7.3 Initial Accounting
7.3.1 Recognition
ASC 470-20 — Glossary
Beneficial Conversion Feature
A nondetachable conversion feature that is in the money at the commitment date.
ASC 470-20
25-5 An embedded beneficial conversion feature present in a convertible instrument shall be recognized separately at issuance by allocating a portion of the proceeds equal to the intrinsic value of that feature to additional paid-in capital. Paragraph 470-20-30-4 provides guidance on measuring intrinsic value that applies to both the determination of whether an embedded conversion feature is beneficial and the allocation of proceeds.
An embedded conversion feature is considered beneficial (i.e., a BCF exists) if it is in-the-money on the basis of a comparison between (1) the initial fair value of the shares of the issuer’s stock into which the instrument is convertible and (2) the instrument’s effective conversion price (see Section 7.3.2).
The timing of the recognition of a BCF depends on whether it is contingent:
- A noncontingent (or initial) BCF either (1) is immediately exercisable or (2) will become exercisable if there is no change in circumstances other than the passage of time. A noncontingent BCF is accounted for separately from the convertible debt instrument in which it is embedded; at issuance, the issuer allocates to APIC a portion of the proceeds received for the convertible debt instrument equal to the BCF’s intrinsic value (see Section 7.3.2). The resulting discount (or reduced premium) on the convertible debt instrument is amortized as interest expense (see Section 7.4.1).
- A contingent BCF is triggered if an uncertain future event or circumstance occurs. There are two types of contingent BCFs: (1) those that are only contingently exercisable (e.g., a conversion feature that can only be exercised if an IPO occurs) and (2) those that are associated with contingently adjustable conversion ratios (e.g., a conversion ratio that resets upon a change of control so that it becomes beneficial or more beneficial). Contingent BCFs are not recognized unless they are triggered (see Section 7.5).
If a BCF becomes exercisable upon the occurrence of an event that is within the
holder’s control (i.e., the holder has the unilateral ability to cause the
conversion feature to become exercisable), the BCF would be considered
noncontingent. If an instrument contains two contingently exercisable BCFs that
are mutually exclusive of one another (e.g., one conversion feature is
contingent on a merger’s occurring by a certain date and the other conversion
feature is contingent on a merger’s not occurring by that date), the
convertible instrument contains a noncontingent BCF because a merger would not
occur upon only the passage of time. The issuer should treat the merger’s effect
on the BCF (e.g., to increase, reduce, or eliminate the noncontingent BCF) like
a contingent BCF and not recognize it before the merger occurs.
Example 7-1
Convertible Debt Instrument With a Noncontingent BCF
A convertible debt instrument is issued at par for cash proceeds of $1 million. The instrument contains a
noncontingent BCF with an intrinsic value of $200,000 as of the commitment date.
The journal entry on the date of issuance is as follows:
7.3.2 Measurement
7.3.2.1 Intrinsic Value
ASC 470-20
25-5 An
embedded beneficial conversion feature present in a
convertible instrument shall be recognized
separately at issuance by allocating a portion of
the proceeds equal to the intrinsic value of that
feature to additional paid-in capital. Paragraph
470-20-30-4 provides guidance on measuring intrinsic
value that applies to both the determination of
whether an embedded conversion feature is beneficial
and the allocation of proceeds.
30-3 An embedded beneficial
conversion feature recognized separately under
paragraph 470-20-25-5 shall be measured initially at
its intrinsic value.
30-4 The following guidance on measurement of the intrinsic value of an embedded conversion feature applies for purposes of both determining whether the feature is beneficial and allocating proceeds under paragraph 470-20-25-5, if applicable.
30-6 Intrinsic value shall be calculated at the commitment date (see paragraphs 470-20-30-9 through 30-12) as the difference between the conversion price (see paragraph 470-20-30-5) and the fair value of the common stock or other securities into which the security is convertible, multiplied by the number of shares into which the security is convertible.
30-8 If the intrinsic value of the beneficial conversion feature is greater than the proceeds allocated to the convertible instrument, the amount of the discount assigned to the beneficial conversion feature shall be limited to the amount of the proceeds allocated to the convertible instrument.
To determine whether a BCF exists in a convertible debt instrument and, if so, to measure it, an issuer should calculate the feature’s intrinsic value, if any. The calculation of the intrinsic value depends on the following:
- The fair value of the shares of stock into which the instrument is convertible on the applicable measurement date (generally the commitment date; see Section 7.3.2.3.1).
- The instrument’s effective conversion price (see Section 7.3.2.2), which depends on the amount of proceeds allocated to the instrument and the number of instruments issued.
The issuer computes the intrinsic value by multiplying (1) any excess of the initial fair value of each share of common stock or other securities into which the instrument is convertible (S0) over the effective conversion price (X0; see Section 7.3.2.2) by (2) the number of shares into which the instrument is convertible (n0); all values are determined as of the applicable measurement date (typically the commitment date; see Section 7.3.2.3.1). Algebraically, this can be expressed as follows:
Intrinsic value = (max [S0, X0]
– X0) × n0
Because the calculation of the effective conversion price (X0)
depends on the number of shares to be issued upon conversion
(n0) and the amount of proceeds (P0)
allocated to the instrument (i.e., X0 =
P0 ÷ n0), an alternative method of
determining the intrinsic value is to calculate the excess, if any, of (1)
the initial fair value of the instruments into which the instrument is
convertible (i.e., S0 × n0) over (2) the
amount of proceeds (P0) allocated to the instrument.
Algebraically, this can be expressed as follows:
Intrinsic value = max
([(S0 × n0) –
P0], 0)
Example 7-2
Calculation of Intrinsic Value
A convertible debt instrument whose terms permit the holder to convert it into the issuer’s equity shares after
five years is issued for proceeds of $1 million, which equals its carrying amount. The terms specify a fixed
conversion price of $100 per share. Accordingly, the holder would receive 10,000 shares upon conversion
($1,000,000 ÷ $100). The commitment-date stock price is $105. Therefore, the intrinsic value per share is $5
(calculated as the excess of the commitment-date stock price of $105 over the effective conversion price of
$100). The amount of the BCF equals the aggregate intrinsic value associated with the conversion feature,
which is $50,000 ($5 × 10,000 shares).
The journal entry on the date of issuance is as follows:
If this example was modified so that the commitment-date stock price was $95 instead of $105, the intrinsic
value would be zero and no BCF would be present. A BCF exists only if the conversion feature is beneficial to
the holder on the basis of the commitment-date stock price.
If the intrinsic value exceeds the proceeds allocated to the convertible debt instrument, the amount
assigned to the BCF is limited by the amount allocated to the convertible debt instrument (i.e., the
amount of BCF recognized in APIC cannot exceed the amount of proceeds allocated to the convertible
debt instrument). In this circumstance, the issuer should disclose (1) the excess of the fair value of the
instrument that the holder would receive at conversion over the proceeds received and (2) the period
over which the discount is amortized (see ASC 505-10-50-8).
Example 7-3
Calculation of Intrinsic Value When It Exceeds Proceeds From Issuance
Entity A issues a convertible debt instrument that contains a BCF for cash proceeds of $13 million. The intrinsic
value of the BCF is $15 million. Since the intrinsic value is greater than the proceeds allocated to the convertible
instrument, the amount of the debt discount is limited to $13 million.
The journal entry at the date of issuance is as follows:
Although the intrinsic value calculation incorporates the fair value of the stock into which the instrument is convertible, the conversion feature’s intrinsic value differs from its fair value. For instance, the intrinsic value excludes any option time value associated with the feature. When developing the BCF guidance that was subsequently codified in ASC 470-20, the EITF considered adopting a fair value measurement approach for BCFs but ultimately rejected it because of practical issues in determining fair value. Further, as discussed in EITF Issue 00-27, Issue Summary 1 (November 2, 2000), some noted that measuring the BCF at fair value would be inconsistent with the guidance that applies to traditional convertible debt, which prohibits separate accounting for an out-of-the money conversion option (see Chapter 4).
7.3.2.1.1 Illustrations — BCF Calculations
ASC 470-20
Example 7: Beneficial Conversion Features or Contingently Adjustable Conversion Ratios
55-28 The following Cases illustrate the guidance for beneficial conversion features or contingently adjustable conversion ratios for convertible securities:
- Instrument is convertible at inception, fixed dollar conversion terms (Base Case) (Case A).
- Instrument is not convertible at inception, fixed dollar conversion terms (Base Case) (Case B). . . .
Case A: Instrument Is Convertible at Inception, Fixed Dollar Conversion Terms (Base Case)
55-29 This Case illustrates the guidance in paragraph 470-20-35-7.
55-30 This Case has the following assumptions:
- $1,000,000 of convertible debt with a redemption date on the fifth anniversary of issuance
- Convertible at date of issuance
- Convertible at $40 per share
- Fair value of common stock at commitment date equals $50 per share.
55-31 The calculation is as follows.
55-32 The beneficial conversion feature is calculated at its intrinsic value (that is, the difference between the conversion price and the fair value of the common stock into which the debt is convertible, multiplied by the number of shares into which the debt is convertible) at the commitment date. A portion of the proceeds from issuance of the convertible debt, equal to the intrinsic value, is then allocated to additional paid-in capital. Because the debt has a stated redemption on the fifth anniversary of issuance, the debt discount should be amortized over a five-year period from the date of issuance to the stated redemption date.
55-33 Entry at date of issuance.
Case B: Instrument Is Not Convertible at Inception, Fixed Dollar Conversion Terms (Base Case)
55-34 This Case illustrates the guidance in paragraph 470-20-35-7.
55-35 This Case has the following assumptions:
- $1,000,000 of convertible debt with a redemption date on the fifth anniversary of issuance
- Convertible in one year
- Convertible at $40 per share
- Fair value of common stock at commitment date equals $50 per share.
55-36 The calculation is as follows.
55-37 The beneficial conversion feature is calculated at its intrinsic value at the commitment date (that is,
the difference between the conversion price and the fair value of the common stock into which the debt is
convertible, multiplied by the number of shares into which the debt is convertible). A portion of the proceeds
from issuance of the convertible debt, equal to the intrinsic value, is then allocated to additional paid-in capital.
Because the debt has a stated redemption on the fifth anniversary of issuance, the debt discount should be
amortized over a five-year period from the date of issuance to the stated redemption date.
55-38 Entry at date of issuance.
