the interest method in ASC 835-30 is the debt’s current amortized cost (i.e., the amount due at maturity adjusted for any remaining unamortized premium or discount and remaining unamortized debt issuance cost as of the date of extinguishment determined by using the interest method). The net carrying amount includes any interest accrued to the date of extinguishment even if it is forfeited (i.e., it is not reversed; see Section 4.5.2.1).

If an entity accounts for the debt at fair value by using the fair value option in ASC 825-10, the determination of the extinguishment gain or loss should be based on the fair value of the carrying amount as of the date of extinguishment (i.e., the fair value on the reacquisition date is the net carrying amount of the extinguished debt). As indicated in ASC 470-50-40-2A, “upon extinguishment an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive income for the extinguished debt that resulted from changes in instrument-specific credit risk.”

If the convertible debt has an equity component, allocation of the reacquisition price between the liability and equity components is required. See further discussion in Sections 4.5.5.1, 6.5, and 7.6.2.

4.5.5.3 Extinguishments Between Related Parties

In accordance with ASC 470-50-40-2, “extinguishment transactions between related entities may be in essence capital transactions.” This guidance has generally been interpreted to suggest that there is a rebuttable presumption that debt extinguishments with related parties (e.g., the investor, before conversion, is a significant shareholder, part of management, or an affiliate of the issuer) that benefit the borrower are capital transactions unless there is substantive evidence that the entity would have obtained the same economic outcome in an arm’s length transaction. For instance, if the issuer settles identical debt instruments with a related party and third-party investors, and the settlement terms (e.g., the reacquisition price) are the same for all parties, the extinguishment transaction with the related party should not be treated as a capital transaction.

In his remarks at the 2010 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Sagar Teotia explained that the SEC staff expects issuers to determine whether an extinguishment transaction with a related party represents a capital transaction. Noting that “the staff has not formed any bright line views on these types of transactions and analyzes these questions individually on a specific facts and circumstances basis,” Mr. Teotia provided examples of the questions the staff has asked registrants related to the analysis:

What was the role of the related party in the transaction?
Why would the related party accept the Company’s offer which resulted in the related party accepting common stock that was significantly lower in value than the carrying value of the debt?
Was the substance of the arrangement a forgiveness of debt that was owed to a related party?

Mr. Teotia emphasized that the “staff believes that a full analysis is required in assessing the substance of these types of transactions. Accordingly, the staff would expect that registrants consider all of the facts and circumstances and related party relationships in a particular transaction when making its accounting assessment.”

4.5.6 Modifications and Exchanges

ASC 470-20

40-18 For additional guidance on modifications of debt, see Subtopic 470-50.

If an issuer modifies or exchanges an outstanding convertible debt instrument, it should assess whether the transaction should be accounted for as either a modification or an extinguishment of the original instrument under ASC 470-50. While a detailed discussion of these requirements is beyond the scope of this Roadmap, this section provides a brief overview of the requirements in ASC 470-50 that apply to modifications and exchanges of convertible debt.

The guidance on modifications and exchanges in ASC 470-50 does not apply to:

Conversions that occur under the original terms of the instrument (see Section 4.5.2).
Conversion price adjustments that are made in accordance with the original terms of the instrument. For example, an adjustment under a down-round protection feature would not be evaluated in accordance with the requirements for modifications and exchanges in ASC 470-50. Instead, the issuer should evaluate such provisions under other GAAP (e.g., for a discussion of how to evaluate whether the instrument contains an embedded derivative that must be separated under ASC 815-15, see Section 2.3; for a discussion of how to evaluate whether the instrument contains a contingent BCF that should be monitored and potentially recognized under ASC 470-20, see Section 7.5).
Changes to the terms of the conversion privileges that represent an induced conversion under ASC 470-20 (see Section 4.5.4).
Modifications and exchanges that occur on the instrument’s maturity date. By analogy to ASC 470-20-30-19 (see Section 7.3.2.2.5), the guidance in ASC 470-50 on modifications and exchanges of debt instruments does not apply to modifications or exchanges that occur on the original contractual maturity date of an outstanding instrument. Instead, if a debt instrument is issued as consideration on the original maturity date of another debt instrument, the issuer reflects a repayment of the debt at maturity in return for noncash consideration (i.e., the new debt instrument), which results in the extinguishment of the original debt instrument. Accordingly, the issuer recognizes (1) the new debt instrument at fair value and (2) the difference between this amount and the net carrying amount of the extinguished debt as an extinguishment gain or loss (see Section 4.5.5.2).
TDRs (see Section 4.5.7).
Announcements of intent. For example, as indicated in ASC 470-50-55-9(a), ASC 470-50 does not apply to an “announcement of intent by the debtor to call a debt instrument at the first call date.”
Transactions between the issuer (or its agent) and a party other than the debt holder (or its agent). Thus, as indicated in ASC 470-50-55-9(c), ASC 470-50 does not apply to “[a]n agreement with a creditor that a debt instrument issued by the debtor and held by a different party will be redeemed.”
Transactions among debt holders unless funds pass through the debtor or its agent (see ASC 470-50-40-7 and ASC 470-50-55-6).

In accordance with ASC 470-50-40-9 and ASC 470-50-55-8, respectively, the requirements for modifications and exchanges in ASC 470-50 apply to the following transactions unless otherwise exempted:

“Transactions involving contemporaneous exchanges of cash between the same debtor and creditor in connection with the issuance of a new debt obligation and satisfaction of an existing debt obligation by the debtor.”
“[T]ransactions in which the terms of a debt instrument are modified through execution of a binding contract between the debtor and creditor that requires a debt instrument to be redeemed at a future date for a specified amount.” For example, a binding contract between a debtor and creditor to settle the debt one year before the contractual maturity date represents a modification of the debt terms that should be evaluated under ASC 470-50. Conversely, the debtor’s announcement of an intent to settle the debt one year before its contractual maturity date is not evaluated as a modification of the terms unless there is a binding contract to do so.

Although ASC 470-50-40-10 does not specifically address modifications and exchanges of instruments with mandatory conversion features (e.g., the automatic conversion of convertible debt into the issuer’s shares upon the occurrence of a contingent event), its guidance on modifications and exchanges that involve embedded conversion options can be applied by analogy to modifications and exchanges of instruments with mandatory conversion features.

In a manner consistent with the guidance in ASC 470-50-40-6, an exchange or modification of an outstanding debt instrument is accounted for as an extinguishment (see Section 4.5.5) of that instrument only if the original and new terms are substantially different. Otherwise, the modification or exchange is accounted for as a modification of the original instrument. Under ASC 470-50-40-10, the terms are considered substantially different if any of the following three circumstances exist:

The “present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument.” The cash flows are discounted by using the effective interest rate of the original instrument. (A change in the fair value of an embedded conversion option is not treated as a cash flow in applying this test.)
The “modification or an exchange affects the terms of an embedded conversion option” and “the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange . . . is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange.” (This guidance does not apply, however, if the conversion option is bifurcated as an embedded derivative before the modification, after the modification, or both.)
The “modification or an exchange of debt instruments adds a substantive conversion option or eliminates a conversion option that was substantive at the date of the modification or exchange.” (This guidance does not apply, however, if the conversion option is bifurcated as an embedded derivative.) For a discussion of how to assess whether an embedded conversion option is substantive, see Section 4.5.3.2.

If the original and new terms are considered substantially different, the original instrument is accounted for as being extinguished (see Section 4.5.5). Accordingly, the issuer recognizes (1) the new or modified debt instrument at its fair value and (2) a debt extinguishment gain or loss related to the original instrument to reflect the difference between the previous net carrying amount and the consideration exchanged (i.e., the fair value of the new debt instrument). Any fee payments made by the debtor or received by the creditor are included in the debt extinguishment gain or loss, and any third-party costs directly related to the modification or exchange are treated as debt issuance costs of the newly recognized instrument. The issuer may also need to consider, for example, whether it is required to apply the accounting guidance for CCFs or BCFs to the new instrument (see Chapters 6 and 7) even if that guidance did not previously apply. In addition, a new date would be established for the issuer’s election of the fair value option (see Section 2.5 for a discussion of when the fair value option may be applied to a convertible debt instrument).

