6.1 Overview

This chapter discusses the guidance in the Cash Conversion subsections of ASC 470-20 on an issuer’s accounting for certain instruments that contain a CCF. The guidance applies not only to debt instruments but also to liability-classified convertible preferred stock (see Section 6.2.2). However, the CCF guidance does not apply if the conversion feature must be bifurcated and accounted for as a derivative instrument under ASC 815-15 (see Sections 2.3 and 6.2.4.1).

Economically, a convertible debt instrument can be analyzed as a combination of (1) a debt obligation with a below-market interest coupon and (2) an equity conversion option. Investors are willing to accept a below-market interest rate on their investment because they also receive an equity conversion option. If, for accounting purposes, all the issuance proceeds are attributed to the debt feature, it may appear that the issuer is able to borrow at a below-market rate; however, this ignores the fact that the issuer has given investors a valuable equity conversion option in exchange for the low interest rate. In the absence of a conversion feature, the issuer would have to pay a higher rate that is commensurate with its nonconvertible debt borrowing rate.

Consequently, the objective of the CCF guidance in ASC 470-20 is to ensure that the interest cost of instruments within its scope reflects the issuer’s nonconvertible borrowing rate. That is, as indicated in paragraph B7 of the Background and Basis for Conclusions of FSP APB 14-1, the cost recognized should reflect “the same interest cost [the issuer] would have incurred had it issued a comparable debt instrument without the embedded conversion option.” The issuer accomplishes this by allocating the amounts received as follows:

• To the liability component — An amount of proceeds that equals the fair value of a similar liability that does not have an associated equity component.
• To the equity component — The remainder of the proceeds.

The resulting debt discount (or reduction in debt premium) increases the reported interest cost in future periods as a result of the application of the effective interest method. Since any debt discounts or premiums are amortized to earnings under this method, the reported interest cost includes the implicit interest cost that was “paid” through the inclusion of a conversion option in the instrument.

The FASB concluded that it would be inappropriate to account for convertible debt instruments that may be settled in cash (including partial settlement) upon conversion wholly as debt in accordance with ASC 470-20-25-12 (see Chapter 4). In paragraph B3 of FSP APB 14-1, the Board observed that such accounting guidance “was based, in part, on [an assumption of] the mutual exclusivity of the debt and the conversion option such that the holder cannot exercise the option to convert into equity shares unless the holder forgoes the right to repayment of the debt component”; however, that assumption is not valid for convertible debt instruments that may be settled in cash upon conversion. Further, such accounting “can provide misleading information to investors,” since “the diluted earnings-per-share treatment of convertible debt instruments with the characteristics of Instrument C [as described in Section 6.1.3] is a treasury-stock-type method that is consistent with the diluted earnings-per-share treatment of debt issued with detachable warrants.”

As indicated in paragraph B5 of FSP APB 14-1, the Board considered but decided against expanding the scope of the CCF guidance “broadly to all convertible debt instruments, including those instruments that must be settled entirely in shares upon conversion,” pending “a broad reconsideration of the accounting for all convertible instruments . . . in connection with the Board’s liabilities and equity project.”

The separation and allocation approach required under the CCF guidance differs from approaches that apply to other types of debt instruments with conversion features. In developing the guidance, the FASB concluded that the liability-first separation approach would be less difficult to apply than an equity-first separation approach or a relative-fair value separation approach that potentially would have required an entity to determine the fair value of the conversion feature by using complex option-pricing models. Further, the Board noted that the CCF guidance has a different objective (i.e., to measure the interest cost that is “paid” with the conversion feature) than other separation or allocation approaches under GAAP (e.g., to measure bifurcated embedded derivatives at fair value; see Section 3.5.4).