7.3.2.2 Conversion Price
7.3.2.2.1 Effective Conversion Price
ASC 470-20
30-5 The effective conversion price based on the proceeds received for or allocated to the convertible
instrument shall be used to compute the intrinsic value, if any, of the embedded conversion option. Specifically,
an issuer shall do all of the following:
- First, allocate the proceeds received in a financing transaction that includes a convertible instrument to the convertible instrument and any other detachable instruments included in the exchange (such as detachable warrants) on a relative fair value basis.
- Second, apply the guidance beginning in paragraph 470-20-25-4 to the amount allocated to the convertible instrument.
- Third, calculate an effective conversion price and use that effective conversion price to measure the intrinsic value, if any, of the embedded conversion option.
Example 2 (see paragraph 470-20-55-10) illustrates the application of this guidance.
As discussed in Section 7.3.2.1, the intrinsic value of a BCF is calculated as the product of (1) the excess, if any, of the fair value of the common stock or other securities into which the instrument is convertible over the effective conversion price and (2) the number of shares into which the security is convertible.
The initial effective conversion price (X0) is the ratio between the total proceeds allocated to the convertible instrument (P0) and the number of securities into which it is convertible (n0), determined as of the measurement date (generally the commitment date for the instrument; see Section 7.3.2.3.1). Algebraically, this can be expressed as follows:
Often, the effective conversion price differs from the stated conversion price (i.e., the conversion price specified in the instrument’s terms, which is the ratio between the principal amount of the convertible debt instrument and the number of securities into which it is convertible) because the instrument was issued at an amount different from its principal amount (i.e., at a discount or premium) or was issued together with other detachable financial instruments. The carrying amount used to compute the effective conversion price reflects any initial discount or premium on the debt and excludes proceeds allocated to any freestanding financial instruments (e.g., detachable warrants) that were issued together with the convertible instrument (see Sections 3.4 and 3.5).
In the determination of the effective conversion price, the carrying amount of the convertible debt instrument (1) is not adjusted for issuance costs (see Section 7.3.2.2.3) and (2) includes the amount attributable to any embedded derivatives other than the conversion feature that must be separated under ASC 815-15 (see Section 7.3.2.2.4). Although ASC 470-20-30-5(a) suggests that a relative fair value method applies in the allocation of the proceeds among multiple units of account, this method is not always appropriate (see Section 3.5.2).
Example 7-4
Calculation of Effective Conversion Price
Entity A issues a convertible debt instrument along with detachable warrants for
total gross proceeds of $1 million (which equals
the principal amount of the convertible debt
instrument) and determines that the detachable
warrants are freestanding financial instruments
that qualify for equity classification. Therefore,
in accordance with ASC 470-20-30-1 and 30-2, A
allocates the total proceeds to the convertible
debt and the detachable warrants on a relative
fair value basis (see Section 3.5.2).
After the allocation of proceeds to the detachable warrants, the convertible debt instrument has a carrying amount of $950,000. Per the terms of the instrument, holders can convert the debt into 10,000 common shares of A at any time. The stated conversion price is $100 per share, which also represents the market price of A’s shares on the commitment date.
To determine whether the convertible debt instrument contains a BCF, A
calculates the effective conversion price by
dividing the carrying amount of the convertible
debt instrument before any adjustment for issuance
costs ($950,000) by the number of shares into
which the instrument can be converted (10,000).
Entity A determines that the effective conversion
price is $95, which is less than the market price
of the underlying shares on the commitment date.
Thus, the conversion option is in-the-money and a
BCF exists. Entity A calculates the intrinsic
value of the BCF to be $50,000, or ($100 – $95) ×
10,000.
The journal entry on the date of issuance is as follows:
7.3.2.2.1.1 Illustration — Whether an Embedded Conversion Option Is Beneficial to the Holder
ASC 470-20
Example 2: Evaluating Whether an Embedded Conversion Option Is Beneficial to Holder
55-10 This Example illustrates the guidance in paragraph 470-20-30-5.
55-11 Assume Entity A issues for $1 million convertible debt with a par amount of $1 million and 100,000
detached warrants. The convertible debt is convertible at a conversion price of $10 per share (holder would
receive 100,000 shares of Entity A common stock upon conversion). The fair value of Entity A’s stock at the
commitment date is $10. Further, assume that the ratio of the relative fair values of the convertible debt and
the detached warrants is 75 to 25. After allocating 25 percent or $250,000 of the proceeds to the detached
warrants (based on relative fair values), the convertible debt is recorded on the balance sheet at $750,000 (net
of the discount that arises from the allocation of proceeds to the warrants), and the detached warrants are
recorded in paid-in capital in the balance sheet at $250,000.
55-12 Entity A must evaluate whether the embedded conversion option within the debt instrument is beneficial
(has intrinsic value) to the holder. The effective conversion price (that is, the allocated proceeds divided by
the number of shares to be received on conversion) based on the proceeds of $750,000 allocated to the
convertible debt is $7.50 ($750,000 ÷ 100,000 shares). The intrinsic value of the conversion option therefore
is $250,000 [(100,000 shares) × ($10.00 – $7.50)] and is recognized as a reduction to the carrying amount of
the convertible debt and an addition to paid-in capital. The total debt discount immediately after the initial
accounting is performed is $500,000 ($250,000 from the allocation of proceeds to the warrants and an
additional $250,000 from the measurement of the intrinsic value of the conversion option). The same answer
would result if the debt had been issued without detachable warrants for $750,000 in proceeds.
The guidance in ASC 470-20-55-12 implies that Entity A made the following
accounting entry at issuance:
An inherent assumption in ASC 470-20-55-11 is that the detachable warrants qualify as equity. If such
warrants were required to be classified as liabilities and subsequently accounted for at fair value, with
changes in fair value recognized in earnings under ASC 480-10 or ASC 815-40, a relative fair value
approach would not be appropriate (see Section 3.5.2).
7.3.2.2.2 Most Favorable Conversion Price
ASC 470-20
30-7 The most favorable conversion price that would be in effect at the conversion date, assuming there are no changes to the current circumstances except for the passage of time, shall be used to measure the intrinsic value of an embedded conversion option. Example 3 (see paragraph 470-20-55-13) illustrates the application of this guidance.
30-15 If an instrument incorporates a multiple-step discount, the computation of the intrinsic value shall use the conversion terms that are most beneficial to the investor. Example 10 (see paragraph 470-20-55-69) illustrates the application of this paragraph.
If the contractual terms of a convertible debt instrument specify different conversion prices on different dates or in different circumstances, the intrinsic value is measured on the basis of the most beneficial (favorable) conversion price available to the holder provided that there will be no change in current facts and circumstances except for the passage of time. For example, the intrinsic value of a convertible debt instrument with a conversion price that involves a multiple-step discount to the issuer’s commitment-date stock price is calculated on the basis of the most favorable discount available to the holder over the convertible instrument’s life.
Example 7-5
Conversion Price Declines With the Passage of Time
A convertible debt instrument whose terms permit the holder to convert it into
the issuer’s common shares at any time is issued
for proceeds of $1 million, which equals its
carrying amount. The terms specify a conversion
price of $120 in year 1, $110 in year 2, and $100
in year 3. The commitment-date stock price is
$105. If there are no changes in circumstances
except for the passage of time, the most favorable
conversion price will be $100. Therefore, the
intrinsic value of the conversion feature is
calculated on the basis of an effective conversion
price of $100 per share. The amount of the BCF is
$50,000, which is calculated as ($105 – $100) ×
($1,000,000 ÷ $100).
Example 7-6
Instrument With Multiple-Step Discount
A convertible debt instrument that can be converted into the issuer’s common
shares at any time is issued for proceeds of $1
million, which equals its carrying amount. As
specified in the instrument’s terms, the
conversion price is at a 10 percent discount to
the commitment-date stock price in year 1 and a 20
percent discount to the commitment-date stock
price in year 2. The stock price on the
commitment-date is $100. Provided that there are
no changes in circumstances except for the passage
of time, the most favorable conversion price is an
effective conversion price of $80, or $100 × (100%
– 20%). The amount of the BCF is $250,000, which
is calculated as ($100 – $80) × ($1,000,000 ÷
$80).
When the contractual terms of a convertible instrument specify potential adjustments to the conversion terms that are based on the occurrence of specified future events or circumstances (e.g., the conversion price depends on whether an IPO occurs), the convertible debt instrument may contain both an initial BCF (also known as a “basic,” “active,” or “noncontingent BCF”) and one or more contingent BCFs. The intrinsic value of the initial BCF is measured on the basis of the most favorable conversion price that would be available to the holder on the conversion date if there were no changes in circumstances except for the passage of time (e.g., if the conversion price is adjusted on the basis of the amount of the issuer’s earnings, the initial intrinsic value is determined under the assumption that the issuer will not generate any earnings after the instrument’s commitment date). If potential changes to the conversion terms are contingent on future events or circumstances, the feature is analyzed as a contingent BCF (see
Section 7.5).
A conversion price adjustment provision often causes a conversion feature to be
considered not indexed to the entity’s own equity shares (see
Chapter
4 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity). The issuer should evaluate whether such a
provision results in a requirement to bifurcate the conversion feature
from its host contract under ASC 815-15 (see Section 2.3 and Appendix A).
Further, if the conversion price adjustment is designed so that the
monetary value the holder will receive upon conversion is fixed or
approximately fixed, the conversion feature should be analyzed as a
share-settled redemption feature (see Sections 2.4 and 7.2.3).
7.3.2.2.2.1 Illustration — Conversion Price Contingent on IPO
ASC 470-20
Example 3: Conversion Price to Be Used to Measure Intrinsic Value
55-13 This Example illustrates the guidance in paragraph 470-20-30-7.
55-14 Assume Entity A, a private entity, issues for $1 million a convertible instrument that is convertible 4 years
after issuance at a conversion price of $10 per share (fair value of the stock is $10 at the commitment date).
The instrument also contains a provision that the conversion price adjusts from $10 to $7 per share if Entity A
does not have an initial public offering with a per-share price of $13 or more within 3 years. Entity B, a private
entity, issues for $1 million a convertible instrument that is convertible 4 years after issuance at a conversion
price of $7 per share (fair value of the stock is $10 at the commitment date). The instrument also contains a
provision that the conversion price adjusts from $7 to $10 per share if Entity B successfully completes an initial
public offering for a per-share price of $13 or more within 3 years.
