Chapter 5 — Convertible Debt Issued at a Substantial Premium

5.1 Overview

The guidance in U.S. GAAP related to the issuer’s accounting for traditional convertible debt (see Chapter 4) contains an exception for convertible debt issued at a substantial premium to par. This chapter discusses the scope of this exception (see Section 5.2) as well as the initial and subsequent accounting for instruments within that scope (see Sections 5.3 and 5.4). Because there are no specific incremental derecognition or disclosure requirements for these instruments under GAAP, the related guidance for traditional convertible debt instruments applies (see Sections 4.5 and 4.6).

5.2 Scope

ASC 470-20

25-13 It is not practicable in paragraph 470-20-25-11 to discuss all possible types of debt instruments with conversion features, debt instruments issued with stock purchase warrants, or debt instruments with a combination of such features. Instruments not explicitly discussed in that paragraph shall be dealt with in accordance with the substance of the transaction. For example, if a convertible debt instrument is issued at a substantial premium, there is a presumption that such premium represents paid-in capital.

Sometimes, convertible debt is sold or initially recognized at a substantial premium over the principal amount to be repaid at maturity. In this circumstance, the prohibition in ASC 470-20-25-12 against allocating part of the proceeds to equity does not apply. Instead, there is a presumption that the premium should be recognized in equity as paid-in capital if it is substantial.

Because ASC 470-20-25-13 only applies to convertible debt instruments that are not specifically addressed in other GAAP, the guidance is inapplicable to:

Convertible debt instruments with a conversion feature that must be bifurcated as a derivative under ASC 815-15 (see Section 2.3 and Appendix A).
Convertible debt instruments that have a separated equity component under the CCF or BCF guidance in ASC 470-20 (see Chapters 6 and 7).

The guidance on allocating a substantial premium to paid-in capital may apply in circumstances such as the following:

An acquirer assumes an acquiree’s outstanding convertible debt in a business combination.
Convertible debt is issued upon the exercise of a physically settled liability-classified warrant (see Section 7.3.4).

Although ASC 470-20 does not define substantial, a premium of 10 percent is considered substantial (e.g., by analogy to ASC 470-50-40-10). In certain circumstances, a premium of less than 10 percent may also be considered substantial (e.g., for a zero-coupon convertible debt instrument that is initially recognized at a premium, because of the value of the conversion feature, and for which negative interest expense would be reported if the premium was not allocated to equity).

While ASC 470-20 does not address the circumstances in which an issuer may overcome the presumption that a substantial premium should be recorded in paid-in capital, the presumption may be overcome if the premium is not attributable to the value of the equity conversion feature. Examples of such circumstances include:

The convertible debt was issued or assumed at a premium because it pays a higher coupon rate than that on similar nonconvertible debt.
The convertible debt includes an embedded feature other than the conversion feature that significantly increased the proceeds received for the debt.

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:

5.4 Subsequent Accounting

Since ASC 470-20 does not address the subsequent measurement of convertible debt to which the guidance on substantial premiums in ASC 470-20-25-13 applies, an issuer should refer to other GAAP. Such convertible debt contains a separated equity component (the premium), and thus the issuer cannot elect the fair value option in ASC 825-10 (see Section 2.5). Therefore, except for any bifurcated embedded derivatives, the liability-classified portion of the convertible debt instrument would be subsequently measured at amortized cost, which the issuer determines by using the interest method described in ASC 835-30. The issuer would not subsequently remeasure the amount initially recognized for the premium in equity.