7.4 Subsequent Accounting
7.4.1 Overview
ASC 470-20
35-6 Subtopic 835-10 provides overall guidance on accretion and amortization of discount. This guidance addresses the following incremental matters:
- Effects of beneficial conversion features
- Instrument with conversion feature that terminates
- Interest forfeiture.
35-7 Any discount recognized by the allocation of proceeds to a beneficial conversion feature under paragraph 470-20-25-5 shall be accounted for as follows: . . .
2. For convertible debt securities, that discount shall be recognized as interest expense using the effective yield method.
The allocation of part of the carrying amount of
a convertible debt instrument to a BCF that is recognized within equity creates
a discount (or reduced premium) on the convertible debt instrument. This
discount is amortized by using the effective interest method in accordance with
ASC 835-30. The periodic amortization is recognized as interest expense in
earnings:
As indicated in ASC 835-30-35-2, under the interest method, the amortization of
a discount or premium is computed “in such a way as to result in a constant rate
of interest when applied to the amount outstanding at the beginning of any given
period.” The amortization method depends on whether the instrument has a stated
redemption date (see Section
7.4.2), involves a multiple-step discount (see Section 7.4.3), or does
not possess those features (see Section 7.4.4).
7.4.2 Instruments With a Stated Redemption Date
ASC 470-20
35-7 Any discount recognized by the allocation of proceeds to a beneficial conversion feature under paragraph
470-20-25-5 shall be accounted for as follows:
- Instruments having a stated redemption date. If a convertible instrument has a stated redemption date (such as debt and mandatorily redeemable preferred stock), that discount shall be accreted from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs. Example 7 (see paragraph 470-20-55-28) illustrates the application of this guidance. . . .
35-10 Otherwise, if a beneficial conversion option terminates after a specified time period and the instrument
is then mandatorily redeemable at a premium, any resulting discount under paragraph 470-20-25-5 shall
be accreted to the mandatory redemption amount. Example 6 (see paragraph 470-20-55-25) illustrates the
application of this guidance.
Debt discounts and issuance costs associated with a convertible debt instrument that contains a
BCF and is not puttable by the holder should be amortized to the debt’s maturity date even if the
instrument’s terms permit earlier conversion. If the conversion feature expires after a specified period
and the instrument becomes mandatorily redeemable at a premium, the resulting discount is amortized
to the mandatory redemption amount over the period to the required redemption date.
While not directly addressed in ASC 470-20, discounts and issuance costs
related to convertible debt instruments that (1)
contain a BCF and (2) are puttable by the investor
before the stated maturity date should be
amortized over the period to the first date the
holder has or will obtain the unilateral ability
to exercise the put option only on the basis of
the passage of time (i.e., the earliest “stated
redemption date”). For example, if a convertible
debt instrument is immediately puttable on the
date of issuance, any discount or issuance cost
would be amortized immediately at inception. If
the holder’s ability to exercise the put option is
contingent on circumstances beyond its control but
the holder is expected to obtain the unilateral
ability to exercise it, by analogy to ASC
470-10-35-2, it is acceptable to amortize
discounts and issuance costs over the period until
the holder is expected to obtain such unilateral
ability.
7.4.2.1 Illustrations — Amortization From the Date of Issuance to the Stated Redemption Date
ASC 470-20-55 contains the following illustrations in which a debt discount resulting from the recognition of a noncontingent BCF is amortized from the convertible debt instrument’s date of issuance to its stated redemption date:
- In Example 6 in ASC 470-20-55-25 through 55-27, a $1 million convertible debt instrument (1) is convertible by the holder one year from issuance, (2) must be redeemed by the issuer for $1.2 million if not converted at the end of one year, and (3) has a beneficial conversion option whose intrinsic value is $200,000. The guidance states that “[t]he total proceeds of $1 million are therefore allocated as follows: $800,000 to the convertible debt and $200,000 to the conversion option (recognized as additional paid-in capital). The debt is then accreted from $800,000 to the $1.2 million redemption amount over the 1-year period to the required redemption date.”
- In Cases A, E, and F of Example 7 in ASC 470-20-55-29 through 55-60A, a $1 million convertible debt instrument has a redemption date on the fifth anniversary of issuance and is convertible on the issuance date. For each case, the guidance states that “[b]ecause 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.”
- In Case B of Example 7 in ASC 470-20-55-34 through 55-38, a $1 million convertible debt instrument has a redemption date on the fifth anniversary of issuance and is convertible one year from the issuance date. The guidance states that “[b]ecause 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.”