55-15 The active conversion price for both Entity A and Entity B is $7, which is the conversion option price that
would apply if there were no change in circumstances after the issuance date other than the passage of time.
The intrinsic value of the conversion option of $428,571 [($1 million ÷ $7) × ($10 – $7)] should be recognized
at the issuance date of the convertible instrument. If an event occurs that triggers a decrease in the number
of shares to the holder upon conversion (the initial public offering in this Example), the intrinsic value of the
adjusted conversion option should be recomputed using the commitment-date fair value of the underlying
stock and the proceeds received for or allocated to the convertible instrument in the initial accounting.
The guidance in ASC 470-20-55-14 and 55-15
implies that if the convertible instrument was issued in the form of
debt, Entity A would have made the following entry at issuance:
An unstated assumption in Example 3 is that the conversion feature is not
required to be bifurcated as a derivative instrument under ASC
815-15-25-1 since that would have caused the instrument to fall
outside the scope of the BCF guidance in ASC 470-20. While the
example contains a conversion price adjustment that is contingent on
the occurrence or nonoccurrence of an IPO, such occurrence or
nonoccurrence is not an input in the pricing of a fixed-for-fixed
forward or option on the issuer’s equity shares (see Deloitte’s
Roadmap Contracts on an Entity’s Own Equity), and
therefore the conversion feature is not indexed to the entity’s own
equity before the occurrence of an IPO. Accordingly, it does not
qualify as equity under ASC 815-40 and would not qualify under the
scope exception from derivative accounting in ASC 815-10-15-74(a)
for contracts that are both indexed to the issuer’s own stock and
classified in stockholders’ equity. However, although the feature
does not qualify as equity, it would not require bifurcation as a
derivative instrument under ASC 815-15 if any of the criteria in ASC
815-15-25-1 were not met (e.g., the feature may not meet the net
settlement characteristic in the definition of a derivative in ASC
815-10-15-83 if it involves gross physical settlement in
private-company stock, such as in the example above).
Example 3 in ASC 470-20-55-13 also contains an illustration of the application of the contingent BCF guidance in ASC 470-20 (see Section 7.5).
7.3.2.2.2.2 Illustration — Conversion Price That Adjusts on the Basis of Outstanding Shares if No IPO Occurs
Convertible debt instruments sometimes have a conversion option with a stated conversion price that adjusts to a more favorable price from the perspective of the investor if the issuing entity does not complete an IPO before a specified date by giving holders an additional number of shares equal to a fixed percentage of the total shares outstanding as of a specified future date. In this circumstance, the issuing entity should calculate the most favorable conversion price by assuming that no changes in current circumstances have occurred (i.e., that no IPO will occur and that there will be no change in the number of shares outstanding) except for the passage of time.
Example 7-7
Convertible Debt Instrument With Conversion Price Reset if
an IPO Does Not Occur
On January 1, 20X1, Company ABC issues at par $1 million of 7.5 percent senior secured convertible notes with the following terms:
- The notes mature at par on January 1, 20X5.
- The notes are not redeemable or callable before maturity.
- Holders of the notes can convert them at any time into common shares of the company.
- The initial conversion price is $100, which is the fair value of the common shares as of the issuance date.
- Company ABC has 100,000 shares outstanding as of the issuance date.
- If ABC does not complete an IPO within two years of issuance, the conversion price will be adjusted to give the holders, upon conversion, an additional number of shares equal to 2 percent of outstanding shares as of January 1, 20X3 (the “IPO adjustment provision”).
Assume that ABC has determined that the conversion option embedded in the notes is not a derivative instrument under ASC 815 because it does not permit net settlement and therefore does not need to be bifurcated. Further assume that the convertible debt is not subject to the CCF guidance in ASC 470-20 and there were no transaction costs.
Company ABC is considering whether it needs to record a BCF upon issuing the notes. Even though the initial conversion price of $100 equals the fair value of the common shares on the issuance date, that is not the most favorable conversion price that would be in effect on the conversion date if there were no changes to the current circumstances except for the passage of time, because under the IPO adjustment provision, a favorable adjustment to the conversion terms is required after two years unless a contingent event (i.e., an IPO) occurs. Accordingly, ABC should not use the initial conversion price of $100 in measuring the intrinsic value of the conversion feature.
When determining the most favorable conversion price under ASC 470-20-30-7, ABC assumes that there will be no changes to the current circumstances except for the passage of time (i.e., an IPO will not occur and there will be no changes in the number of outstanding shares). Company ABC would therefore calculate the initial effective conversion price as follows:
- Number of shares received upon conversion at original conversion price = $1,000,000 ÷ $100 = 10,000 shares.
- Number of bonus shares received (provided that there is no IPO) = 2% × 100,000 shares = 2,000 shares.
- Effective conversion price = most favorable conversion price = $1,000,000 ÷ 12,000 shares = $83.33.
Because the initial effective conversion price ($83.33) is less than the current
fair value of a share ($100) as of the commitment
date, the convertible notes contain a BCF at
issuance. The intrinsic value of the BCF is
$200,000, or 12,000 shares × ($100 – $83.33).
Accordingly, ABC would recognize the intrinsic
value of the BCF in equity. Specifically, ABC
would record the following on the date of
issuance:
7.3.2.2.3 Issuance Costs
ASC 470-20
30-13 Costs of issuing convertible instruments do not affect the calculation of the intrinsic value of an
embedded conversion option; specifically, issuance costs shall not be offset against the proceeds received in
the issuance in calculating the intrinsic value of a conversion option. Issuance costs are limited to incremental
and direct costs incurred with parties other than the investor in the convertible instrument. Any amounts paid
to the investor when the transaction is consummated represent a reduction in the proceeds received by the
issuer (not issuance costs) and shall affect the calculation of the intrinsic value of an embedded option.
In computing the effective conversion price of a convertible debt instrument,
the issuer considers any issuance premium or discount but does not
deduct issuance costs paid to third parties from the proceeds allocated
to the convertible debt instrument. Accordingly, before computing the
effective conversion price, the issuer would add back any third-party
issuance costs that it had deducted from the face amount of the
instrument in measuring its net carrying amount under ASC 835-30-45-1A.
Amounts paid by the issuer to the investor such as commitment fees,
origination fees, and reimbursements for lender expenses (e.g., for the
legal fees of the holder that are associated with due diligence)
represent a reduction of the proceeds, not an issuance cost.1 Therefore, unlike fees paid to third parties, such amounts do
affect the determination of the effective conversion price.
Example 7-8
Calculation of Effective Conversion Price — Issuer Pays Fees to Third Parties and Investor
Entity A issues convertible debt to new unrelated investors for gross proceeds
of $5 million. The stated conversion price is $10
per share. Entity A pays fees of $45,000 to third
parties to cover its own legal costs and $55,000
to the investor to cover its legal fees associated
with due diligence. In computing the effective
conversion price, A deducts amounts paid to the
investor, but not third-party issuance costs, from
the gross proceeds. Accordingly, the effective
conversion price is $9.89, which is calculated as
($5,000,000 – $55,000) ÷ ($5,000,000 ÷ $10).
7.3.2.2.4 Embedded Derivatives
While not explicitly addressed in ASC 470-20, the effective conversion price
should be computed on the basis of the proceeds allocated to the
convertible debt instrument before separation of any embedded
derivatives that must be separated under ASC 815-15 (e.g., a bifurcated
embedded put option). This is because any embedded derivative would be
extinguished if the conversion option was exercised. Therefore, in the
determination of whether a BCF exists, proceeds received for or
allocated to the convertible debt instrument include any proceeds
attributed to embedded derivatives that are accounted for separately
under ASC 815-15.
This approach is consistent with the nonauthoritative guidance in the working
draft of AICPA Technical Q&A, “Convertible Debt, Convertible
Preferred Shares, Warrants, and Other Equity-Related Financial
Instruments (2006),” which states, in part:
[S]eparately accounting for an embedded
derivative under [ASC 815] (for example, an embedded prepayment
option) does not affect the effective conversion price for
purposes of measuring a beneficial conversion feature. That is,
the proceeds received for or allocated
to a convertible instrument include the proceeds ascribed to
embedded derivatives that are accounted for separately
from the host contract under [ASC 815]. Generally this is how it
has been applied in practice. [Emphasis added]
7.3.2.2.5 Convertible Instruments Issued as Repayment of Nonconvertible Instrument
ASC 470-20
30-19 If a convertible instrument is issued as repayment of a nonconvertible instrument at the nonconvertible instrument’s maturity, the fair value of the newly issued convertible instrument shall be the redemption amount owed at the maturity date of the original instrument if both of the following conditions exist:
- The original instrument has matured.
- The exchange of debt instruments is not a troubled debt restructuring that would be accounted for by the issuer under Subtopic 470-60.
30-20 After the exchange accounting occurs, any intrinsic value of the embedded conversion option in the new instrument shall be measured and accounted for under paragraph 470-20-25-5 based on the proceeds received for that instrument (the satisfaction of the redemption amount of the old instrument).
30-21 If the original instrument is extinguished before maturity, Subtopic 470-50 shall be applied first.
Sometimes, entities issue a convertible debt instrument to repay a nonconvertible instrument that has matured. In this circumstance, ASC 470-20-30-19 and 30-20 require the issuer to treat the redemption amount owed on the original instrument’s maturity date as the assumed proceeds received for the newly issued instrument unless the exchange is a TDR that must be accounted for in accordance with ASC 470-60. The issuer uses the amount of assumed proceeds to calculate the effective conversion price and the intrinsic value of any BCF associated with the newly issued convertible instrument.
If a convertible debt instrument is issued to repay a nonconvertible debt instrument before its maturity, the guidance on modifications and exchanges of debt instruments in ASC 470-50 applies (see Section 7.6.3). If the modification or exchange is treated as an extinguishment of the original debt instrument, there is no requirement to treat the redemption amount of the original instrument as the fair value of the new instrument. Instead, the fair value of the new instrument is determined in accordance with ASC 820.
