5.3 Initial Recognition
When initially recognizing convertible debt to which the guidance in ASC 470-20-25-13 on substantial
premiums applies, the issuer allocates the initial amount attributable to the debt (see Section 3.5.2)
between the instrument’s debt and equity components. The face amount is recognized as debt, and
the premium is recognized in APIC. The issuer should also determine whether the instrument contains
any embedded features that must be bifurcated as derivatives under ASC 815-15-25-1 (e.g., a put, call,
redemption, or indexation feature). While the issuer should reduce the initial carrying amount of the
convertible debt by any direct or incremental issuance costs paid to third parties associated with the
debt’s issuance, the guidance in U.S. GAAP does not explicitly address whether or, if so, how to allocate
such costs between an instrument’s debt and equity components (see Section 3.5.3).
Example 5-1
Convertible Debt Assumed in a Business Combination
Entity A acquires Entity B and assumes outstanding convertible debt that was previously issued by B. The
convertible debt’s fair value ($1.2 million) is significantly higher than its principal amount ($1 million). Entity A
determines that (1) the conversion option does not have to be bifurcated as a derivative under ASC 815-15
and (2) the debt does not contain a CCF or BCF under ASC 470-20. In accordance with ASC 805-20-30-1, the
acquirer in a business combination measures liabilities assumed at their acquisition-date fair values. Because
the difference between the convertible debt’s fair value and face amount is substantial, A allocates a portion of
the initial carrying amount equal to the excess of the fair value over the face amount (i.e., $200,000) to equity
(APIC) under ASC 470-20-25-13.
Example 5-2
Convertible Debt Issued Upon Exercise of
Liability-Classified Warrant
In EITF Issue 00-27 (superseded), the following tentative guidance illustrated
the application of ASC 470-20-25-13 to convertible debt
issued upon the exercise of a liability-classified
physically settled warrant (see Section 7.3.4.2 for the associated BCF
analysis):
Assume Company A issues a
freestanding warrant to Company B on January 15,
20X0, for its fair value, $20. . . . The warrant
provides Company B with the right during the next 2
years to exercise the warrant for $100 in cash and
receive Company A $100 par value convertible debt.
The debt is convertible into 10 shares of Company A
common stock. The fair value of Company A stock on
January 15, 20X0, is $11 per share. Company B
exercises the warrant on February 15, 20X1, when the
fair value of Company A stock is $20 per share and
the fair value and carrying amount of the warrant is
$105. [The] warrant terms require physical
settlement upon exercise and Company A has
determined that the warrant is classified as a
liability. . . . The exercise of the warrant and
resulting issuance of the convertible debt would be
recorded as follows: