Chapter 7 — Beneficial Conversion Features

7.5 Contingent BCFs

7.5.1 Concept of Contingent BCF

ASC 470-20

05-8 Certain convertible instruments may have a contingently adjustable conversion ratio; that is, a conversion price that is variable based on future events such as any of the following:

A liquidation or a change in control of the entity
A subsequent round of financing at a price lower than the convertible instrument’s original conversion price
An initial public offering at a share price lower than an agreed-upon amount.

35-2 The guidance in the following paragraph applies to an instrument with either of the following characteristics:

The instrument becomes convertible only upon the occurrence of a future event outside the control of the holder.
The instrument is convertible from inception but contains conversion terms that change upon the occurrence of a future event.

Contingent BCFs, which are triggered by uncertain future events or circumstances, include BCFs that are (1) only contingently exercisable (e.g., a conversion feature that can only be exercised if an IPO or a qualifying financing were to occur) or (2) associated with contingently adjustable conversion ratios (e.g., a conversion ratio that resets upon a change of control). However, a standard antidilution provision would not be analyzed as a contingent BCF (see Section 7.5.1.1). Similarly, a conversion rate that adjusts only if an uncertain future event or circumstance does not occur is not a contingent BCF because it will occur (i.e., become exercisable) upon the mere passage of time without a change in circumstances. Rather, the initial active BCF, if any, is measured under the assumption that there are no changes other than the passage of time. However, the actual occurrence of the uncertain event or circumstance and the resulting adjustment to the conversion rate may lead to the recognition of a contingent BCF, an elimination of a BCF, or an increase or a reduction in the amount of the BCF.

If the issuer of a convertible debt instrument that contains a contingent BCF irrevocably elects to account for the instrument under the fair value option in ASC 825-10, it is exempt from the contingent BCF guidance in ASC 470-20 (see Sections 2.5 and 7.2.4).

The requirement to identify and measure BCFs on the basis of the commitment-date stock price applies to both noncontingent and contingent BCFs. For a contingent BCF, the stock price when the contingency is triggered is not relevant to the analysis. Accordingly, an issuer may be required to recognize the accounting effect of a contingent BCF that is in-the-money as of the commitment date even if the adjusted conversion price exceeds the current stock price (i.e., the conversion feature is out-of-the-money) as of the date the contingent BCF is triggered. While a contingent BCF is measured on the basis of the commitment-date stock price, it is not recognized until the contingency occurs.

A contingent BCF must involve an exercise contingency (e.g., a conversion feature contingent on an IPO), a conversion rate adjustment (e.g., a down-round feature), or both. ASC 815-40-15 contains detailed guidance on evaluating whether an exercise contingency or adjustment provision precludes a conclusion that a contract or feature is indexed to the entity’s own equity. If the equity conversion feature is not considered indexed to the issuer’s equity under ASC 815-40, the issuer should evaluate whether it must be bifurcated as an embedded derivative under ASC 815 (see Section 2.3 and Appendix A). The BCF guidance in ASC 470-20 does not apply to equity conversion features that are bifurcated as embedded derivatives from convertible debt instruments (see Section 7.2.2).

7.5.1.1 Antidilution Provisions

ASC Master Glossary

Antidilution

An increase in earnings per share amounts or a decrease in loss per share amounts.

Down Round Feature

A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.

A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.

Equity Restructuring

A nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying an option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend.

Standard Antidilution Provisions

Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction that are designed to maintain the value of the conversion option.

Often, the terms of convertible debt instruments contain contingent adjustments to the conversion ratio to protect the holder from dilution of the value of the conversion feature upon the occurrence of specified events (e.g., stock splits, stock dividends, or tender offers). If such an adjustment term meets the definition of a standard antidilution provision, the feature does not represent a contingent BCF because it does not give the holder any additional benefit or value. This reasoning is consistent with the guidance in ASC 470-20-25-11(c), which implies that — for traditional convertible debt to which ASC 470-20-25-12 applies — an entity should not separately recognize a conversion feature for which the conversion price adjusts under an antidilution provision (see Section 4.2). In addition, ASC 815-40- 25-41 states, in part (see also Section 5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity):

Standard antidilution provisions contained in an instrument do not preclude a conclusion that the instrument is convertible into a fixed number of shares.

If the adjustment terms do not meet the definition of a standard antidilution provision, however, the feature may represent a contingent BCF that would need to be evaluated under the BCF guidance in ASC 470-20 unless it is exempt from the scope of the guidance (see Section 7.2).

A contractual term is considered a standard antidilution provision if it (1) results in an adjustment to the conversion ratio upon the occurrence of an equity restructuring transaction (i.e., in accordance with the ASC master glossary definition of equity restructuring, a “nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying a [contract] to change”) and (2) is designed to maintain the value of the conversion feature rather than provide incremental value to the holder.

Certain events may result in an adjustment to the conversion ratio under the contractual terms of a convertible debt instrument. The table below provides examples of adjustments that may qualify as standard antidilution provisions and adjustments that may be nonstandard. The assessment of whether the adjustment meets the definition of a standard antidilution provision could differ depending on how the provision is worded and other facts and circumstances (e.g., whether the adjustment provides incremental value to the holder).

Standard	Nonstandard
Stock dividend — The issuance of shares of common stock as a dividend or distribution to all common stockholders. Stock split — A subdivision of shares of common stock. Reverse stock split — A combination of outstanding shares of common stock. Spinoff — The dividend or other distribution to all holders of common stock, evidence of indebtedness, or assets on a pro rata basis. Rights offering — The dividend distribution or other issuance to all holders of common stock on a pro rata basis of rights or warrants entitling them to purchase shares of common stock or securities convertible into common stock at less than (or with a conversion price per share less than) the current market price as of the date of issuance. Equity restructuring — Recapitalization through a large, nonrecurring cash dividend.	Down round — The issuance of common shares at a price lower than the conversion price in effect immediately before such issuance. Recurring cash dividends — Recurring quarterly cash dividends to all common shareholders. Tender offer or exchange offer — Distributions of cash or other consideration in respect of a tender offer or exchange offer for the issuer’s common stock such that the cash and the value of any such other consideration per share validly tendered or exchanged exceeds the closing sale price per share of the issuer’s common stock.

Standard

Nonstandard

Stock dividend — The issuance of shares of common stock as a dividend or distribution to all common stockholders.
Stock split — A subdivision of shares of common stock.
Reverse stock split — A combination of outstanding shares of common stock.
Spinoff — The dividend or other distribution to all holders of common stock, evidence of indebtedness, or assets on a pro rata basis.
Rights offering — The dividend distribution or other issuance to all holders of common stock on a pro rata basis of rights or warrants entitling them to purchase shares of common stock or securities convertible into common stock at less than (or with a conversion price per share less than) the current market price as of the date of issuance.
Equity restructuring — Recapitalization through a large, nonrecurring cash dividend.

Down round — The issuance of common shares at a price lower than the conversion price in effect immediately before such issuance.
Recurring cash dividends — Recurring quarterly cash dividends to all common shareholders.
Tender offer or exchange offer — Distributions of cash or other consideration in respect of a tender offer or exchange offer for the issuer’s common stock such that the cash and the value of any such other consideration per share validly tendered or exchanged exceeds the closing sale price per share of the issuer’s common stock.

An adjustment that occurs upon the company’s tender or exchange offer to acquire common stock does not meet the definition of an equity restructuring because such offers are reciprocal (i.e., shareholders tender common shares in exchange for consideration). Accordingly, a conversion ratio adjustment triggered by a tender or exchange offer does not represent a standard antidilution provision, and it may represent a contingent BCF that must be evaluated if the contingency is resolved.