7.3.2.2.6 Conversion Into Multiple Instruments
Sometimes, the terms of a convertible debt instrument specify that the holder will receive not just the issuer’s equity shares but also other instruments (e.g., warrants on the issuer’s equity shares) upon exercise of the conversion feature. In this circumstance, the conversion price represents the exercise price for both the equity shares and the other instruments that would be issued upon conversion. Because the BCF guidance focuses on conversion features that are settled solely in the issuer’s equity shares, a question arises about how to measure the intrinsic value of the conversion feature under the BCF guidance. In particular, it may not be clear how to determine the amount of proceeds or the effective conversion price of that portion of the conversion feature that is settled in the issuer’s equity shares upon conversion. As part of deliberating Issue 00-27, the EITF reached a tentative conclusion but never finalized it, and therefore the FASB did not incorporate the guidance into the Codification. Nevertheless, it is reasonable to apply the EITF’s reasoning if this issue is encountered in practice. EITF Issue 00-27, Issue Summary 1, Supplement 1 (February 28, 2008), states, in part:
It is the FASB staff’s understanding that there is little diversity in practice concerning [the] tentative conclusions [in EITF Issue 00-27]. Although the conclusions are tentative, as there is no other authoritative literature to address these issues, reporting entities have looked to the tentative conclusions for guidance. [These] tentative conclusions have been treated as authoritative GAAP by practitioners when evaluating the accounting for the corresponding transactions.
EITF Issue 00-27
(Nonauthoritative Text)
Issue 15 — How a beneficial
conversion amount should be measured when an
entity issues a convertible instrument that, if
converted, will result in the holder receiving
common stock and other equity instruments of the
issuer, such as warrants to acquire common stock
of the issuer.
52. The Task Force reached a
tentative conclusion that the intrinsic value of
the conversion option should be computed based on
a comparison of (a) the proceeds of the
convertible instrument allocated to the common
stock portion of the conversion option and (b) the
fair value at the commitment date of the common
stock to be received by the holder upon
conversion. The excess of (b) over (a) is the
intrinsic value of the embedded conversion option
that should be recognized by the issuer at the
issuance date for the convertible instrument.
The EITF’s tentative conclusion suggests that in measuring the intrinsic value associated with a
conversion feature that upon conversion will result in the delivery of equity shares and other
instruments, the issuer should allocate the proceeds of the convertible instrument between (1) the
portion attributable to conversion into equity shares and (2) the portion attributable to other
instruments.
7.3.2.2.6.1 Illustration: Conversion Into a Bundle of Instruments
EITF Issue 00-27
(Nonauthoritative Text)
53. For example, assume
Company A issues for $1 million, convertible debt
with a par value of $1 million. The convertible
debt is immediately convertible at a conversion
price of $10 per share (that is, holder will
receive 100,000 shares of Company A stock upon
conversion). In addition, upon conversion, the
holder also will receive 100,000 warrants to
acquire Company A’s common stock. Each warrant
entitles the holder to purchase 1 share of common
stock at $10 per share. The warrants (which have
not yet been issued) would have a fair value of
$250,000 at the commitment date, and the fair
value of Company A’s common stock at the
commitment date is $9.
54. The beneficial conversion
option amount related to the convertible
instrument is $117,391 and is calculated as the
difference between the $900,000 fair value of the
common stock on the commitment date and the
$782,609 proceeds allocated to the common stock
conversion option ($1,000,000 total proceeds
received × $900,000 fair value of the common stock
at the commitment date ÷ $1,150,000 total fair
value of all instruments received by the holder
upon conversion at the commitment date). Upon
conversion, the warrants would be recognized at
$217,391 ($1,000,000 × $250,000 ÷ $1,150,000, or
$1,000,000 – $782,609).
7.3.2.3 Stock Price
7.3.2.3.1 Measurement Date
ASC 470-20
30-9 This guidance addresses when a commitment date should occur for purposes of determining the fair value of the issuer’s common stock to be used to measure the intrinsic value of an embedded conversion option.
30-10 The commitment date is the date when an agreement has been reached that meets the definition of a firm commitment.
30-12 If an agreement includes subjective provisions that permit either party to rescind its commitment to consummate the transaction, a commitment date does not occur until the provisions expire or the convertible instrument is issued, whichever is earlier. Both of the following are examples of subjective provisions that permit either party to rescind its commitment to consummate the transaction:
- A provision that allows an investor to rescind its commitment to purchase a convertible instrument in the event of a material adverse change in the issuer’s operations or financial condition
- A provision that makes the commitment subject to customary due diligence or shareholder approval.
ASC 470-20 — Glossary
Firm Commitment
An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
- The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
- The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.
For convertible debt instruments other than those issued to nonemployees for goods and services (see Section 7.3.5), the issuer evaluates whether a conversion feature is beneficial and measures its intrinsic value, if any, on the basis of the issuer’s stock price as of the instrument’s commitment date. Under ASC 470-20-30-10, the “commitment date is the date when an agreement has been reached that meets the definition of a firm commitment” — that is, as stated in ASC 470-20-20, an agreement that “specifies all significant terms” and “includes a disincentive for nonperformance that is sufficiently large to make performance probable.”
Under ASC 470-20-30-12, the commitment date is the earlier of the issuance date and the date that any subjective provisions expire. If the issuer or investor is permitted to withdraw its commitment on the basis of subjective conditions (e.g., a material adverse change in the issuer’s operations or financial condition, customary due diligence, or a requirement for shareholder approval that is not perfunctory), a firm commitment does not yet exist. Because agreements often contain subjective provisions that
permit the investor to rescind the transaction, it is common for the commitment date to coincide with
the issuance date, although this cannot be assumed without an analysis of the contractual terms and
the specific facts and circumstances. An issuer should carefully evaluate the nature of all provisions
to determine whether they are subjective in nature and would allow either party to terminate the
agreement without any potential remedies.
Example 7-9
Identification of Commitment Date
Issuer A enters into a convertible debt agreement on September 15. The closing date for issuance of the
convertible debt was December 10. The significant terms of the agreement were not finalized and agreed upon
until the issuance date. Further, the agreement became legally enforceable and gave rise to statutory rights
such that a nondefaulting party could pursue remedies for default that are equivalent to the damages suffered
on the closing date. In these circumstances, the December 10 closing date represents the commitment date in
the evaluation of whether the debt contains a BCF.
An option to purchase convertible debt (e.g., an overallotment option that permits an underwriter to
purchase more securities at a fixed price over a short period after the original issuance of convertible
debt) does not represent a firm commitment to issue additional securities until such option is exercised.
Accordingly, the commitment date for any securities issued under the terms of the overallotment option
is not reached before the option’s exercise date.
7.3.2.3.2 Absence of a Public Market
Any fair value measurements that are required in the application of the BCF guidance (e.g., the fair
value of the equity shares that will be delivered upon the instrument’s conversion) are performed
in accordance with ASC 820. In the past, the SEC staff has stressed the importance of appropriately
determining the fair value of the common stock that will be delivered upon conversion when there is
not yet a public market for the common shares. In particular, the staff has been skeptical of an issuer’s
assertion that no BCF exists in circumstances in which an entity is in the process of negotiating an IPO
and the minimum estimated IPO price exceeds the conversion price. At the 1999 AICPA Conference on
Current SEC Developments, then Professional Accounting Fellow Pascal Desroches stated, in part:
An issue frequently encountered by the staff is determining whether a convertible debt or preferred security
has a beneficial conversion feature when there is not yet a public market for the common shares.
Specifically, during this past year, the staff observed that several companies issued convertible securities within
a short period before an initial public offering (IPO) with a conversion price below the expected IPO price. In
each case, the company asserted that the conversion price was equal to the fair value of the common stock
at the date of issuance (or commitment) of the securities and therefore the securities were not beneficially
convertible. However, the fair value determined by the company was below the minimum estimated IPO price
for the common stock. In some cases, this occurred even though the convertible securities were issued while
the company was negotiating an IPO and the estimated IPO price range. For example, one company issued
convertible preferred stock on June 8 at a price of $5.50 per share. The preferred stock was convertible at any
time into common stock on a one-for-one basis. Upon the IPO, each share of preferred stock automatically
converted to one share of common stock. Three days later, the company filed a registration statement for an
IPO, with a price range of $11 to $13 per share. As of the date the preferred stock was issued, the company
had information that the minimum estimated IPO price was $11 per share; however, the company continued
to assert that the fair value of the common stock on June 8 was $5.50 per share and thus the convertible
preferred stock did not contain a beneficial conversion feature.
[C]onvertible securities issued within a year prior to the filing of an initial registration statement with a
conversion price below the initial offering price are presumed to contain an embedded beneficial conversion
feature. To overcome this presumption, a registrant should provide sufficient, objective, and verifiable evidence
to support its assertion that the conversion price represented fair value at the issuance or commitment date.
As part of this process, registrants and their auditors should consider any valuations that an underwriter has
discussed with senior management and or the board of directors.
In an October 13, 2000, letter to the AICPA, then SEC Chief Accountant Lynn Turner echoed the comments that the SEC staff made about BCFs at the 1999 SEC Conference. He stated, in part:
In the evaluation of the fair value of its stock, the registrant should consider the proximity of the issuance of stock to an initial public offering, intervening events, transfer restrictions and exercise dates, profitability and financial condition of the company, and historical cash transactions involving stock with similar terms and restrictions. We consider the sufficiency of objective, verifiable evidence as the best support for the determination of fair value.
Further, the SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated August 31, 2001) states, in part:
The staff may request information about valuations that the underwriter discussed with senior management or the board of directors.
However, estimates of an IPO price or the ultimate IPO price are not necessarily
a reasonable estimate of the fair value of pre-IPO transactions in an
entity’s stock. Paragraph 10.10 of the AICPA Accounting and Valuation
Guide Valuation of Privately-Held-Company Equity Securities Issued as
Compensation (2013) states, in part:
Among [the] factors [that contribute to
differences between the fair value of an enterprise’s equity
securities in periods preceding the IPO and the ultimate IPO
price] are the marketability provided by the IPO event and the
reduction in the newly public enterprise’s cost of capital
resulting from its access to more liquid and efficient sources
of capital.
7.3.3 Paid-in-Kind Features
ASC 470-20
30-16 If dividends or interest on a convertible instrument must be paid in kind with the same convertible instruments as those in the original issuance and are not discretionary, the commitment date for the original instrument is the commitment date for the convertible instruments that are issued to satisfy interest or dividends requirements.
30-17 For purposes of the preceding paragraph, dividends or interest are not discretionary if both of the following conditions exist:
- Neither the issuer nor the holder can elect other forms of payment for the dividends or interest.
- If the original instrument or a portion thereof is converted before accumulated dividends or interest are declared or accrued, the holder will always receive the number of shares upon conversion as if all accumulated dividends or interest have been paid in kind.
30-18 In that circumstance, the intrinsic value of the embedded conversion option in the paid-in-kind instruments is measured using the fair value of the underlying stock of the issuer at the commitment date for the original issuance. Otherwise, the commitment date for the convertible instruments issued as paid-in-kind interest or dividends is the date that the interest or the dividends are accrued and the fair value of the underlying issuer stock at the recognition or declaration date shall be used to measure the intrinsic value of the conversion option embedded in the paid-in-kind instruments.
The terms of some convertible debt instruments include a paid-in-kind (PIK) interest payment feature that requires or permits the issuer to satisfy any interest payment obligations by issuing the same convertible debt instrument. The following are two types of such PIK interest payment features:
- On the interest payment date, the issuer satisfies the interest payment obligation by issuing additional convertible debt securities to the holder(s). That is, additional fungible securities are issued.
- On each interest payment date, the issuer increases the principal amount of the original debt security to reflect the interest accrued to the benefit of the holder, which results in a proportionate increase in the number of equity shares that will be issued upon exercise of the conversion feature. For example, some convertible debt securities contain a requirement for the issuer to pay accrued interest by increasing the security’s principal amount while maintaining the same conversion price (although the conversion rate per security increases). Upon conversion, the holders will receive additional common shares on the basis of the increased principal amount. Economically, other than with respect to potential differences due to the compounding terms of an instrument, such a PIK feature has the same effect as delivering additional instruments.
ASC 470-20 contains specific requirements for the issuer’s identification of the
commitment date for a convertible debt instrument issued as a payment of
interest under a PIK feature. Because the commitment date is the measurement
date in the determination of the fair value of an issuer’s stock, which is then
used in the calculation of a BCF’s intrinsic value (see Section 7.3.2.3.1), the
identification of the commitment date can affect both the determination of
whether a BCF exists in such an instrument and the measurement of its intrinsic
value, if any. In addition, as further discussed below, the commitment date can
also affect the initial measurement of the PIK interest payment and, therefore,
the determination of whether a BCF exists and the measurement of its intrinsic
value. The guidance distinguishes between discretionary and nondiscretionary PIK
features as follows:
|
PIK Feature
|
Description
|
Commitment Date for PIK Interest
|
|---|---|---|
|
Discretionary
|
A PIK feature is discretionary if
either of the following conditions exist:
|
The date that interest is accrued (i.e.,
the interest cost recognition date).
|
|
Nondiscretionary
|
A PIK feature is nondiscretionary if
both of the following conditions exist:
|
The commitment date for the original
convertible debt instrument.
|
As described above and in ASC 470-20-30-17(b), one of the conditions for PIK
interest payments to be considered nondiscretionary is that “[i]f the original
instrument or a portion thereof is converted before accumulated dividends or
interest are declared or accrued, the holder will always receive the number of
shares upon conversion as if all accumulated dividends or interest have been
paid in kind.” This guidance may be ambiguous for the following two reasons:
-
It is unclear whether the words “before . . . interest [is] accrued” refer to (1) the interest earned to date, on the basis of a daily accrual approach, that is associated with the amount due on the next contractual interest payment date or (2) the interest that has not yet been earned, on the basis of a daily accrual approach, as of the conversion date. Since entities typically accrue interest more frequently than on the contractual payment dates (e.g., daily), this wording may be subject to multiple interpretations.
-
It is unclear whether the word “accumulated” is intended to qualify only dividends or also interest payments. It is also unclear what portion of interest that may or may not have been accrued must be paid in kind.
As a result of this ambiguity, there are two acceptable interpretations that
entities may apply consistently as an accounting policy election:
-
View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that would have accrued during the entire life of the security (i.e., to the contractual maturity date).Under this view, the issuer must know at the inception of the original convertible debt instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument at its principal amount adjusted for PIK interest or, if PIK interest is paid through the issuance of additional convertible debt instruments, conversion of both the original convertible debt instrument at its principal amount and any additional convertible debt instruments. Potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot quantify the number of equity shares that will be issued or the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. In most cases, PIK interest payments would be discretionary under View A since entities typically do not issue convertible debt instruments that allow the holder to effectively earn future interest that would not have accrued on an early conversion (i.e., instruments with make-whole equivalents to all future interest on an undiscounted basis; see Examples 7-10 and 7-11). See Example 7-13 for discussion of the accounting if PIK interest is deemed to be nondiscretionary under this view (which would be the same as the accounting under View B, discussed below).
-
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that would have accrued during the entire period that the security has been outstanding (i.e., to the conversion date).Under this view, the holder always receives upon conversion the number of equity shares as if all interest that has accrued (i.e., been earned to date) is paid in equity shares even if such interest has not yet been contractually paid (i.e., if conversion occurs between contractual interest payment dates). Thus, the frequency of contractual interest payment dates has no impact on the number of equity shares that the holder will receive upon conversion because a holder that elects to convert the security in between contractual interest payment dates will receive additional equity shares for the interest that has accrued from the last contractual interest payment date (see Examples 7-10 and 7-11).
The view selected will not affect the conclusion that PIK interest is discretionary in cases in which a
convertible debt instrument allows either the holder or issuer to choose to pay interest in cash or in
kind. In these circumstances, the PIK interest would be considered discretionary regardless of whether
the entity adopted View A or View B above (see Example 7-12).
ASC 470-20 does not specifically address how to determine the initial amount to recognize for PIK
interest payments. That amount, however, is important because it affects the calculation of the effective
conversion price, which is compared with the commitment-date stock price (see Section 7.3.2.1), and
thus could affect the determination of whether the instrument that is issued as PIK interest contains
a BCF.
In Discussion Document 3 (March 8, 2001), the EITF Issue 00-27 Working Group stated, in part:
The FASB staff recommends that for purposes of recognizing a paid-in-kind dividend, the fair value of the
paid-in-kind instrument should be determined on the commitment date . . . . As a result, the fair value (and
deemed proceeds) from the issuance of the paid-in-kind instrument always will be determined on the same
date as the fair value of the stock underlying the conversion option in the paid-in-kind instrument. If the issuer
is committed to paying dividends in the form of paid-in-kind instruments, the commitment date will be the
commitment date for the original instrument. The fair value of paid-in-kind instruments issued as dividends will
equal the fair value of the original instruments evidenced in the transaction. If the issuer has discretion to pay
the dividends in another form such as cash, the fair value of the paid-in-kind instrument issued as a dividend
will be determined on the date the issuer commits to its issuance.
Although the approach recommended by the EITF Issue 00-27 Working Group was not
codified, it is generally appropriate for the initial recognition of PIK
interest payments. That is, if the PIK feature is nondiscretionary, an entity
initially measures the convertible debt instrument issued as PIK interest on the
basis of the fair value of the original convertible debt
instrument on its commitment date, which would equal the stated
principal amount of the PIK interest payments only if the principal amount
equaled the original convertible debt instrument’s commitment-date fair value.
However, if the PIK feature is discretionary, an entity initially measures the
convertible debt instrument issued as PIK interest on the basis of the fair value of the PIK convertible debt instrument on its
commitment date, which is generally the interest cost accrual date.
While interest typically accrues on convertible debt on a daily basis, the
commitment date for discretionary PIK interest does not change daily. Rather, an
entity should consider the frequency with which it recognizes accrued interest
and the compounding terms of the convertible debt security, among other factors,
to arrive at a reasonable and practical approach to recognizing the fair value
of convertible debt instruments issued as PIK interest. In determining an
appropriate method, the entity should consider the definition of “commitment
date” and how that definition would apply to the terms of the convertible debt
instrument. On the basis of these considerations, an entity may determine that
the contractual payment date is the commitment date for which the fair value of
the convertible debt instrument issued as PIK interest is ultimately recorded.
Because discretionary PIK interest payments are recognized at fair value, a BCF
will often not exist in those convertible debt instruments.
The approach described above for recognizing discretionary PIK interest is consistent, by analogy, with
ASC 505-20-30-3, which states, in part:
In accounting for a stock dividend, the corporation shall transfer from retained earnings to the category of
capital stock and additional paid-in capital an amount equal to the fair value of the additional shares issued.
Example 7-10
Discretionary PIK Interest Feature — Interest Between Payment Dates Is Forfeited
Entity B issues $30 million of convertible debt that pays 5 percent stated interest per annum. The interest is payable in arrears on a semi-annual basis on March 30 and September 30 of each year, at a rate of 2.5 percent, in additional convertible debt with the same terms as the original convertible debt instrument. Thus, on each interest payment date, the holder will receive an additional convertible debt instrument with a principal amount of $750,000. The holder can convert the original instrument at any time into an equal fixed number of shares of common stock (i.e., each $1,000 principal amount of convertible debt contains the same conversion rate). The contractual terms specify that the original convertible debt instrument will mature on September 30, 20X0. If the holder elects the conversion before September 30, 20X0, it would not receive any portion of the interest that has not yet been contractually paid (e.g., if conversion occurred on June 1, the holder would not receive the interest that had accrued or would have accrued from April 1). Therefore, the PIK feature is considered discretionary under both views discussed above, and the commitment date for any convertible debt instruments issued under the PIK feature is the associated interest cost accrual date. Further, each PIK instrument is measured at its fair value as of its interest cost accrual date.
Example 7-11
Nondiscretionary PIK Interest Feature — Interest Between Payment Dates Is Paid in Kind
Company A issued a convertible debt security with the following features on July 1, 2X03, when the market price of A’s stock was $15 per share:
- A principal amount of $1 million is issued at par.
- The instrument is convertible at any time into common shares at a conversion price of $25 per share.
- Interest of 3 percent is always payable in kind through additional shares of convertible debt.
- The PIK convertible debt securities also have a fixed conversion price of $25 per share.
- The instrument matures in 10 years.
- Upon conversion, the holder receives the unpaid interest that has accrued to the conversion date.
The commitment date (see Section 7.3.2.3.1) for the original convertible security was July 1, 2X03.
Under View B above, this PIK feature is considered nondiscretionary because the holders — upon an early conversion — will always receive interest that has accrued to the conversion date. Accordingly, the commitment date for any convertible debt securities issued under the PIK feature is the July 1, 2X03, commitment date of the original convertible debt security. However, under View A above, this PIK feature is considered discretionary because the holders — upon an early conversion — will not receive all the interest that would have accrued over the security’s 10-year contractual life. Accordingly, the commitment date for any convertible debt securities issued under the PIK feature is the associated interest cost accrual date.
Example 7-12
Discretionary PIK Interest Feature — Interest May Be Paid in Cash or Paid in Kind
Company R issued convertible debt securities with interest coupons that may be paid in cash or additional convertible debt securities at R’s option. The original convertible debt security pays interest at an 8 percent per annum rate. Company R elects the form of interest payments immediately before each payment date. The conversion price in the PIK convertible debt securities is equal, at all times, to the conversion price in the original convertible debt securities. The holders of the convertible debt securities, including any additional convertible debt securities issued as payment for interest coupons, have the right to convert, at any time after issuance, any or all of the securities in their possession.
Under the BCF guidance, this PIK feature is considered discretionary since R can choose the form of payment of the interest coupons. Therefore, the commitment date for any convertible debt security issued as PIK interest is the accrual date of the interest, and the initial measurement amount of the PIK convertible debt securities is their fair value on the interest cost accrual date. This conclusion would be the same regardless of whether the issuer applied View A or View B as described above.
If PIK interest is nondiscretionary, regardless of whether the interest is added to the principal amount
of the original convertible debt instrument or paid in newly issuable convertible debt securities, the
issuer must use the commitment date of the original convertible debt instrument to calculate any BCF
associated with the PIK interest and to recognize the PIK interest. The calculations of both the BCF, if
any, and the interest cost are generally performed as if the convertible debt instrument is a zero-coupon
instrument. The calculations of the BCF amounts to recognize, if any, may be complex, particularly if the
original convertible instrument was initially recognized at an amount less than its commitment-date fair
value, for example, because of discounts created by other freestanding financial instruments. Note that
if PIK interest payments are nondiscretionary, they are initially recognized on the basis of the original
convertible debt instrument’s commitment-date fair value (which may equal or approximate the stated
principal amounts of the PIK interest payments). Convertible debt issued as PIK interest is not initially
recognized at the amount initially recognized for the original convertible debt instrument if that amount
differs from the original instrument’s commitment-date fair value. The amount initially recognized for
the original convertible debt instrument on its commitment date may vary from the principal amount
of the original convertible debt instrument for many reasons, including, but not limited to, the pricing of
the original instrument before its commitment date or discounts recognized on the original instrument
as a result of the allocation of proceeds to other freestanding financial instruments. Additional
complexities arise if the PIK interest amounts are not level over the entire life of the convertible debt
instrument; in such cases, the guidance in ASC 470-20-35-7(b) on instruments with multiple-step
discounts may be applicable (see also Section 7.4.3).
In the unusual circumstance in which an entity issues a convertible debt
instrument that, upon conversion, allows the holder to receive all PIK interest
that would have accrued to the contractual maturity date regardless of the date
the holder converts the interest, the entity would calculate an effective
conversion rate on the basis of the fixed number of equity shares that would be
issuable regardless of when conversion occurs. This number of common shares is
not computed on the basis of the original conversion price excluding the
capitalization of PIK interest amounts but is based on the effective conversion
price after including the additional principal amount that results from all of
the PIK interest. These calculations will also be necessary in the determination
of the amount of interest cost to be recognized under the interest method. After
determining the debt discount (if any) arising from the BCF, an entity may, in
applying the interest method, treat the original convertible debt instrument in
a manner similar to how it treats a zero-coupon bond for which interest is only
paid on contractual maturity. If the PIK interest is added to the principal
amount of the original convertible debt instrument, there will not be any BCFs
in the PIK interest payments themselves because the total BCF will be calculated
as of the commitment date of the original convertible debt instrument inclusive
of the PIK interest payments that affect the fixed number of shares to be
received regardless of when the conversion occurs (see the example below).
Example 7-13
Calculation of BCF for Convertible Debt Instrument With Nondiscretionary PIK Interest Payments
Entity A issues convertible debt with the following terms:
Contractual Terms
Contractual Compounding
BCF Calculation
Initial Journal Entry
Example 7-14
Convertible Debt With Discretionary and Nondiscretionary PIK Interest Payments
On March 31, 20X0, Entity A issued 100,000 convertible debt securities with a principal amount of $1,000
for total proceeds of $100 million. The securities’ original maturity date is six years from the issuance date,
and they earn interest at an annual rate of 10 percent per annum of the principal amount per security,
compounded annually. During the first three years, A is required to pay interest in kind by delivering additional
convertible debt securities. During years 4–6, A has the option to pay interest either in cash or in kind. If
interest is paid in kind, the number of additional convertible debt securities is determined on the basis of the
initial purchase price (i.e., A will deliver one-tenth of a convertible debt security for each outstanding convertible
debt security). The holders of the convertible debt securities do not have the option to convert them before
the third anniversary of their issuance, and they do not contain any put, call, or redemption features. Thus, at
the end of year 3, after payment of interest in kind, there will be a total of 133,100 convertible debt securities
outstanding (100,000 × 1.103).
This example presents a unique fact pattern in which the PIK interest payments
could be considered to contain both a discretionary and
nondiscretionary element. Because there may be different
ways to interpret the accounting literature, more than
one view of the nature of the PIK interest payments may
be acceptable. A literal read of ASC 470-20-30-17 would
lead to a conclusion that all the interest is
discretionary. However, it may also be acceptable to
view this convertible debt instrument as (1) effectively
paying no interest during years 1–3 and (2) paying
interest coupons in years 4–6 through discretionary PIK
interest payments. While this view would be similar to
the conclusion that PIK interest is nondiscretionary
during years 1–3 and discretionary for years 4–6 (since
A may elect to pay interest either in cash or in kind),
to appropriately apply the interest method, an entity
would need to take into account the fact that interest
is effectively only being paid in years 4–6. The
commitment date for any additional convertible debt
securities issued after March 31, 20X3, is their
interest accrual date.
7.3.4 Warrants Exercisable Into Convertible Debt Instruments
Sometimes, entities issue convertible debt instruments in accordance with the exercise provisions of a physically settled warrant (e.g., a warrant on a convertible debt security). As part of its deliberations on Issue 00-27, the EITF reached several tentative conclusions related to the application of the BCF guidance in such circumstances. However, because the conclusions were never finalized by the EITF, the FASB did not incorporate them into the Codification. Nevertheless, it is generally reasonable to apply these tentative conclusions to convertible instruments issued upon the exercise of physically settled warrants to the extent that they are not exempt from the scope of the BCF guidance in ASC 470-20. Further, these tentative conclusions may be relevant in analogous fact patterns (e.g., when an instrument is convertible into another convertible instrument). EITF Issue 00-27, Issue Summary 1, Supplement 1
(February 28, 2008), states, in part:
It is the FASB staff’s understanding that there is
little diversity in practice concerning [the] tentative conclusions [in
EITF Issue No. 00-27]. Although the conclusions are tentative, as there
is no other authoritative literature to address these issues, reporting
entities have looked to the tentative conclusions for guidance. [These]
tentative conclusions have been treated as authoritative GAAP by
practitioners when evaluating the accounting for the corresponding
transactions.
Under the EITF’s tentative conclusions, the BCF analysis related to physically
settled warrants depends on whether they are classified as equity (see Section 7.3.4.1) or liabilities (see Section 7.3.4.2). While
warrants to issue a convertible debt instrument would never be classified within
stockholders’ equity, the guidance on equity-classified warrants may still be
relevant, as discussed below.
7.3.4.1 Equity-Classified Warrants
EITF Issue 00-27 (Nonauthoritative
Text)
Issue 13 — A company issues a
warrant that allows the holder to acquire a
convertible instrument for a stated exercise
price. The warrant provides only for physical
settlement (that is, delivery of the convertible
instrument in exchange for the stated exercise
price) and is classified as an
equity instrument (either temporary or
permanent). The issue is how to measure and when
to recognize a beneficial conversion option in the
underlying warrant.
7.3.4.1.1 Commitment Date
EITF Issue 00-27
(Nonauthoritative Text)
Issue 13(a) — Whether the
commitment date for purposes of measuring the
intrinsic value of the conversion option in the
convertible instrument that is the underlying for
the warrant is (a) the commitment date for the
warrant or (b) the exercise date of the
warrant.
43. The Task Force reached a
tentative conclusion that the date used to measure
the intrinsic value of a conversion option in a
convertible instrument that is the underlying for
a warrant that provides only for physical
settlement upon exercise and that is classified as
an equity instrument should be the commitment date
for the warrant, provided the issuer receives fair
value for the warrant (or for the warrant and for
any other instruments issued at the same time as
the warrant) upon its issuance. The Task Force
also reached a tentative conclusion that if the
holder transfers consideration upon issuance of
the warrant that is less than the fair value of
the warrant (or for the warrant and for any other
instruments issued at the same time as the
warrant), the exercise date of the warrant should
be used to measure the intrinsic value of the
conversion option.
Technically, the above guidance would only apply to a warrant on a convertible stock instrument (e.g., on convertible preferred stock) because a warrant on a convertible debt instrument could never be classified in equity. However, the guidance may be applied by analogy to a liability-classified warrant on a convertible debt instrument in some limited situations, particularly when the warrant is not subsequently remeasured during its life (i.e., the initial amount recognized is not remeasured before
exercise or expiration). In this situation, provided that the issuer received fair value for the warrant
(or for the warrant and any other instruments issued concurrently) upon its issuance, it would be
appropriate to measure the intrinsic value of any BCF in the convertible debt instrument underlying the
warrant on the warrant’s commitment date.
A warrant on a convertible debt security will often be subsequently measured at
fair value through earnings because it (1) meets the definition of a
derivative instrument, (2) represents a liability under ASC 480-10-25-8,
(3) is measured as such under the fair value option, or (4) is subject
to the SEC staff’s long-standing position on written options. In these
circumstances, or if the issuer did not receive fair value for the
warrant upon its issuance, the commitment date for the convertible debt
instrument is the warrant’s exercise date. If the warrant is classified
as a liability and subsequently remeasured by using a measurement
attribute other than fair value, such as its intrinsic value, the
commitment date for measuring the BCF should also be the exercise
date.
7.3.4.1.2 Deemed Proceeds
EITF Issue 00-27
(Nonauthoritative Text)
Issue 13(b) — When
measuring the intrinsic value of a conversion
option embedded in a convertible instrument that
is the underlying for the warrant, how the deemed
proceeds for the convertible instrument should be
computed.
44. The Task Force reached a
tentative conclusion that the deemed proceeds for
the convertible instrument are equal to the sum of
the proceeds received for (or allocated to) the
warrant and the exercise price of the warrant.
As the above guidance indicates, the EITF tentatively concluded that in the calculation of the effective
conversion price of a convertible instrument issued upon the exercise of an equity-classified warrant
that is evaluated on the basis of the warrant’s commitment date, the deemed proceeds received for the
convertible instrument should be the sum of (1) the proceeds received for (or allocated to) the warrant
and (2) the warrant’s exercise price. The same approach would be applied to a liability-classified warrant
on a convertible debt instrument that is evaluated on the basis of the warrant’s commitment date (see
Section 7.3.4.1.1).
7.3.4.1.3 Conversion Value in Excess of Deemed Proceeds
EITF Issue 00-27
(Nonauthoritative Text)
Issue 13(c) — Whether the
measured intrinsic value of a beneficial
conversion option in a convertible instrument that
is the underlying for the warrant should be
recognized at the date the warrant is issued or at
the date the warrant is exercised and the
convertible instrument is issued.
45. The Task Force reached a
tentative conclusion that if the sum of the
proceeds received for or allocated to the warrant
and the exercise price of the warrant is less than
the fair value of the common stock that would be
received upon exercising the conversion option in
the convertible instrument that is the underlying
for the warrant, the excess (limited to the total
proceeds originally received for or allocated to
the warrant) represents a deemed distribution to
the holder of the warrant for the convertible
instrument that should be recognized over the life
of the warrant. Any intrinsic value in excess of
the proceeds received for or allocated to the
warrant upon its issuance should be recognized
when the warrant is exercised. On the date the
warrant is exercised, that excess intrinsic value
and any remaining unamortized intrinsic value
measured at the date the warrant was issued should
be combined and amortized over the period
specified in [ASC 470-20-35-7] based on the
characteristics of the convertible instrument.
The tentative guidance above would be applied to a liability-classified warrant
on a convertible debt instrument that is evaluated on the basis of
the warrant’s commitment date (see Section 7.3.4.1.1). However,
this tentative conclusion is limited to noncontingent BCFs since the
recognition of a contingent BCF before it is triggered would be
inconsistent with the guidance for contingent BCFs (see Section 7.5).
Further, in accordance with ASC 470-20-30-8, the amount of intrinsic
value that can be recognized as a deemed distribution on the warrant
or a discount on the convertible debt instrument cannot be greater
than the deemed proceeds for the convertible instrument.
7.3.4.1.4 Illustration — Application of EITF’s Conclusions
EITF Issue 00-27
(Nonauthoritative Text)
46. The following example
illustrates the application of the Task Force’s
tentative conclusions on Issues 13(a), 13(b), and
13(c).
Assume Company A issues a
freestanding warrant to Company B on January 15,
20X0, for its fair value, $20. Also assume the
commitment date for the warrant is the date of
issuance. The warrant provides Company B with the
right during the next 2 years to exercise the
warrant for $100 in cash and receive 1 share of
Company A $100 par value nonredeemable convertible
preferred stock. The preferred stock is
convertible into 10 shares of Company A common
stock 1 year after the preferred stock’s issuance
date. Also assume that the terms of the warrant
require physical settlement upon exercise and
Company A has determined that the warrant is
classified in equity. The fair value of Company A
common stock on January 15, 20X0, is $15 per
share. Company B exercises the warrant on July 15,
20X0, when the fair value of Company A stock is
$20 per share.
47. The sum of the proceeds
received for the warrant ($20) and the warrant’s
exercise price ($100) equals $120, which is
considered to be the proceeds of issuance of the
convertible instrument pursuant to the Task
Force’s tentative conclusion on Issue 13(b). The
fair value (as of the commitment date of the
warrant pursuant to the Task Force’s tentative
conclusion on Issue 13(a)) of Company A’s common
stock that would be received upon exercising the
conversion option in the convertible instrument is
equal to $150 ($15 per share × 10 shares). The
difference between the fair value of the common
stock ($150) and the proceeds of issuance of the
convertible instrument ($120) is $30, which
represents the intrinsic value of the conversion
option in the instrument underlying the warrant
(that is, a beneficial conversion option
exists).
48. The amount of the
beneficial conversion option recognized upon
issuance of the warrant would be limited to $20,
the amount of proceeds received for the warrant
(pursuant to the Task Force’s tentative conclusion
on Issue 13(c)). That amount would be recognized
over the life of the warrant as a distribution to
the warrant holder. Through the date the warrant
is exercised, Company A recognized approximately
$5 in amortization of the $20 beneficial
conversion amount as a distribution to the warrant
holder (that is, the remaining unamortized balance
is $15). When the warrant is exercised and the
convertible preferred stock is issued, the amount
of the originally measured intrinsic value of the
conversion option ($30) in excess of the proceeds
received for the warrant ($20) of $10 is
recognized. The sum ($25) of that $10 increment
and the $15 unamortized amount of the $20
intrinsic value measured at the date the warrant
was issued is immediately recognized as a deemed
distribution to the holder of the convertible
preferred stock because the instrument is not
redeemable and is immediately convertible by the
holder.
While the example in the tentative guidance above addresses a warrant on convertible preferred stock, it is illustrative of the accounting for a liability-classified warrant on a convertible debt instrument that is evaluated on the basis of the warrant’s commitment date (see Section 7.3.4.1.1).
7.3.4.2 Liability-Classified Warrants
EITF Issue 00-27 (Nonauthoritative
Text)
Issue 14 — A company issues a
warrant that allows the holder to acquire a
convertible instrument for a stated exercise
price. The warrant provides only for physical
settlement (that is, delivery of the convertible
instrument in exchange for the stated exercise
price) and is classified as a
liability instrument. The issues are (1)
whether the commitment date for purposes of
measuring the intrinsic value of a conversion
option in a convertible instrument that is the
underlying for a warrant is (a) the commitment
date for the warrant or (b) the exercise date of
the warrant, (2) how the deemed proceeds for the
convertible instrument should be computed, and (3)
when the intrinsic value of a beneficial
conversion option in the underlying convertible
instrument should be recognized.
49. The Task Force reached a
tentative conclusion that the date used to measure
the intrinsic value of a conversion option in a
convertible instrument that is the underlying for a
warrant that provides only for physical settlement
upon exercise and that is classified as a liability
instrument should be the exercise date for the
warrant. The Task Force observed that a warrant that
is classified as a liability is being marked to fair
value through earnings while it is outstanding and
that warrant’s fair value depends in part on the
value of the conversion option in the underlying
convertible instrument.
If a physically settled warrant on a convertible debt instrument is classified as a liability and subsequently
remeasured at fair value through earnings, the commitment date for the convertible debt instrument
that would be issued upon its exercise is the warrant’s exercise date.
Because a liability-classified warrant is accounted for at fair value on a recurring basis, the deemed proceeds for the convertible instrument equal the sum of the warrant’s (1) exercise-date fair value and (2) exercise price (see paragraph 51 of EITF Issue 00-27). Since the fair value of the warrant reflects the value of the underlying conversion option in the convertible debt instrument issued upon the warrant’s exercise, a BCF in the convertible debt instrument would not usually exist upon issuance. However, there could be a contingent BCF if there are contingent adjustments to the conversion rate (see Section 7.5).
7.3.4.2.1 Illustration — Liability-Classified Warrant
EITF Issue 00-27
(Nonauthoritative Text)
50. Assume that Company A issues
a freestanding warrant to Company B on January 15,
20X0, for its fair value, $20. Also assume the
commitment date for the warrant is the date of
issuance. The warrant provides Company B with the
right during the next 2 years to exercise the
warrant for $100 in cash and receive Company A
$100 par value convertible debt. The debt is
convertible into 10 shares of Company A common
stock. The fair value of Company A stock on
January 15, 20X0, is $11 per share. Company B
exercises the warrant on February 15, 20X1, when
the fair value of Company A stock is $20 per share
and the fair value and carrying amount of the
warrant is $105. Also assume that the warrant
terms require physical settlement upon exercise
and Company A has determined that the warrant is
classified as a liability.
51. Because Company A has
classified the warrant as a liability instrument,
the exercise date for the warrant should be used
to measure and recognize the intrinsic value of
the conversion option in the convertible
instrument that is the underlying for the warrant.
Accordingly, the fair value of the stock on the
exercise date of $20 per share should be used to
calculate the intrinsic value of the conversion
option. When the warrant is classified as a
liability instrument, the deemed proceeds for the
convertible instrument ($205) should equal the sum
of the carrying amount of the warrant at the
exercise date ($105) and the warrant’s exercise
price ($100). In this example, there is no
beneficial conversion option because the amount of
proceeds ($205) exceeds the fair value of the
common stock into which the instrument can be
converted ($200, calculated as $20 per share × 10
shares). The exercise of the warrant and resulting
issuance of the convertible debt would be recorded
as follows:
7.3.5 Convertible Debt Instruments Issued to Nonemployees in Share-Based Payment Transactions
ASC 470-20
25-19 If the convertible instrument is issued for cash proceeds that indicate that the instrument includes a beneficial conversion feature and the purchaser of the instrument also provides (receives) goods or services to (from) the issuer that are the subject of a separate contract, the convertible instrument shall be recognized with a corresponding increase or decrease in the purchase or sales price of the goods or services.
30-22 To determine the fair
value of a convertible instrument granted as part of a
share-based payment transaction to a nonemployee in
exchange for goods or services or as consideration
payable to a customer that is equity in form or, if debt
in form, that can be converted into equity instruments
of the issuer, the entity shall first apply Topic 718 on
stock compensation.
30-23 The requirements of
this Subtopic shall then be applied such that the fair
value determined pursuant to Topic 718 is considered the
proceeds from issuing the instrument for purposes of
determining whether a beneficial conversion option
exists. The measurement of the intrinsic value, if any,
of the conversion option under paragraph 470-20-25-5
shall then be computed by comparing the proceeds
received for the instrument (the instrument’s fair value
under Topic 718) to the fair value of the common stock
that the grantee would receive upon exercising the
conversion option. For purposes of determining whether a
convertible instrument contains a beneficial conversion
feature under paragraph 470-20-25-5, an entity shall use
the effective conversion price based on the proceeds
allocated to the convertible instrument to compute the
intrinsic value, if any, of the embedded conversion
option.
30-24 Topic 718 shall be used
both to measure the fair value of the convertible
instrument and to measure the intrinsic value, if any,
of the conversion option as of the date the convertible
instrument granted as part of a share-based payment
award becomes fully vested. That is, in measuring the
intrinsic value of the conversion option under paragraph
470-20-25-5, the fair value of the issuer’s equity
securities into which the instrument can be converted
shall be determined as of the date the convertible
instrument granted as part of a share-based payment
award becomes fully vested, and not on the commitment
date specified in this Subtopic.
30-25 Both of the following
guidelines for determining the fair value of convertible
instruments shall be used:
-
Subparagraph superseded by Accounting Standards Update No. 2018-07
-
Recent issuances of similar convertible instruments for cash to parties that only have an investor relationship with the issuer may provide the best evidence of fair value of the convertible instrument.
-
If reliable information under (b) is not available, the fair value of the convertible instrument shall be deemed to be no less than the fair value of the equity shares into which it can be converted.
30-26 If an entity issues a convertible instrument for cash proceeds that indicate that the instrument includes a beneficial conversion option and the purchaser of the instrument also provides (receives) goods or services to (from) the issuer that are the subject of a separate contract, the terms of both the agreement for goods or services and the convertible instrument shall be evaluated to determine whether their separately stated pricing is equal to the fair value of the goods or services and convertible instrument. If that is not the situation, the terms of the respective transactions shall be adjusted by measuring the convertible instrument initially at its fair value with a corresponding increase or decrease in the purchase or sales price of the goods or services. It may be difficult to evaluate whether the separately stated pricing of a convertible instrument is equal to its fair value. If an instrument issued to a goods or services provider (or purchaser) is part of a larger issuance, a substantive investment in the issuance by unrelated investors (who are not also providers or purchasers of goods or services) may provide evidence that the price charged to the goods or services provider represents the fair value of the convertible instrument.
Sometimes, a convertible debt instrument is issued to a nonemployee in exchange
for goods or services or a combination of goods or services and cash (e.g., cash
plus advisory services). In these circumstances, an entity must carefully
evaluate the terms of the instrument to appropriately recognize and measure any
embedded BCF since the amount of any cash proceeds received do not reflect the
value of the goods or services received. At the 1999 AICPA Conference on Current
SEC Developments, then Professional Accounting Fellow Pascal Desroches
said, in part:
[I]n certain transactions reviewed by the staff,
registrants have issued beneficially convertible preferred securities to
third parties with whom they have existing or established business
relationships beyond that of an investor-investee. On the surface these
transactions appear to be purely financing transactions in which the
issuer is issuing beneficially convertible preferred equity securities
to raise capital. . . . In cases where we have reviewed some of the
governing agreements to these arrangements, . . . the staff has observed
that some of these arrangements may involve elements of compensation for
goods or services. In such cases, . . . the transaction is measured at
fair value and is not limited to proceeds received from issuing the
equity security. . . . Accordingly, I would encourage registrants and
their auditors to evaluate carefully the terms of the governing
agreements to these arrangements.
An entity that grants a convertible debt instrument to a
nonemployee in exchange for goods and services (or a combination of cash and
goods and services) must apply other GAAP for financial instruments once the
convertible debt instrument has fully vested (see Section 2.8). ASC 718-10-35-9A requires an entity to apply other
GAAP applicable to convertible instruments to such instruments that are granted
to nonemployees in a share-based payment arrangement once “the award is fully
vested.” After a convertible debt instrument becomes subject to other GAAP, the
issuer must evaluate the instrument for a BCF unless either (1) the conversion
option requires bifurcation under ASC 815-15 or (2) the instrument is subject to
the CCF guidance.
When a convertible debt instrument is issued in exchange for goods or services
(or a combination of cash and goods and services) and is subject to evaluation
for a BCF (i.e., because the conversion option does not require bifurcation
under ASC 815-15 and the convertible debt instrument is not subject to the CCF
guidance), the issuer should first apply ASC 718 to determine the fair value of
the convertible debt instrument issued to a nonemployee in return for goods and
services. The issuer should then apply the steps below to recognize and measure
any embedded BCF.
7.3.5.1 Step 1 — Determine the Instrument’s Effective Conversion Price on the Basis of the Proceeds Allocated
In a manner consistent with the general requirements for
determining the amount of any BCF, which are discussed in ASC 470-20-30-23,
an entity “shall use the effective conversion price based on the proceeds
allocated to the convertible instrument to compute the intrinsic value, if
any, of the embedded conversion option.” The proceeds received from issuing
the instrument are a required input in the calculation of the effective
conversion price. The fair value of the convertible debt instrument under
ASC 718 is considered the proceeds from issuing the convertible debt
instrument in accordance with ASC 470-20.
Under ASC 718, the fair value of the convertible debt
instrument is initially determined on the grant date. However, depending on
the subsequent recognition and measurement of the convertible debt
instrument under ASC 718, the amount that is recognized may change when the
award is fully vested, which is the date on which the instrument becomes
subject to other GAAP applicable to convertible instruments. Under ASC 718,
the fair value of a convertible debt instrument issued to a nonemployee in a
share-based payment transaction must be measured on the basis of the
instrument (i.e., measuring on the basis of the goods or services exchanged
is not allowed). ASC 470-20-30-25 and 30-26 provide additional guidance on
determining the fair value of the convertible debt instrument for BCF
measurement purposes. This guidance should not be interpreted to mean that
the fair value used for measuring the cost of the goods or services
exchanged under ASC 718 should differ from the fair value used for measuring
proceeds under ASC 470-20. Rather, ASC 470-20-30-25 and 30-26 are merely
providing interpretive guidance that is in keeping with the measurement
guidance in ASC 718. This view is consistent with ASC 470-20-30-23, which
states that the fair value determined in accordance with ASC 718 is
considered the proceeds from issuing the instrument in the assessment of
whether a BCF exists.
ASC 470-20-30-24 states, in part, that “Topic 718 shall be
used both to measure the fair value of the convertible instrument and to
measure the intrinsic value, if any, of the conversion option as of the
date the convertible instrument granted as part of a share-based payment
award becomes fully vested” (emphasis added). It is not clear
whether the qualifying language (in italics) applies to the measurement of
the convertible instrument or only to the measurement of the conversion
feature’s intrinsic value. If a convertible debt instrument is being
remeasured to fair value in its entirety under the subsequent measurement
guidance in ASC 718, the instrument’s carrying amount and fair value as of
the date the award is fully vested would be the same.
However, in many cases, a convertible debt instrument is not
subsequently measured at fair value in its entirety. For example, an entity
may determine that under ASC 718 a convertible debt instrument contains an
equity component (e.g., a written call option on equity) and a liability
component (e.g., a host debt instrument). Since the equity component would
not be remeasured under ASC 718, the combined amounts would not be expected
to equal the convertible instrument’s fair value on the date the award is
fully vested. As another example, a nonpublic entity that has elected to
subsequently measure liability-classified awards at intrinsic value may
subsequently measure a convertible debt instrument in its entirety at an
amount that reflects any intrinsic value in the embedded conversion feature
(i.e., if it concludes that the entire instrument requires classification as
a liability). If the issuer uses the fair value of the convertible debt
instrument on the date the instrument is fully vested as the proceeds in
calculating the effective conversion price, there would often be no
intrinsic value (i.e., initial BCF) because the proceeds would take into
account the then-current fair value of the conversion option. However, it is
not clear whether it would be appropriate to calculate the BCF on the basis
of the instrument’s fair value on the date it is fully vested if such
proceeds differ from the fair value amount(s) used to measure the cost of
the goods or services under ASC 718. As indicated in informal discussions
with the FASB staff, an entity may use the fair value of the convertible
debt instrument on the date it becomes fully vested as the deemed proceeds
when calculating any BCF. Therefore, entities often will not recognize any
BCF upon vesting, although they might be required to recognize a contingent
BCF after it vests if the instrument contains such a feature.
Once the issuer uses the proceeds to calculate the effective
conversion price of the instrument, it proceeds to step 2.
7.3.5.2 Step 2 — Compute a BCF’s Intrinsic Value by Comparing the Convertible Debt Instrument’s Effective Conversion Price to the Fair Value of the Equity Instrument the Holder Would Receive Upon Exercising the Option
As discussed above, ASC 470-20-30-24 requires an issuer to
measure the fair value of the equity instrument that would be issued upon
conversion “as of the date the convertible instrument granted as part of a
share-based payment award becomes fully vested.” In the absence of a
remeasurement of the entire convertible debt instrument at fair value under
ASC 718, the measurement date of the fair value of the equity shares into
which the instrument is convertible would differ from that of the proceeds
used in the determination of the effective conversion price. However, as
stated in Section
7.3.5.1, it is acceptable to use the fair value of a
convertible debt instrument as of the date it is fully vested. As a result,
an initial BCF often will not exist (although a contingent BCF may
exist).
7.3.6 Deferred Taxes
ASC 470-20
25-7 For the application of Topic 740 to beneficial conversion features that result in basis differences, see paragraph 740-10-55-51.
ASC 740-10
55-51 The issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes of applying this Topic. The recognition of a beneficial conversion feature effectively creates two separate instruments — a debt instrument and an equity instrument — for financial statement purposes while it is accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial conversion feature is a temporary difference for purposes of applying this Topic because that difference will result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability is presumed to be settled at its current carrying amount (reported amount). The recognition of deferred taxes for the temporary difference of the convertible debt with a beneficial conversion feature should be recorded as an adjustment to additional paid-in capital. Because the beneficial conversion feature (an allocation to additional paid-in capital) created the basis difference in the debt instrument, the provisions of paragraph 740-20-45-11(c) apply and therefore the establishment of the deferred tax liability for the basis difference should result in an adjustment to the related components of shareholders’ equity.
As a result of applicable taxation requirements (e.g., the Internal Revenue Code), the recognition of a BCF in equity for a convertible debt instrument often causes the carrying amount of the debt under GAAP (the book basis) to differ from its tax basis, as determined in accordance with ASC 740-10. In practice, such a basis difference usually results in the recognition of a deferred tax liability under ASC 740-10 because (1) it is considered a temporary difference under ASC 740-10 and (2) the debt’s tax basis (e.g., the entire amount of proceeds received at issuance of the debt) exceeds its book basis (i.e., the amount that remains after the separation of a BCF under ASC 470-20). Because the BCF is recognized in APIC, ASC 740-10 requires the deferred tax liability to be recognized through a charge to APIC.
Footnotes
1
If the investor is a related party or existing
investor in the entity, the issuer should consider whether the
amounts paid represent a dividend.