6.5 Derecognition
6.5.1 General Approach
ASC 470-20
40-19 If an instrument within the scope of the Cash Conversion Subsections is derecognized, an issuer shall allocate the consideration transferred and transaction costs incurred to the extinguishment of the liability component and the reacquisition of the equity component.
40-20 Regardless of the form of consideration transferred at settlement, which may include cash (or other assets), equity shares, or any combination thereof, that allocation shall be performed as follows:
- Measure the fair value of the consideration transferred to the holder. If the transaction is a modification or exchange that results in derecognition of the original instrument, measure the new instrument at fair value (including both the liability and equity components if the new instrument is also within the scope of the Cash Conversion Subsections).
- Allocate the fair value of the consideration transferred to the holder between the liability and equity components of the original instrument as follows:
- Allocate a portion of the settlement consideration to the extinguishment of the liability component equal to the fair value of that component immediately before extinguishment.
- Recognize in the statement of financial performance as a gain or loss on debt extinguishment any difference between (i) and (ii):
- The consideration attributed to the liability component.
- The sum of both of the following:01. The net carrying amount of the liability component02. Any unamortized debt issuance costs.
- Allocate the remaining settlement consideration to the reacquisition of the equity component and recognize that amount as a reduction of stockholders’ equity.
40-21 If the derecognition transaction includes other unstated (or stated) rights or privileges in addition to the settlement of the convertible debt instrument, a portion of the settlement consideration shall be attributed to those rights and privileges based on the guidance in other applicable U.S. GAAP.
40-22 Transaction costs incurred with third parties other than the investor(s) that directly relate to the settlement of a convertible debt instrument within the scope of the Cash Conversion Subsections shall be allocated to the liability and equity components in proportion to the allocation of consideration transferred at settlement and accounted for as debt extinguishment costs and equity reacquisition costs, respectively.
When an instrument within the scope of the CCF guidance is derecognized (e.g., because it is converted or otherwise settled), the transaction is accounted for as an extinguishment of the liability component (a debt extinguishment) and the reacquisition of the equity component (an equity transaction) irrespective of the form of settlement (e.g., cash or shares or a combination of both). Transactions that could cause an instrument within the scope of the CCF guidance in ASC 470-20 to be derecognized include those in which the issuer is relieved of its obligations through:
- The conversion of the instrument in accordance with its contractual terms.
- A settlement of the convertible debt instrument in which cash is paid to the creditor (e.g., the exercise of an embedded call or put option), which results in the expiration of the conversion feature in accordance with the contractual terms.
- The reacquisition of the convertible debt instrument before its maturity (e.g., in an open-market repurchase of outstanding convertible debt) irrespective of whether the instrument is cancelled or held in treasury.
- A modification of the instrument’s contractual terms if the modification is treated as an extinguishment under ASC 470-50.
- An exchange of the instrument for another instrument if the exchange is treated as an extinguishment under ASC 470-50.
Upon derecognition of the instrument, the fair value of the consideration transferred to the holders
(e.g., cash, other assets, equity shares, services, or a combination thereof) is allocated between the two
components by using the same method as that for allocating the original issuance proceeds between
the two components irrespective of whether the issuer transfers cash, shares, or a combination of cash
and shares upon conversion. The portion of the consideration allocated to the extinguishment of the
liability component is equal to the fair value of that component immediately before conversion. The
amount of consideration that remains is allocated to the reacquisition of the equity component. No gain
or loss is recognized for the amount allocated to the equity component. (ASC 260-10-S99-2 does not
apply to the settlement of the equity component.)
Third-party transaction costs that are directly related to the settlement are allocated to the liability
component as debt extinguishment costs in proportion to the allocation of consideration transferred
to the liability component at settlement. The remaining third-party transaction costs that are directly
related to the settlement are treated as equity reacquisition costs.
Any difference between (1) the amount of settlement consideration plus the costs allocated
to the liability component and (2) the liability component’s net carrying amount (including any
remaining unamortized discount and debt issuance costs) is recognized as a gain or loss upon debt
extinguishment. Accordingly, the settlement of a convertible debt instrument subject to the CCF
guidance in ASC 470-20 typically results in a gain or loss upon extinguishment.
6.5.2 Induced Conversions
ASC 470-20
40-26 An entity may amend the terms of an instrument within the scope of the Cash Conversion Subsections to
induce early conversion, for example, by offering a more favorable conversion ratio or paying other additional
consideration in the event of conversion before a specified date. In those circumstances, the entity shall
recognize a loss equal to the fair value of all securities and other consideration transferred in the transaction
in excess of the fair value of consideration issuable in accordance with the original conversion terms. The
settlement accounting (derecognition) treatment described in paragraph 470-20-40-20 is then applied using
the fair value of the consideration that was issuable in accordance with the original conversion terms. The
guidance in this paragraph does not apply to derecognition transactions in which the holder does not exercise
the embedded conversion option.