Furthermore, a down-round protection provision that reduces the conversion price if new equity shares are issued at a price below the conversion price (or issues new warrants or convertible instruments with a lower exercise price) is not a standard antidilution provision since it gives the holder a benefit that is not available to the other holders of the issuer’s equity shares. As a result, the issuer may be required to recognize the down-round protection provision as a contingent BCF if the provision is triggered (see Section 7.5.3.2.1).

7.5.2 Recognition

ASC 470-20

25-20 Changes to the conversion terms that would be triggered by future events not controlled by the issuer shall be accounted for as contingent conversion options, and the intrinsic value of such conversion options shall not be recognized until and unless the triggering event occurs. The term recognized is used to mean that the calculated intrinsic value is recorded in equity with a corresponding discount to the convertible instrument.

35-3 A contingent beneficial conversion feature in an instrument having the characteristics in the preceding paragraph shall not be recognized in earnings until the contingency is resolved.

55-16 If the amortized amount of discount on the convertible instrument resulting from the initial measurement of the intrinsic value of the conversion option before the adjustment exceeds the remeasured intrinsic value of the conversion option after the adjustment, the excess amortization charge should not be reversed. Any unamortized amount of that original discount amount that exceeds the amount necessary for the total discount (amortized and unamortized) to be equal to the intrinsic value of the adjusted conversion option should be reversed through a debit to paid-in capital (as an adjustment to the intrinsic value measurement of the conversion option). The adjusted unamortized discount, if any, should be amortized using the interest method pursuant to the recommended guidance in this Subtopic.

Although there is no accounting recognition for a contingent BCF upon the issuance of a convertible debt instrument, an issuer should monitor whether the recognition of a contingent BCF is required when a contingent conversion feature is triggered or the conversion price is adjusted in accordance with the instrument’s contractual terms.

If the intrinsic value of a conversion feature is remeasured because of a conversion price adjustment, an entity is not permitted to reverse any previous amortization of a discount that resulted from the recognition of a BCF in the instrument. For example, the entity cannot reverse prior amortizations even if the amount that has already been amortized exceeds the remeasured intrinsic value of the conversion feature. Further, the amount of the remaining unamortized discount is adjusted on the basis of the relationship between the amount previously amortized and the remeasured intrinsic value:

If the amount already amortized in connection with a previously recognized BCF as of the date the conversion price is adjusted exceeds the remeasured intrinsic value of the conversion feature, any remaining unamortized amount of the original discount related to the BCF is reversed through a debit to paid-in capital (Dr: APIC (BCF); Cr: Discount). In this circumstance, no further amortization related to the remeasured intrinsic value is required since the adjusted unamortized discount associated with the BCF is zero.
If the remeasured intrinsic value exceeds the amount that has already been amortized in connection with the previously recognized BCF, the entity adjusts the remaining unamortized discount to equal the difference between (1) the remeasured intrinsic value and (2) the amount that has already been amortized. An increase in the discount is recognized by crediting APIC (Dr: Discount; Cr: APIC (BCF)), and a decrease is recognized by debiting APIC (Dr: APIC (BCF); Cr: Discount). The adjusted unamortized discount is then amortized by using the interest method (see Section 7.4).

Example 7-17

Recognition of Contingent BCF

A convertible debt instrument is issued at its principal amount for cash proceeds of $1 million. The instrument contains a contingent BCF that has an intrinsic value of $200,000 as of the commitment date.

The journal entry on the date of issuance is as follows:

Entry on the date the contingent BCF is triggered:

Example 7-18

Contingent BCF if IPO Occurs

A convertible debt instrument contains a conversion option that is only exercisable if there is an IPO. The determination of whether a BCF exists is based on the market price of the underlying shares on the instrument’s commitment date rather than on the date of the IPO. However, any BCF that arises as a result of the IPO is recognized only when an IPO occurs.

7.5.2.1 Illustration — Recognition of Contingent BCF

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: . . .

d. Instrument contains a fixed percentage conversion feature dependent on a future event (Case D). . . .

Case D: Instrument Containing a Fixed Percentage Conversion Feature Dependent on a Future Event

55-44 This Case illustrates the guidance in paragraphs 470-20-35-2 through 35-3.