Although the guidance in ASC 470-20-35-7 suggests that the amortization of the discount created by a BCF should begin on the issuance date, amortization cannot begin before the discount has been recognized. Thus, a discount resulting from the recognition of a contingent BCF (see Section 7.5) should be amortized from the date the contingent BCF is triggered rather than the date the instrument is issued. This approach is consistent with the implementation guidance in ASC 470-20-55, which illustrates how the amortization of a discount associated with a contingent BCF begins when the contingent BCF is first recognized:
- In Example 5 in ASC 470-20-55-22 through 55-24, Entity A issues a $1 million convertible debt instrument that is convertible at a $10 conversion price. The guidance states that “[i]f Entity A subsequently issues common stock at a price of $8 per share, the holder’s conversion price adjusts to $7.20 . . . . The incremental intrinsic value that results from triggering the contingent option . . . would be recognized upon the subsequent issuance of common stock at the $8 per share price. The accretion of this discount would be required from the date the common stock was subsequently issued at $8 per share.”
- In Case D of Example 7 in ASC 470-20-55-44 through 55-48, a $1 million convertible debt instrument has a redemption date on the fifth anniversary of issuance and is convertible upon an IPO. The guidance states that “[i]f the IPO were completed on the third anniversary of the debt issuance, the discount amount would be recorded at that date and amortized over a two-year period ending on the stated redemption date of the debt.”
By analogy to the guidance on increasing-rate debt in ASC 470-10-35-2, it may in
limited circumstances be acceptable for entities
to recognize discounts resulting from recurring
conversion ratio adjustments that represent
contingent BCFs as an expense (i.e., a period
cost).
Example 7-15
Convertible Debt With Recurring Contingent BCFs
Entity X, which has a history of paying stable recurring dividends on its outstanding common stock, issued
convertible debt with a provision that reduces the conversion price each time X pays such dividends. Because
X has determined that the dividend equivalent applied to reduce the conversion price represents a contingent
BCF, it will recognize an incremental debt discount each time it pays a dividend. In these circumstances, the
recurring conversion price adjustments may in effect represent an incremental interest payment on the
convertible debt that should be recognized as a period cost. If each discount were to be amortized to the
stated redemption date, X would recognize interest expense at an increasing rate as the redemption date
approaches since each discount recognized would be amortized over a shorter period than the previous one.
7.4.2.2 Illustration — BCF That Expires and Instrument Becomes Mandatorily Redeemable at a Premium
ASC 470-20
Example 6: Beneficial Conversion Option Terminates After a Specified Time Period and Instrument Then
Mandatorily Redeemable at a Premium
55-25 This Example illustrates the guidance in paragraph 470-20-35-10.
55-26 Assume Entity A issues for $1 million a convertible debt instrument that is convertible by the holder 1
year from issuance into 120,000 shares of Entity A common stock (fair value of Entity A’s common stock at the
commitment date is $10). If the instrument is not converted at the end of 1 year, Entity A is required to redeem
it for $1.2 million.
55-27 The debt instrument contains a beneficial conversion option with an intrinsic value of $200,000 — that is,
(120,000 shares × $10 per share) (which is equal to the fair value of stock to be received upon conversion) – $1
million (proceeds received). The total proceeds of $1 million are therefore allocated as follows: $800,000 to the
convertible debt and $200,000 to the conversion option (recognized as additional paid-in capital). The debt is
then accreted from $800,000 to the $1.2 million redemption amount over the 1-year period to the required
redemption date in accordance with this Subtopic.
As illustrated in Example 6 above, if a convertible debt instrument includes a BCF that expires after
a specified period and the instrument then becomes mandatorily redeemable at a premium, the
initial carrying amount of the instrument (after separation of the BCF) is accreted to the mandatory
redemption amount (including the redemption premium) over the period to the mandatory redemption
date.
Example 6 implies that Entity A makes the
following entries at issuance:
Over the life of the instrument, Entity A makes
the following cumulative entries to reflect the amortization of the
discount:
7.4.3 Instruments With a Multiple-Step Discount
ASC 470-20
35-7 Any discount recognized by the allocation of proceeds to a beneficial conversion feature under paragraph 470-20-25-5 shall be accounted for as follows: . . .
b. Instruments involving a multiple-step discount. If an instrument incorporates a multiple-step discount and does not have a stated redemption date, that discount shall be amortized over the minimum period in which the investor can recognize that return. However, amortization recognized may require adjustment to ensure that the discount amortized at any point in time is not less than the amount the holder of the instrument could obtain if conversion occurred at that date. This method can be expressed as requiring cumulative amortization equal to the greater of the following:
1. The amount derived using the effective yield method based on the conversion terms most beneficial to the investor
2. The amount of discount that the investor can realize at that interim date. . . .
Example 10: Multiple-Step Discount
55-69 This Example illustrates the application of paragraphs 470-20-30-15 and 470-20-35-7 to an instrument that incorporates a multiple-step discount. If an instrument provides for a 15 percent discount to the market price after 3 months, a 25 percent discount after 6 months, a 35 percent discount after 9 months, and a 40 percent discount after 1 year, paragraph 470-20-30-15 requires that the computation of the intrinsic value be made using the conversion terms that are most beneficial to the investor; that is, the discount would be 40 percent and the amortization period would be 1 year. However, paragraph 470-20-35-7 indicates that the amortization recognized may require adjustment to ensure that the discount amortized at any point in time is not less than the amount the holder of the instrument could obtain if conversion occurred at that date. That is, at the end of 3 months, at least the 15 percent discount should have been recognized. Paragraph 470-20-35-7(a) states that, if a convertible instrument has a stated redemption date, the discount shall be accreted from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs.
If the conversion price of a convertible debt instrument changes with the passage of time, discounts and issuance costs are amortized so that cumulative amortization as of each reporting date equals the greater of (1) the amount the investor can realize as of that reporting date and (2) an amount calculated by using the effective interest method. Although the effective interest rate is determined on the basis of the conversion terms that will be most favorable to the investor over the life of the convertible debt, any discount is amortized over the period until the earliest stated redemption date.
7.4.4 Other Instruments
ASC 470-20
35-7 Any discount recognized by the allocation of proceeds to a beneficial conversion feature under paragraph 470-20-25-5 shall be accounted for as follows: . . .
c. All other instruments. If a convertible instrument does not involve a multiple-step discount and does not have a stated redemption date (such as perpetual preferred stock), that discount shall be amortized from the date of issuance to the earliest conversion date as follows:
1. For convertible preferred securities, that discount (which is analogous to a dividend) shall be recognized as a return to the preferred shareholders using the effective yield method.
2. For convertible debt securities, that discount shall be recognized as interest expense using the effective yield method.
All discounts retain their character such that a discount resulting from the accounting for a beneficial
conversion option is amortized from the date of issuance to the earliest conversion date. For SEC registrants,
other discounts on perpetual preferred stock that has no stated redemption date but that is required to be
redeemed if a future event that is outside the control of the issuer occurs (such as a change in control) shall be
accounted for in accordance with Section 480-10-S99.
Convertible debt instruments almost always have a stated redemption date. As a result, the guidance
in ASC 470-20-35-7(c) generally applies only to nonputtable perpetual convertible stock that does not
include a multiple-step discount. However, there are limited circumstances in which an entity may issue
a convertible instrument that is debt in legal form but does not have any stated redemption date. In
those circumstances, the convertible instrument is classified as a liability and the guidance requiring
application of the effective yield method to the earliest conversion date is applicable.
Although ASC 470-20-35-7(c) suggests that amortization should begin from the issuance date,
amortization of a contingent BCF begins when it is first recognized.
Example 7-16
Perpetual Convertible Debt With Noncontingent BCF
Entity A issues for cash proceeds of $12 million a perpetual convertible instrument that is debt in legal form
and contains a noncontingent BCF whose intrinsic value is $2 million. The convertible instrument has no
maturity date or redemption provisions held by the holder and is immediately convertible upon issuance.
Therefore, the earliest conversion date is the issuance date, and the discount associated with the BCF would
be amortized in full as of the issuance date and recognized as interest expense. Entity A makes the following
journal entry:
The guidance in ASC 470-20-35-7 suggests that if a convertible debt instrument
without a stated redemption date has a discount in
addition to the one created by the BCF, each
discount retains its character, which may require
an entity to track and account for each discount
separately. Although ASC 470-20-35-7 refers to
“all discounts” without specifically limiting the
scope of this guidance to any specific subset of
convertible instruments, the EITF intended the
guidance to be applied to convertible instruments
that do not have a stated redemption date; thus,
this guidance is only relevant to convertible
preferred stock instruments that are subject to
classification in temporary equity in their
entirety.
Connecting the Dots
For further discussion of the application of the SEC’s guidance on temporary
equity, see Chapter
9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.