To induce conversion of convertible debt instruments before a specified date (see Section 4.5.4),
issuers sometimes change the conversion terms (e.g., reduce the conversion price) or give the holders
additional consideration (e.g., cash, equity shares, warrants, other securities).
The wording of the scope guidance on induced conversions of
convertible debt within the scope of the CCF guidance differs from that on
induced conversions of traditional convertible debt (see Section 4.5.4.1). ASC
470-20-40-14 specifies that the induced conversion guidance on traditional
convertible debt applies to an exchange of a convertible debt instrument for
shares, even if the exchange does not involve the legal exercise of the
contractual conversion privileges included in the terms of the debt. However,
ASC 470-20-40-26 notes that the induced conversion guidance on convertible debt
within the scope of the CCF guidance does not apply to derecognition
transactions in which the holder does not exercise the embedded conversion
option. An entity should consider its specific facts and circumstances and the
substance of the transaction in evaluating whether an exchange that does not
involve the legal exercise of contractual conversion privileges should be
accounted for as an induced conversion under ASC 470-20-40-26.
If a holder exercises its option in an induced conversion of a debt instrument within the scope of the CCF guidance in ASC 470-20, the issuer would apply the following two-step model to account for the conversion:
- Step 1 — Determine the amount of the inducement expense. Recognize a loss (an inducement expense) equal to the excess of (1) the fair value of the consideration transferred over (2) the fair value of the consideration that would have been issuable under the original conversion terms. In a manner consistent with the guidance in ASC 470-20-40-16, fair value is determined as of the date the inducement offer is accepted by the convertible debt holder (such as the conversion date or the date the holder enters into a binding agreement to convert, as applicable; see Section 4.5.4 for further discussion).
- Step 2 — Determine the amount of any debt extinguishment gain or loss. Allocate the fair value of consideration issuable under the original terms between (1) the extinguishment of the liability component and (2) the reacquisition of the original instrument’s equity component in accordance with ASC 470-20-40-20. The fair value of the liability component is allocated to the liability component and compared with the net carrying amount of the liability component in the determination of a gain or loss upon debt extinguishment. Any remaining amount of the fair value of consideration issuable under the original terms is allocated to the equity component. Said differently, the issuer applies the derecognition guidance in ASC 470-20-40-20 by using the fair value of the consideration that was issuable under the original conversion terms rather than the fair value of the consideration actually transferred to the holder.
Paragraph B18 of FSP APB 14-1 states:
The Board decided that if an entity amends the terms of a convertible debt instrument within the scope of [the CCF guidance in ASC 470-20] to induce early conversion, the entity must recognize a loss equal to the fair value of all securities and other consideration in excess of the fair value of the consideration issuable pursuant to the original conversion terms. That treatment is consistent with the accounting for such additional consideration under [ASC 470-20-40-16]. No portion of the additional consideration paid to the holder to induce early conversion is attributed to equity because that payment embodies an incremental financing cost.
In some circumstances, the fair value of the liability component exceeds the
fair value of the consideration issuable under the original terms. In such
cases, questions may arise about the method of allocating the fair value of
consideration issuable under the original terms between the liability and equity
components of the original instrument. The issuer cannot allocate an amount
greater than the fair value of consideration issuable under the original terms
in determining the debt extinguishment gain or loss.
If the fair value of the liability component exceeds the fair value of consideration issuable under the original terms, the entity determines the debt extinguishment gain or loss (in step 2) by comparing the carrying amount of the liability component with the fair value of consideration issuable under the original terms (rather than the fair value of the liability component). In this circumstance, no amount is allocated to the equity component because all of the fair value of consideration issuable under the original terms is allocated to the liability component. In certain circumstances, this method could result in a net gain for the debtor (i.e., a debt extinguishment gain that exceeds the inducement loss). We have confirmed this guidance in discussions with the FASB staff.
Example 6-8
Induced Conversion of Convertible Debt With CCF
On January 1, 20X1, Entity A issues at par a 5 percent convertible bond with a $1,200 face amount that will
mature on December 31, 20X8. The bond is convertible into A’s common shares at a price of $60 per share.
Because the stated terms of the bond permit A to settle in cash upon conversion, A applies ASC 470-20-25-23
and allocates $1,000 to the bond’s liability component and $200 to its equity component.
On January 1, 20X6, the liability component has a carrying amount of $1,110 and a fair value of $1,150. To
induce bondholders to convert their bonds promptly, A reduces the conversion price to $40 for bondholders
that convert before February 29, 20X6 (within 60 days). On the conversion date, the market price of A’s
common stock is $50 per share.
Upon conversion of the bonds, a step 1 inducement loss is calculated as follows:
A. Fair Value of Shares Issued Upon
Inducement
Calculated as:
B. Fair Value of Shares Issuable Under Original Terms
Calculated as:
The step 2 debt extinguishment gain is
calculated as follows:
The debt extinguishment gain or loss in step 2 is not calculated by comparing the liability component’s carrying
amount ($1,110) with its fair value ($1,150) but instead is calculated as the difference between the carrying
amount of the liability component and the fair value of consideration issuable under the original terms.
Entity A would record the following entries upon the induced conversion:
6.5.3 Modifications and Exchanges
ASC 470-20
40-23 The guidance in the Cash Conversion Subsections does not affect an issuer’s determination of whether a modification (or exchange) of an instrument within the scope of those Subsections should be accounted for as an extinguishment of the original instrument or a modification to the terms of the original instrument. An issuer shall apply the guidance in Subtopic 470-50 to make that determination. . . .
If a convertible debt instrument is modified or exchanged for another instrument, the issuer applies ASC 470-50 to determine whether the modification or exchange should be accounted for as an extinguishment or a modification (see Section 4.5.6) unless it is a TDR that should be evaluated under ASC 470-60 (see Section 4.5.7).
ASC 470-50 does not explicitly address whether and, if so, how the separation of a CCF affects an issuer’s assessment of whether the terms are substantially different. In the application of the 10 percent cash flow test in ASC 470-50-40-10, it is reasonable for entities to discount the cash flows by using an original effective interest rate that reflects the separation of the CCF (i.e., the discount rate is the effective interest rate of the original debt instrument after separation of the CCF; see Section 6.4.1). However, in the determination of whether the change in the fair value of an embedded conversion option is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange, it is reasonable to add back any discount created by the CCF, since the purpose is to assess the significance of the change in fair value compared with the carrying amount of the instrument as a whole. In other words, this test is performed as if the convertible debt instrument had never been separated into component parts under the CCF guidance, which requires the determination of a pro forma net carrying amount of the convertible debt instrument had separation not occurred.
6.5.3.1 Extinguishment Accounting
If a modification or exchange of an instrument subject to the CCF guidance in ASC 470-20 must be accounted for as an extinguishment, the issuer applies the derecognition guidance described in Section 6.5.1 to the transaction. Under that guidance, the fair value of the consideration transferred is allocated upon derecognition between the liability and equity components of the existing instrument in a manner consistent with the allocation of proceeds upon the initial issuance of a convertible debt instrument within the scope of the CCF guidance in ASC 470-20. Thus, to apply extinguishment accounting to a convertible debt instrument within the scope of the CCF guidance in ASC 470-20, the issuer performs the following steps:
- The issuer determines the fair value of the consideration transferred upon derecognition. This amount includes (a) the fair value of the “new” instrument that has been modified or obtained in the exchange plus (b) the amount of any cash paid to the holder less (c) the amount of any cash received from the holder in the derecognition transaction. If the parties exchange other rights or privileges as part of the transaction, the issuer recognizes them appropriately (e.g., by allocating part of the consideration transferred to them, if applicable).
- The issuer allocates the fair value of the consideration transferred between the extinguishment of the existing instrument’s liability component and the reacquisition of its equity component:
- The amount allocated to the extinguishment of the liability component equals the fair value of the liability component immediately before the derecognition transaction. The issuer recognizes an extinguishment gain or loss for any difference between the amount of consideration allocated to the liability component and the instrument’s net carrying amount (including any unamortized debt issuance costs or debt discount).
- The remaining amount of the fair value of the consideration transferred is allocated to the equity component and treated as a reduction of stockholders’ equity.
- The issuer treats the debt instrument that has been modified or obtained in the exchange as a newly recognized instrument under GAAP and initially records it at fair value (ASC 470-50-40-13). If the new instrument does not require or permit cash settlement upon conversion, it would be outside the scope of the CCF guidance in ASC 470-20, and other GAAP would apply.
- In accordance with ASC 470-50-40-18(a), the issuer treats any third-party transaction costs that are directly related to the exchange or modification as issuance costs of the new instrument. Under ASC 470-20-30-31, if the new instrument is within the scope of the CCF guidance in ASC 470-20, the transaction costs are allocated to the liability and equity components of the new instrument in proportion to the “proceeds” (i.e., fair value) allocated to it.
