6.7 Comprehensive Example

6.7.1 Overview

ASC 470-20-55 contains a comprehensive example of how to apply the CCF guidance to a convertible debt instrument that has a 10-year contractual life and can be converted at any time into the equivalent of a fixed number of the issuer’s common shares. Because the issuer can elect to settle the entire if-converted value (i.e., the principal amount of the debt plus the conversion spread) in cash, common stock, or any combination thereof, the convertible debt instrument represents an Instrument X (as described in Section 6.1.3). Five years into the life of the instrument, the holders elect to convert. The example illustrates the recognition and initial measurement of the instrument’s liability and equity components and associated tax entries, subsequent accounting for the liability component, and derecognition entries upon the instrument’s conversion.

6.7.1.1 Assumptions

ASC 470-20

55-71 This Example illustrates the application of the guidance in the Cash Conversion Subsections. This Example makes all of the following assumptions:

The embedded conversion option does not require separate accounting as a derivative instrument under Subtopic 815-15 because it qualifies for the scope exception in paragraph 815-10-15-74.
On January 1, 2007, Entity A issues 100,000 convertible notes at their par value of $1,000 per note, raising total proceeds of $100,000,000.
The notes bear interest at a fixed rate of 2 percent per annum, payable annually in arrears on December 31, and are scheduled to mature on December 31, 2016.
Each $1,000 par value note is convertible at any time into the equivalent of 10 shares of Entity A’s common stock (that is, representing a stated conversion price of $100 per share).
The quoted market price of Entity A’s common stock is $70 per share on the date of issuance.
Upon conversion, Entity A can elect to settle the entire if-converted value (that is, the principal amount of the debt plus the conversion spread) in cash, common stock, or any combination thereof.
The notes do not contain embedded prepayment features other than the conversion option.
At issuance, the market interest rate for similar debt without a conversion option is 8 percent.
The par value of Entity A’s common stock is $0.01 per share.
The tax basis of the notes is $100,000,000.
Entity A is entitled to tax deductions based on cash interest payments.
Entity A’s tax rate is 40 percent.
On January 1, 2012, when the quoted market price of Entity A’s common stock is $140 per share, all holders of the convertible notes exercise their conversion options. Accordingly, those investors are entitled to aggregate consideration of $140,000,000 ($1,400 per note).
At settlement, the market interest rate for similar debt without a conversion option is 7.5 percent.
Entity A receives no tax deduction for the payment of consideration upon conversion ($140,000,000) in excess of the tax basis of the convertible notes ($100,000,000), regardless of the form of that consideration (cash or shares).

55-72 Transaction costs have been omitted from this Example and journal entry amounts in this Example have been rounded to the nearest thousand.

6.7.2 Recognition and Initial Measurement

ASC 470-20

55-73 Upon issuance of the notes, the liability component is measured first, and the difference between the proceeds from the notes’ issuance and the fair value of the liability is assigned to the equity component. The following illustrates how the fair value of the liability component might be calculated at initial recognition using a discount rate adjustment technique (an income approach). Depending on the terms of the instrument (for example, if the instrument contains prepayment features other than the embedded conversion option) and the availability of inputs to valuation techniques, it may be appropriate to determine the fair value of the liability component using an expected present value technique (an income approach)[,] a valuation technique based on prices and other relevant information generated by market transactions involving comparable liabilities (a market approach) or both an income approach and a market approach.

55-74 The fair value of the liability component can be estimated by calculating the present value of its cash flows using a discount rate of 8 percent, the market rate for similar notes that have no conversion rights, as follows.

55-75 Entity A would make the following journal entries at initial recognition.

6.7.3 Subsequent Accounting

ASC 470-20

55-76 The notes do not contain embedded prepayment features other than the conversion option, so Entity A concludes that the expected life of the notes is 10 years (consistent with the periods of cash flows used to measure the fair value of the liability component) for purposes of applying the interest method. During the 5-year period from January 1, 2007, through December 31, 2011, Entity A recognizes $26,304,228 of interest cost, consisting of $10,000,000 of cash interest payments and $16,304,228 of discount amortization under the interest method. During that period, Entity A recognizes $10,521,691 of income tax benefits, consisting of $4,000,000 of current tax benefits (the tax effect of deductions for cash interest payments) and $6,521,691 of deferred tax benefits (partial reversal of the deferred tax liability due to amortization of the debt discount).

While not shown in ASC 470-20-55-76, the accounting entry on December 31, 2007 (i.e., the end of the first year), would be as follows:

The amounts of interest expense and discount amortization are calculated by using the effective interest method. The effective interest rate is the nonconvertible borrowing rate at inception. The amortization of the debt discount causes annual reported interest expense (8 percent of the net carrying amount at the beginning of each annual period) to exceed the cash interest paid (2 percent of the principal amount of $100,000,000).

Because the issuer is entitled to tax deductions in each annual period that are based on the cash interest it pays during the period, it receives a tax benefit in each annual period equal to the cash interest paid times its tax rate ($2,000,000 × 40%). Further, the deferred tax liability is reduced in each period to reflect that portion of reported interest expense that results from the annual amortization of the debt discount, which is not deductible on the issuer’s tax return. This is calculated as the amount of annual debt amortization multiplied by the issuer’s effective tax rate.

6.7.4 Derecognition

6.7.4.1 General Considerations

ASC 470-20

55-77 Upon settlement of the notes, the fair value of the liability component immediately before extinguishment is measured first, and the difference between the fair value of the aggregate consideration remitted to the holder ($140,000,000) and the fair value of the liability component is attributed to the reacquisition of the equity component. The following illustrates how the fair value of the liability component might be calculated at settlement using a discount rate adjustment present value technique (an income approach). Depending on the terms of the instrument (for example, if the instrument contains prepayment features other than the embedded conversion option) and the availability of inputs to valuation techniques, it may be appropriate to determine the fair value of the liability component using an expected present value technique (an income approach), a valuation technique based on prices and other relevant information generated by market transactions involving comparable liabilities (a market approach), or both an income approach and a market approach.

55-78 The fair value of the liability component (which has a remaining term of 5 years at the settlement date) can be estimated by calculating the present value of its cash flows using a discount rate of 7.5 percent, the market rate for similar notes that have no conversion rights, as follows.

55-79 Regardless of the form of the $140,000,000 consideration transferred at settlement, $77,747,633 would be attributed to the extinguishment of the liability component and $62,252,367 would be attributed to the reacquisition of the equity component. The carrying amount of the liability is $76,043,740 ($100,000,000 principal – $23,956,260 unamortized discount) at the December 31, 2011 settlement date, resulting in a $1,703,893 loss on extinguishment.

As illustrated in ASC 470-20-55-80 through 55-82, some of the accounting entries at settlement depend on the manner of settlement (i.e., cash, shares, or a combination of cash and shares). Other accounting entries, however, are the same irrespective of the manner of settlement. In each settlement alternative:

The current net carrying amount of the liability component is derecognized (i.e., Dr: Debt $100,000,000; Cr: Debt discount $23,956,000).
A debt extinguishment loss is recognized (i.e., Dr: Loss upon extinguishment $1,704,000). The debt extinguishment loss is calculated as the difference between (1) the current net carrying amount of the liability component ($76,044,000) and (2) the portion of the fair value of the consideration transferred to the holder (i.e., cash, equity shares, or both) that is allocable to the liability component (i.e., the fair value of that component immediately before settlement, $77,748,000).
The carrying amount of the equity component is derecognized (i.e., Dr: APIC $62,252,000).
The current carrying amount of the deferred tax liability related to the remaining unamortized debt discount is derecognized (Dr: Deferred tax liability $9,583,000) while making offsetting entries to the deferred tax benefit for the portion attributable to the debt extinguishment loss (i.e., $1,704,000 × 40%; Cr: $682,000) and APIC for the remainder ([$23,956,000 – $1,704,000] × 40%; Cr: $8,901,000).

Accordingly, these are the entries at settlement that do not depend on the form of consideration transferred at settlement: Image cannot be displayed

The remaining entry for an aggregate amount of $140 million (a credit) depends on the form of consideration transferred (i.e., cash, shares, or a combination thereof).

6.7.4.2 Settlement in a Combination of Cash and Shares

ASC 470-20

55-80 At settlement, assume Entity A elects to transfer consideration to the holder in the form of $100,000,000 cash and 285,714 shares of common stock (with a fair value of $40,000,000). The $62,252,367 decrease to additional paid-in capital for the reacquisition of the conversion option, the $39,997,143 increase to additional paid-in capital from the issuance of common stock at conversion, and the $8,900,947 increase to additional paid-in capital to reverse the deferred tax liability relating to the unamortized debt discount at conversion, adjusted for the loss on extinguishment, are presented on a gross basis in this journal entry for illustrative purposes. Based on these assumptions, Entity A would make the following journal entry at settlement.

In the example in ASC 470-20-55-80, the issuer elected to settle by transferring $100 million of cash and $40 million worth of shares. Accordingly, it recognizes entries for the cash paid (Cr: Cash $100,000,000) and the shares issued. If the quoted market price of each share is $140, the issuer would transfer 285,714 shares ($40,000,000 ÷ $140). If the par value of each share is $0.01, the aggregate par value of those shares would be $2,857. In ASC 470-20-55-80, that number has been rounded to $3,000. The issuer allocates the amount recognized in equity between paid-in capital (Cr: Common stock at par $3,000) and APIC (Cr: APIC $39,997,000) on the basis of the aggregate par value of the shares. The other accounting entries are the same as those for the other manners of settlement (i.e., all cash or all shares).

6.7.4.3 Cash Settlement

ASC 470-20

55-81 Assume Entity A elects to transfer consideration to the holder in the form of $140,000,000 cash. Based on that assumption, Entity A would record the following journal entry at settlement:

In the example in ASC 470-20-55-81, the issuer elected to settle by transferring $140 million of cash. Accordingly, it records an entry for the cash paid (Cr: Cash $140,000,000). The other accounting entries are the same as those for the other manners of settlement (i.e., a combination of cash or shares, or all shares).

6.7.4.4 Share Settlement

ASC 470-20

55-82 Assume Entity A elects to transfer consideration to the holder in the form of 1 million shares of common stock (with a fair value of $140,000,000). Based on that assumption, Entity A would record the following journal entry at settlement.

In the example in ASC 470-20-55-82, the issuer elected to settle by transferring $140 million worth of shares. Accordingly, it recognizes entries for the shares issued. If the quoted market price of each share is $140, the issuer transfers 1 million shares ($140 million ÷ $140). If the par value of each share is $0.01, the aggregate par value of those shares is $10,000 (1,000,000 × $0.01). The issuer allocates the amount recognized in equity between paid-in capital (Cr: Common stock at par $10,000) and APIC (Cr: APIC $139,990,000) on the basis of the aggregate par value of the shares. The other accounting entries are the same as those for the other manners of settlement (i.e., combination of cash and shares or all cash).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.