55-45 This Case has the following assumptions:

$1,000,000 of convertible debt with a redemption date on the fifth anniversary of issuance
Convertible upon an initial public offering
Convertible at 80 percent of stock price at commitment date (that is, $40)
Fair value of common stock at commitment date equals $50 per share.

55-46 The calculation is as follows. Image cannot be displayed

55-47 The instrument is not convertible at the commitment date, however it will become convertible and that conversion feature will be beneficial if an initial public offering is completed. The intrinsic value of the beneficial conversion feature is calculated at the commitment date using the stock price as of that date, that is, $250,000. However, that amount would only be recorded at the date an initial public offering is completed. If 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.

55-48 Entry at issuance. Image cannot be displayed

7.5.3 Measurement

ASC 470-20

25-6 A contingent beneficial conversion feature shall be measured using the commitment date stock price (see paragraphs 470-20-30-9 through 30-12) but, as discussed in paragraph 470-20-35-3, shall not be recognized in earnings until the contingency is resolved.

As discussed in Section 7.3.2.2.2, the intrinsic value of a conversion feature for which the conversion price is not fixed is measured on the basis of a comparison of (1) the most favorable conversion price available to the holder on the conversion date if there were no changes in circumstances except for the passage of time and (2) the commitment-date stock price. Therefore, if there is a change in circumstances such that the conversion terms are adjusted, the entity remeasures the conversion feature’s intrinsic value to reflect the most favorable conversion price that would be available under the new circumstances provided that those circumstances would not change other than for the passage of time. For instance, if the conversion price is adjusted on the basis of the issuer’s most recently reported earnings as of the conversion date, the intrinsic value is recomputed on the basis of the effective conversion price that would apply on the reporting date. However, the stock price that is used to remeasure the intrinsic value is the original commitment-date stock price (see Section 7.3.2.3) rather than the stock price on (1) the date the intrinsic value is remeasured, (2) the reporting date, or (3) the conversion date.

The method used to remeasure a feature’s intrinsic value depends on whether the number of shares the holder would receive upon conversion (if the contingency were to be met) is known on the instrument’s commitment date. In other words, because the number of shares that will be received upon conversion is mathematically related to the effective conversion price (i.e., the amount of proceeds allocated to the instrument at inception divided by the number of shares that will be received upon conversion), the measurement of a contingent BCF depends on whether the amount by which the effective conversion price would adjust (if the contingency was met) is known at inception.

For a discussion of how to compute the revised intrinsic value if the number of incremental shares is known at inception (e.g., if an IPO would reduce the conversion price by a fixed monetary amount), see Section 7.5.3.1.

For a discussion of how to compute the incremental intrinsic value if the number of incremental shares is indeterminable at inception (e.g., if the issuance of shares at a price below the original conversion price would reset the conversion price to that share price), see Section 7.5.3.2.

7.5.3.1 Fixed Number of Incremental Shares

If the number of incremental shares that will be issued upon conversion if the contingency is met is known at inception, the revised intrinsic value is determined by multiplying (1) any excess of the commitment-date fair value of each share of common stock or other securities into which the instrument is convertible (S0) over the new effective conversion price (X1) by (2) the number of shares into which the instrument is convertible under the new circumstances (n1). Algebraically, this can be expressed as follows:

Because the calculation of the new effective conversion price (X1) depends on the number of shares to be issued (n1) at that price and the amount of proceeds (P0) allocated to the instrument (i.e., X1 = P0 ÷ n1), an alternative method of determining the new intrinsic value is to calculate the excess, if any, of (1) the commitment-date fair value of the securities into which the instrument is convertible (i.e., S0 × n1) over (2) the amount of proceeds allocated to the instrument (P0). Algebraically, this can be expressed as follows:

These formulas reflect the entire revised BCF. If a BCF was previously recognized, the adjustment on the date the contingent BCF is triggered must take into account the previously recognized BCF (see Section 7.5.2).

ASC 470-20

Example 4A: Resets

55-19A This Example illustrates the guidance in paragraph 470-20-35-4.

55-20 Assume Entity A issues for $1 million a convertible debt instrument with a conversion option that allows the holder to convert the instrument at $12.50 per share for 80,000 shares of Entity A’s common stock. The fair value of the common stock is $10 at the commitment date. The debt instrument also provides that if the market price of Entity A’s common stock falls to $7 or less at any point during the conversion term, then the conversion price resets to $8.75 per share (the instrument would then become convertible into 114,286 shares).

55-21 A contingent beneficial conversion amount of $142,858 [($1 million ÷ $8.75) × ($10.00 – $8.75)] is required to be calculated at the commitment date but only recognized when and if Entity A’s stock price falls to $7 or less. The accretion of this discount would be required from the date the stock price falls to $7 or less (regardless of the fact that the conversion price resets to $8.75 per share) in accordance with this Subtopic.

An implicit assumption in Example 4A above 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 be outside the scope of the BCF guidance in ASC 470-20.

Example 4A implies that Entity A make the following entry at issuance:

If the stock price falls to $7, Entity A makes the following entry:

Example 7-19

Example 3 in ASC 470-20-55

Example 3 in ASC 470-20-55-13 through 55-17 illustrates the accounting for the remeasurement of the intrinsic value of a conversion feature that results from a conversion price adjustment. The pertinent assumptions are as follows (see Section 7.3.2.2.2.1):

Entity A “issues for $1 million a convertible instrument that is convertible 4 years after issuance at a conversion price of $10 per share.”
The “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.”

An implicit 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 even though it would not qualify as equity under ASC 815-40 (see Section 7.3.2.2.2).

Initially, the intrinsic value of the conversion feature is determined on the basis of (1) the conversion price that would apply if no IPO occurs (i.e., $7), because that is the price that applies if there were no change in circumstances after the issuance date other than the passage of time, and (2) the commitment-date stock price (i.e., $10). Accordingly, the initial intrinsic value of the conversion feature is $428,571, which is calculated as ($1 million ÷ $7) × ($10 – $7).

The entry on the date of issuance is as follows:

ASC 470-20

55-17 For example, assume in this Case that Entity A had an amortized discount of $85,714 and the remaining unamortized discount was $342,857 at the time it completed an initial public offering for a per-share price of more than $13. Entity A would remeasure the intrinsic value of the conversion option based on the adjusted conversion price of $10 per share and determine that there is no intrinsic value of the adjusted conversion option because the adjusted conversion price equals the fair value of the common stock at the initial commitment date. Entity A would reverse the entire $342,857 of remaining unamortized discount (credit) with an offsetting entry (debit) to additional paid-in capital. The $85,714 of discount previously amortized is not reversed.

The guidance in ASC 470-20-55-17 implies that the entity made the following cumulative entries between the date of issuance and the date the intrinsic value was remeasured (if the convertible instrument was a debt instrument):

The conversion feature is no longer beneficial after the conversion price adjustment because the adjusted conversion price ($10) equals the commitment-date stock price ($10). Accordingly, the entity reverses the remaining unamortized discount (see Section 7.5.2):

7.5.3.2 Indeterminable Number of Incremental Shares

ASC 470-20

35-1 If the terms of a contingent conversion option do not permit an issuer to compute the number of shares that the holder would receive if the contingent event occurs and the conversion price is adjusted, an issuer shall wait until the contingent event occurs and then compute the resulting number of shares that would be received pursuant to the new conversion price. The number of shares that would be received upon conversion based on the adjusted conversion price would then be compared with the number that would have been received before the occurrence of the contingent event. The excess number of shares multiplied by the commitment date stock price equals the incremental intrinsic value that results from the resolution of the contingency and the corresponding adjustment to the conversion price. That incremental amount shall be recognized when the triggering event occurs. Example 5 (see paragraph 470-20-55-22) illustrates the application of this guidance.

Sometimes, the terms of a conversion feature do not permit the issuer to calculate the number of shares the holder would receive upon conversion before the occurrence of the contingent event (e.g., if the conversion price is down-round protected). In this case, the issuer computes the number of shares that it will deliver once the event occurs (unless the conversion feature represents a share-settled redemption feature; see Sections 2.4 and 7.2.3).

The guidance in ASC 470-20-35-1 suggests that If the triggering event occurs, the incremental intrinsic value will equal the product of (1) the commitment-date stock price (S0) and (2) the excess number of shares that would be received upon conversion on the basis of the adjusted conversion price over the number that would have been received before the contingent event occurred (n1 – n0). Algebraically, this can be expressed as follows:

However, this manner of calculating the incremental intrinsic value relies on two key assumptions: (1) the commitment-date stock price equals the conversion price before the adjustment (in a manner similar to ASC 470-20-55-23) and (2) the conversion feature is in-the-money on the basis of the adjusted conversion price.

The FASB staff has indicated that recognition of a beneficial conversion charge upon the adjustment of the conversion price is only required when the adjusted conversion price is reduced below the commitment-date fair value of the issuer’s common stock. That is, a BCF exists only to the extent that the conversion feature is in-the-money (i.e., the adjusted conversion price is lower than the commitment-date stock price).

If the conversion feature is out-of-the-money (i.e., the conversion price exceeds the commitment-date stock price) both before and after the conversion price adjustment, no beneficial conversion charge is required. However, if the conversion feature is out-of-the-money before the conversion price adjustment but becomes in-the-money afterward (i.e., the reduced conversion price is below the commitment-date stock price), the entity should perform the following steps to calculate the amount of the beneficial conversion charge:

Compute the number of incremental shares to be issued as the difference between (a) the number of shares that would be issued upon conversion on the basis of the reduced conversion price and (b) the number of shares that would have been issued upon conversion had the conversion price been equal to the commitment date stock price (i.e., not the number of shares that would have been issued on the basis of the prior conversion price).
Multiply the number of incremental shares by the commitment date stock price.

If, on the basis of the commitment-date stock price, the conversion feature is in-the-money both before and after the conversion price adjustment and the conversion price is further reduced, an additional beneficial conversion charge is required. In that circumstance, the number of incremental shares to be issued as a result of the conversion price adjustment is computed in a manner consistent with ASC 470-20-35-1 as the difference between (1) the number of shares that would be received upon conversion on the basis of the reduced conversion price and (2) the number of shares that would be received upon conversion on the basis of the conversion price before the reduction. The incremental beneficial conversion charge is again computed by multiplying the number of incremental shares by the commitment-date stock price. However, the beneficial conversion charge(s) cannot be greater than either (1) the initial proceeds received (or allocated) from issuing the convertible instrument or (2) the current carrying amount of the instrument.

Example 7-20

Conversion Price Adjustment Based on Dividends

Company S issues $1 million of convertible debt with an initial conversion price of $27 per common share as of the commitment date, at which time the fair value of S’s common shares is $25. There are no embedded derivatives that require bifurcation under ASC 815, and the convertible debt is not subject to the CCF guidance in ASC 470-20. The convertible debt indenture stipulates that if S declares a dividend on common stock greater than $1.00 per common share, the conversion price automatically adjusts downward on the basis of the following formula:

New conversion price = old conversion price – [4 × (dividend per share – $1.00)]

Because the convertible debt terms require an adjustment to reduce the conversion price upon the occurrence of a contingent event (i.e., the declaration of a dividend greater than $1.00), S should consider whether it must recognize a contingent BCF if that event occurs. However, S would recognize a BCF as of the date the contingent event occurs only if the adjusted conversion price is considered beneficial to the holder under ASC 470-20 (i.e., if the adjusted conversion price is less than the fair value of the shares as of the commitment date).

