7.2 Scope

The BCF guidance in ASC 470-20 applies to the issuer’s accounting for debt instruments that are convertible into its equity shares if (1) the conversion feature is beneficial to the holder (see Section 7.3 for a discussion of how to determine whether a conversion feature is beneficial) and (2) no scope exception is applicable. The guidance applies to both convertible debt and equity-classified convertible shares (e.g., convertible preferred stock); however, this Roadmap only addresses BCFs in convertible debt instruments.

Examples of instruments that may fall within the scope of the BCF guidance include:

• Debt instruments that are convertible into shares of the issuer’s common or preferred stock.
• Debt instruments that are convertible into a combination of debt instruments and detachable warrants on the issuer’s stock.
• Physically settled warrants that upon exercise will be settled in the issuer’s convertible debt securities.

For a discussion of the application of the BCF guidance to instruments with share-settled redemption features, see Sections 2.4 and 7.2.3.

In some convertible instruments, the conversion terms continuously reset to provide the holder with a fixed value (i.e., the number of shares delivered varies to achieve a constant value) or a value that is indexed to a variable other than the issuer’s stock price. For example, the conversion terms may require the issuer to deliver a variable number of shares that is calculated by dividing the instrument’s principal amount by the current share price (or a fixed percentage thereof) on the conversion date so that the aggregate fair value of the shares delivered upon conversion equals or approximates a fixed monetary amount.

In accordance with ASC 815-15, an issuer should evaluate a feature that is settled in a variable number of shares equal to a fixed monetary amount or a monetary amount that is indexed to an unrelated underlying to determine whether it must be bifurcated as an embedded put, call, redemption, or indexation feature and accounted for as a derivative instrument under ASC 815 (see Section 2.4). An entity should also evaluate any variable share-settled instrument under ASC 480-10-25-14 to determine whether it must be classified as a liability under ASC 480.

If a convertible instrument is in the legal form of a share and the obligation to issue a variable number of equity shares is unconditional (i.e., conversion is certain to occur) and based solely or predominantly on a fixed monetary amount known at inception, the instrument must be accounted for as a liability under ASC 480-10-25-14. Similarly, if a convertible instrument is in the legal form of a share and the instrument embodies multiple obligations that in combination represent an unconditional obligation to repurchase the shares by either transferring assets or issuing a variable number of shares equal to a fixed value, the instrument is required to be classified as a liability under ASC 480-10 (see Deloitte’s Roadmap Distinguishing Liabilities From Equity). If a convertible instrument is in the legal form of a share and is not required to be classified as a liability under ASC 480-10 because the obligation is conditional (i.e., conversion or settlement is not certain to occur), the instrument generally does not have to be classified as a liability under U.S. GAAP.

The guidance in ASC 470-20-25-8 suggests that ASC 470-20-25-5, which addresses the recognition of a BCF at issuance, applies to initial recognition of the convertible instrument for which conversion would result in the delivery of shares worth a fixed value; however, ASC 470-20-55-19 states that there is no BCF in such an instrument. In a manner consistent with ASC 470-20-55-19, the BCF guidance does not apply to a conversion feature that economically represents a share-settled redemption feature. That is, the BCF guidance applies only to a “true” conversion feature that has a value that changes with the underlying share price.

EITF Issue 98-5 originally included three illustrative examples of convertible instruments whose conversion price was a function of the current or average stock price on the conversion date (Cases 1(c), 1(d), and 5). Each instrument had a face amount of $1 million and a commitment-date stock price of $50 and was convertible on the date of issuance. The conversion prices and associated conversion values (i.e., the monetary values of the shares received upon conversion) in the three examples are indicated in the table below.

The guidance in EITF Issue 98-5 on each of these examples suggested that an initial BCF should be recognized since conversion was assumed to occur at a beneficial conversion price (i.e., $40, $40, and $36, respectively) compared with the commitment-date stock price ($50). However, EITF Issue 08-4 removed these examples. Cases 1(c) and 5 were removed because “the instruments described in those examples are within the scope of [ASC 480-10],” and Case 1(d) was removed because “the instruments described in that example require an assessment of accounting literature that was issued subsequent to [EITF Issue 98-5].” Accordingly, share-settled redemption features that specify fixed or approximately fixed values such as those illustrated in these examples, whether on the final maturity date or upon an earlier conversion, should not be evaluated by using the BCF guidance.

In addition to a share-settled redemption component with a fixed monetary amount ($1.25 million), the instrument in Case 1(d) contains a “true” equity conversion option component with an effective conversion price of $50 — that is, the conversion value varies with changes in the issuer’s stock price if the conversion-date stock price exceeds $50. Although the BCF guidance does not apply to the share-settled redemption component of the instrument, the issuer should consider whether there is a BCF attributable to the “true” conversion component (unless the feature must be bifurcated under ASC 815-15 or is within the scope of the CCF guidance in ASC 470-20). (This Roadmap does not address whether an entity should analyze the two components as a single compound embedded feature or as two separate embedded features in evaluating whether the instrument contains any features that require bifurcation as a derivative instrument under ASC 815. When the EITF decided to delete Case 1(d) of EITF Issue 98-5, it observed that there was diversity in practice on this issue.)

ASC 825-10 does not explicitly state whether an issuer may elect the fair value option for a debt instrument that contains a contingent BCF and for which no portion of the carrying amount would be classified in shareholders’ equity unless or until the contingent BCF is triggered. However, because no part of the instrument is classified in shareholders’ equity at issuance (see Section 7.5), the issuer is not precluded from electing the fair value option in ASC 825-10. If the contingency is triggered after election of this option, the instrument would continue to be subject to fair value measurement under ASC 825-10 since the fair value option is irrevocable and is applied to the entire instrument. In this circumstance, ASC 825-10 effectively overrides the guidance on contingent BCFs in ASC 470-20 once the fair value option has been elected. Accordingly, an instrument that the issuer elected to measure at fair value under the fair value option in ASC 825-10 is outside the scope of the contingent BCF guidance in ASC 470-20.

While the guidance on temporary equity applies to equity-classified redeemable convertible stock with a BCF, such guidance does not apply if a convertible debt instrument with a BCF is not currently redeemable even if it may become redeemable in the future. As indicated in ASC 480-10-S99(12), for convertible debt instruments with a BCF, the amount of temporary equity is limited to the excess (if any) of “(1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion . . . over (2) the carrying amount of the liability-classified component of the convertible debt instrument” both at initial measurement and on subsequent balance sheet dates.

To be classified as a liability under ASC 480-10-25-4, a convertible share must meet the definition of a mandatorily redeemable financial instrument in ASC 480-10-20; that is, redemption in cash or other assets would need to be certain upon conversion. If such a conversion feature is not required to be bifurcated as a derivative under ASC 815-15, the instrument would be within the scope of the CCF guidance in ASC 470-20 because it requires or permits settlement in cash or other assets upon conversion. Consequently, it would be exempt from the scope of the BCF guidance in ASC 470-20.

Further, to be classified as a liability under ASC 480-10-25-14, a convertible share must contain an unconditional obligation to deliver a variable number of shares that is predominantly based on (1) a fixed monetary amount known at inception, (2) variations in something other than the fair value of the issuer’s equity shares, or (3) variations that are inversely related to changes in the fair value of the issuer’s equity shares. Economically, such features do not represent conversion features. Instead, the issuer is using its own equity shares as currency to settle the monetary amount of the obligation that does not vary in the same manner as changes in the fair value of the issuer’s equity shares. As noted in Section 7.2.3, the BCF guidance does not apply to stock-settled instruments regardless of whether they are in the legal form of equity or debt.