6.4 Subsequent Accounting
6.4.1 Liability Component
ASC 470-20
35-12 The excess of the principal amount of a liability component recognized in accordance with paragraph
470-20-25-23 over its carrying amount shall be amortized to interest cost using the interest method as
described in paragraphs 835-30-35-2 through 35-4.
35-13 For purposes of applying the interest method to a convertible debt instrument within the scope of the Cash Conversion Subsections, debt discounts and debt issuance costs shall be amortized over the expected life of a similar liability that does not have an associated equity component (considering the effects of embedded features other than the conversion option).
35-14 If, under Subtopic 820-10, an issuer uses a valuation technique consistent with an income approach to measure the fair value of the liability component at initial recognition, the issuer shall consider the periods of cash flows used in the fair value measurement when determining the appropriate discount amortization period.
35-16 The expected life of the liability component shall not be reassessed in subsequent periods unless the terms of the instrument are modified. Therefore, the reported interest cost for an instrument within the scope of the Cash Conversion Subsections shall be determined based on its stated interest rate once the debt discount has been fully amortized.
After initial recognition, the issuer measures the liability component of convertible debt subject to the CCF guidance in ASC 470-20 at amortized cost by applying the interest method in ASC 835. This means that the excess of the principal amount to be repaid at the end of the expected life of a similar hypothetical nonconvertible debt over the initial carrying amount of the liability component is treated as a debt discount. As indicated in ASC 835-30-35-2, under the interest method, the amortization of the debt discount is computed “in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period.”
The issuer amortizes the debt discount and any transaction costs allocated to the liability component (i.e., the debt issuance costs) by using the interest method over the expected life of a similar hypothetical nonconvertible debt instrument. It determines the expected life by considering all substantive terms and features (e.g., substantive puts or calls) of the convertible debt other than the conversion feature (see Section 6.3.2.4.1). The amortization period is not subsequently reassessed unless the terms of the instrument are modified.
The periodic amortization of the debt discount and any debt issuance costs adds a noncash component to interest expense that reflects the difference between the cash coupon rate on the convertible debt and the effective interest rate on the liability component. Paragraph B14 of FSP APB 14-1 notes that this “treatment is consistent with the objective that an issuer’s reported interest cost from convertible debt instruments within the scope of [the CCF guidance in ASC 470-20] should reflect its nonconvertible debt borrowing rate” (see Section 6.1.2).
If the issuer determines the initial fair value of the liability component by using an income approach (e.g., discounted cash flows), it estimates that fair value on the basis of contractual cash flows of a similar hypothetical nonconvertible debt instrument over its expected life. In this circumstance, the entity uses the same expected-life assumption in determining the appropriate amortization period for the debt discount and any associated debt issuance costs after initial recognition.
The method of determining the amortization period over the liability component’s expected term is unique to instruments within the scope of the CCF guidance in ASC 470-20. For instruments outside the scope of the CCF guidance, the amortization period is usually the contractual life or the earliest noncontingent put date unless special requirements apply. Paragraph B15 of FSP APB 14-1 states, in
part:
The Board is aware that for debt instruments containing prepayment features, different accounting policies
have been applied in practice for purposes of estimating the amortization period for discounts, premiums,
and deferred transaction costs under [ASC 835-30]. The guidance [in the Cash Conversion subsections of
ASC 470-20] on determining an appropriate discount amortization period is not intended to be a broad-based
interpretation applicable to debt instruments that are not within the scope of [this guidance].
6.4.2 Equity Component
ASC 470-20
35-17 The equity component (conversion option) shall not be remeasured as long as it continues to meet
Subtopic 815-40’s conditions for equity classification.
35-18 A reclassification of the equity component (conversion option) would not affect the accounting for the
liability component.
35-19 If Subtopic 815-40 requires the conversion option to be reclassified from stockholders’ equity to
a liability measured at fair value (see the guidance beginning in paragraph 815-40-35-8), the difference
between the amount previously recognized in equity and the fair value of the conversion option at the date of
reclassification shall be accounted for as an adjustment to stockholders’ equity.
35-20 If Subtopic 815-40 requires that a conversion option that was previously reclassified from stockholders’
equity be subsequently reclassified back into stockholders’ equity, gains or losses recorded to account for the
conversion option at fair value during the period it was classified as a liability shall not be reversed.
After initial recognition, the issuer does not remeasure the equity component of convertible debt
subject to the CCF guidance in ASC 470-20 unless the conversion feature no longer meets the equity
classification conditions in ASC 815-40. In a manner consistent with the guidance in ASC 815-40-35-8,
the issuer reassesses the classification of the equity component of a convertible debt instrument
accounted for under the CCF guidance in ASC 470-20 as of each balance sheet date. If an event causes a
change in the required classification, the contract is reclassified as of the date of the event.
If the conversion feature no longer meets the equity classification conditions in ASC 815-40 (e.g.,
because the issuer has voluntarily issued equity shares so that it no longer has a sufficient number of
authorized and unissued shares to settle the convertible debt in shares upon conversion), the issuer
reclassifies the previously recognized equity component as a liability. The liability and equity components
of the convertible debt instrument are not recombined; instead, the liability component and the
conversion feature continue to be treated as two separate units of account. The entity continues to
accrete the liability component and accounts for the previously recognized equity-classified conversion
feature as a liability at fair value, with changes in fair value recognized in earnings under ASC 815-40, as
long as the feature does not meet the equity classification conditions in ASC 815-40.
An issuer would not reclassify the equity component as a liability merely because it has decided to settle
the instrument in cash upon conversion (or has a history of cash settlements of similar contracts) as
long as the conversion feature continues to meet the criteria for equity classification in ASC 815-40 (e.g.,
the issuer could not be forced to cash settle the feature upon conversion).
Connecting the Dots
For a discussion of the application of ASC 815-40, see Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity.
See Section 2.6 for discussion of the requirement for SEC registrants to classify the equity component in temporary equity.