6.5.3.2 Modification Accounting
ASC 470-20
40-23 . . . If a modification (or exchange) does not result in derecognition of the original instrument, then the
expected life of the liability component shall be reassessed based on the guidance in paragraph 470-20-35-15
and the issuer shall determine a new effective interest rate for the liability component in accordance with the
guidance in Subtopic 470-50.
If a modification or exchange of an instrument subject to the CCF guidance in ASC 470-20 must be
accounted for as a modification, the issuer would not remeasure the instrument to its current fair value
but instead should perform the following steps if the convertible debt instrument remains subject to the
CCF guidance:
- The issuer should reassess the effective life of the instrument under ASC 470-20-35-15 (see Section 6.3.2.4.1 for a discussion of how to estimate the expected life).
- If the terms of the embedded conversion option are modified, the issuer should calculate the increase or decrease in the option’s fair value in accordance with ASC 470-50-40-15 as the difference between its fair value immediately before and after the modification or exchange. An increase in the option’s fair value reduces the carrying amount of the liability component (increasing a debt discount), with a corresponding increase to APIC. No accounting recognition is given to a decrease in the option’s fair value.
- The issuer should make a prospective yield adjustment in accordance with ASC 470-20- 40-23 and ASC 470-50-40-14 by updating the effective interest rate of the liability component prospectively on the basis of (a) the liability component’s adjusted carrying amount and (b) the modified cash flows.
6.5.3.3 Convertible Debt Modified to Remove CCF
ASC 470-20
40-24 If an instrument within the scope of the Cash Conversion Subsections is modified such that the conversion option no longer requires or permits cash settlement upon conversion, the components of the instrument shall continue to be accounted for separately unless the original instrument is required to be derecognized under Subtopic 470-50. If an instrument is modified or exchanged in a manner that requires derecognition of the original instrument under Subtopic 470-50 and the new instrument is a convertible debt instrument that may not be settled in cash upon conversion, the new instrument would not be subject to the guidance in the Cash Conversion Subsections and other U.S. GAAP would apply (for example, paragraph 470-20-25-12).
If an instrument ceases to require or permit cash settlement upon conversion as
a result of a modification or exchange, the liability and equity components
would not be recombined unless extinguishment accounting applies. If the
modification or exchange is accounted for as an extinguishment, the new
convertible debt is accounted for as a newly issued instrument on the basis
of its modified terms (see Section 6.5.3.1).
Paragraph B17 of FSP APB 14-1 states, in part:
If an instrument within the scope [of the CCF guidance ASC 470-20] is modified such that the conversion option no longer requires or permits cash settlement upon conversion, the components of the instrument would continue to be accounted for separately pursuant to the [cash conversion] guidance in [ASC 470-20] unless extinguishment accounting is required under [ASC 470-50]. That guidance is consistent with the EITF’s conclusions in Issues 06-6 and 06-7 that [ASC 470-20-25-12] only applies at inception. Therefore, a convertible debt instrument within the scope of [the CCF guidance in ASC 470-20] that is originally separated into liability and equity components should not be recombined at a later date due to a modification that is not accounted for as an extinguishment. Rather, the liability component should continue to be accreted to its principal amount based on the modified terms of the instrument.
6.5.3.4 Convertible Debt Modified to Add CCF
ASC 470-20
40-25 If a convertible debt instrument that is not within the scope of the Cash Conversion Subsections is modified such that it becomes subject to the Cash Conversion Subsections, an issuer shall apply the guidance in Subtopic 470-50 to determine whether the original instrument is required to be derecognized. If the modification is not accounted for by derecognizing the original instrument, the issuer shall apply the guidance in the Cash Conversion Subsections prospectively from the date of the modification. In that circumstance, the liability component is measured at its fair value as of the modification date. The carrying amount of the equity component represented by the embedded conversion option is then determined by deducting the fair value of the liability component from the overall carrying amount of the convertible debt instrument as a whole. At the modification date, a portion of any unamortized debt issuance costs shall be reclassified and accounted for as equity issuance costs based on the proportion of the overall carrying amount of the convertible debt instrument that is allocated to the equity component.
If a convertible debt instrument outside the scope of the CCF guidance is modified so that it becomes subject to the guidance, the issuer applies the guidance prospectively. If the modification or exchange is accounted for as an extinguishment, the convertible debt is accounted for as a newly issued instrument with a CCF. If the modification or exchange is accounted for as a modification, a portion of the debt’s current net carrying amount equal to the modification-date fair value of the liability component becomes the carrying amount of the liability component. Any remaining portion of the current net carrying amount is allocated to the equity component. Further, a portion of any remaining unamortized debt issuance cost is reclassified to equity as an equity issuance cost in proportion to the current net carrying amount allocated to the equity component.