If the original and new terms are considered not substantially different, the original instrument is accounted for as being modified. Accordingly, the issuer adjusts the effective interest rate on the basis of (1) the carrying amount of the original debt instrument, which is reduced if the modification or exchange causes an increase (but not a decrease) in the fair value of an embedded conversion option, and (2) the revised cash flows. Such a reduction in the carrying amount of the debt is recorded against APIC (i.e., a debit to “Debt discount” and a credit to “Equity — APIC”). There is no recognition of (1) a decrease in the fair value of the embedded conversion option that results from the modification or exchange or (2) a change in the instrument’s fair value that is not attributable to the modification or exchange. Any fee payments made by the debtor or received by the creditor are recognized in the basis of the modified instrument, and any third-party costs directly related to the modification or exchange are expensed as incurred. Because the original and new terms are considered not substantially different, the issuer is precluded from recognizing a BCF or reassessing an existing BCF upon the modification or exchange (see Section 7.6.3).

4.5.7 Troubled Debt Restructurings

ASC Master Glossary

Troubled Debt Restructuring

A restructuring of a debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.

If an issuer modifies or exchanges an outstanding convertible debt instrument, it should assess whether the transaction should be accounted for as a TDR under ASC 470-60. While a detailed discussion of the requirements in ASC 470-60 is beyond the scope of this Roadmap, this section provides a brief overview of the requirements that apply to TDRs of convertible debt.

In a manner consistent with the guidance in ASC 470-60-15-5, a modification or exchange of debt would be considered a TDR if “the creditor [i.e., holder] for economic or legal reasons related to the debtor’s [i.e., issuer’s] financial difficulties grants a concession to the debtor [i.e., issuer] that it would not otherwise consider.” Accordingly, ASC 470-60-55-5 indicates that for a modification or exchange to qualify as a TDR, the answer to both of the following questions must be yes:

“Is the debtor experiencing financial difficulty (see paragraphs 470-60-55-7 through 55-9)?”
“Has the creditor granted a concession (see paragraphs 470-60-55-10 through 55-14)?”

Generally, ASC 470-60-35 requires the following treatment for a modification or exchange of convertible debt that is accounted for as a TDR:

If the issuer transfers cash or other assets to settle the convertible debt in full, the issuer recognizes a restructuring gain equal to the excess of (1) the carrying amount of the debt over (2) the fair value of the assets transferred, adjusted for any direct restructuring costs. A difference between the fair value and the carrying amount of the assets transferred represents a gain or loss on the transfer of those assets.
If the issuer grants or issues an equity interest (e.g., equity shares) to settle the debt in full, the equity interest issued is recognized at its fair value less any legal fees and other direct costs incurred in granting the equity interest. The difference between that amount and the carrying amount of the debt is recognized as a restructuring gain after adjustment for any other direct restructuring costs.
If the terms of the debt are modified, the accounting depends on whether the carrying amount exceeds the total future undiscounted cash payments specified by the new terms:
- If the carrying amount is equal to or less than the total future undiscounted cash payments specified by the new terms, the issuer accounts for the modification prospectively by adjusting the effective interest. Any direct restructuring costs are recognized immediately.
- If the carrying amount exceeds the total future undiscounted cash payments specified by the new terms, the issuer reduces the carrying amount of the debt to an amount equal to those payments and recognizes a restructuring gain equal to the reduction, adjusted for any direct restructuring costs. (Note, however, that a gain should not be recognized if the undiscounted, maximum total future cash payments, including contingently payable amounts, could exceed the carrying amount.)
If the restructuring represents a combination of the types described above (i.e., it involves both an asset transfer or grant of equity interests and a modification of the debt terms), the issuer should reduce the carrying amount of the debt by the fair value of any assets transferred and equity interests granted before applying the requirements previously discussed for TDRs that involve a modification of the debt terms.

If the TDR is with a related party, the issuer should consider whether the restructuring represents a capital transaction (see Section 4.5.5.3).

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.