In accordance with ASC 470-20-35-1, because S cannot determine the number of shares that the convertible debt investor would receive until the occurrence of the contingent event, the value of the BCF, if any, would equal the product of (1) the number of incremental shares issuable under the adjusted conversion price and (2) the fair value of the shares as of the commitment date.

If, after the commitment date, S declares a dividend of $1.25, it would not need to recognize a BCF because the adjusted conversion price of $26, or $27 – [4 × ($1.25 – $1.00)], is greater than the commitment-date fair value of the common shares, $25.

However, if, after the commitment date, S instead declares a dividend of $1.75, it would recognize a BCF because the adjusted conversion price of $24, or $27 – [4 × ($1.75 – $1.00)], is lower than the fair value of the common shares as of the commitment date ($25). The value of the BCF is calculated in the table below:

On the basis of the calculations indicated above, S would record the BCF arising from the conversion price adjustment (to $24) as follows:

7.5.3.2.1 Down-Round Protection

ASC Master Glossary

Down Round Feature

ASC 470-20

35-4 A contingent conversion feature that will reduce (reset) the conversion price if the fair value of the underlying stock declines after the commitment date to or below a specified price is a beneficial conversion option if that specified price is below the fair value of the underlying stock at the commitment date. This is the case even if both of the following conditions exist:

The initial active conversion price is equal to or greater than the fair value of the underlying stock at the commitment date.
The contingent conversion price is greater than the then fair value of the underlying stock at the future date that triggers the adjustment to the conversion price.

A beneficial conversion amount shall be recognized for such a beneficial conversion option when the reset occurs.

35-5 Example 4A (see paragraph 470-20-55-19A) illustrates the application of this guidance.

Convertible debt instruments often contain down-round price protection provisions that entitle the holders to a reduction in the instruments’ conversion price if future convertible securities or other equity or equity-linked instruments are issued with lower prices (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). If there is a reduction in the conversion price in accordance with a down-round feature and (1) the conversion feature is not required to be accounted for as a derivative instrument in accordance with ASC 815 and (2) the instrument is not subject to the CCF guidance in ASC 470-20, the issuer should evaluate whether the recognition of a contingent BCF is necessary when a conversion price adjustment is triggered by a down-round feature. Recognition of a contingent BCF is required if the reduced effective conversion price is less than the commitment-date fair value of the issuer’s common stock.

Example 7-21

Contingent BCF for Down-Round Feature

Company ABC issues 100 units of convertible debt securities for $100 per security, resulting in total proceeds of $10,000. Each security is convertible into one share of common stock; thus, the conversion price is $100. At the time the debt is issued (the commitment date), the fair value of ABC’s common stock is $10 per share. The convertible debt contains a down-round protection provision that resets the conversion price to that of a future round of financing, if lower.

One year after the issuance of the convertible debt, ABC issues Series A convertible preferred stock for $50 per share. Each share is convertible into one share of common stock. At the time the convertible preferred stock is issued, the common stock’s fair value is $7 per share. Upon the issuance of the stock, the conversion price of the convertible debt is adjusted under the down-round protection provision to $50 so that each convertible debt security is then convertible into two shares of common stock instead of one.

The reduction in the conversion price does not result in a requirement for ABC to recognize a beneficial conversion charge because the adjusted conversion price of $50 is greater than the common stock’s fair value of $10 as of the commitment date.

Two years after the issuance of the Series A convertible preferred stock, ABC issues a second round of convertible preferred stock for $4 per share. Each share is convertible into one share of common stock. At the time the additional convertible preferred stock is issued, the common stock’s fair value is $3 per share. Upon the issuance of the additional stock, the conversion price of the convertible debt is adjusted under the down-round protection provision to $4 so that each convertible debt security is then convertible into 25 shares of common stock.

As a result of the second reduction in the conversion price, ABC must record a beneficial conversion charge because the adjusted conversion price of $4 is less than the $10 fair value of the common stock as of the commitment date. The beneficial conversion charge is calculated as follows:

In accordance with ASC 470-20-35-7, ABC would recognize the amortization of the discount in the convertible debt created by the beneficial conversion charge as an increase in interest cost.

Note that an entity would not analyze a conversion feature that economically represents a share-settled redemption feature as a contingent BCF (see Section 7.2.3). A share-settled redemption feature differs from a conversion feature with down-round protection because the latter type of conversion feature has a fair value that varies on the basis of changes in the issuer’s stock price.

Example 7-21A

Share-Settled Redemption Feature

An entity issues a debt instrument with a principal amount of $10 million that is automatically converted into the issuer’s equity shares upon an IPO. The conversion price is the lower of (1) 80 percent of the stock price in the IPO or (2) $50. Although the conversion price is reduced to the IPO price if the IPO price is less than $50, this potential adjustment is not a down-round feature that should be evaluated as a contingent BCF because the associated settlement has a monetary value equal to a fixed monetary amount ($10,000,000 ÷ 0.80 = $12,500,000). Instead, an entity should evaluate this share-settled redemption feature in a manner similar to a put or call option embedded in a debt host contract to determine whether the feature must be separated as a derivative under ASC 815-15 (see Section 2.4).

Example 7-21B

Down-Round Feature

An entity issues a 10-year convertible debt instrument with a principal amount of $10 million. The conversion price is $50. If an IPO occurs and the IPO price is less than $50, the conversion price is reduced to the IPO price. The holder is not required to convert the debt upon an IPO; it can continue to hold the debt and elect to convert it at a later date. If this conversion feature is otherwise within the scope of the BCF guidance in ASC 470-20, the potential adjustment to the conversion price upon an IPO is a down-round feature that should be evaluated as a contingent BCF. This is because the conversion feature has a monetary value that varies on the basis of the changes in the issuer’s stock price both before and after the IPO.

7.5.3.2.1.1 Illustrations — Application of Contingent BCF Guidance to Down-Round Feature

ASC 470-20

Example 5: Contingent Conversion Option Does Not Permit Calculation of Shares Received on Conversion

55-22 This Example illustrates the guidance in paragraph 470-20-35-1.

55-23 Assume Entity A issues for $1 million a convertible debt instrument that is convertible into 100,000 shares of Entity A common stock ($10 conversion price) when the fair value of the stock is $10. This instrument provides that if Entity A subsequently issues common stock at a price less than $10, the conversion price adjusts to 90 percent of that subsequent issue price.

55-24 If Entity A subsequently issues common stock at a price of $8 per share, the holder’s conversion price adjusts to $7.20 ($8 × 90%) and the holder now would receive 138,888 shares ($1 million ÷ $7.20) upon conversion, an increase of 38,888 shares from the 100,000 shares that would have been received before the occurrence of the contingent event. The incremental intrinsic value that results from triggering the contingent option is $388,888 — calculated as 38,888 shares × $10 stock price at the commitment date or, alternatively, ($1 million ÷ $7.20) × ($10 - $7.20) — and 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 accordance with this Subtopic.

Example 5 illustrates the application of the contingent BCF guidance to a down-round feature. The guidance in ASC 470-20-55-24 implies that Entity A makes the following entry when the contingent BCF is triggered:

In the calculation of intrinsic value in Example 5 in ASC 470-20-55-22 through 55-24, it is assumed that (1) the original conversion price equals the commitment-date stock price (i.e., the conversion feature was at-the-money on the commitment date) and (2) the adjusted conversion price is lower than the commitment-date stock price (i.e., the adjusted conversion feature is in-the-money on the basis of the commitment-date stock price). If, instead, the conversion feature is out-of-the-money on the commitment date (i.e., the original conversion price exceeded the commitment-date stock price) and the adjusted conversion feature is in-the-money on the basis of the commitment-date stock price, the issuer may compute the incremental number of shares as the difference between (1) the number of shares that it would have issued upon conversion had the conversion price been equal to the commitment-date stock price (i.e., not the number of shares that it would have issued on the basis of the prior conversion price) and (2) the number of shares it would issue at the adjusted conversion price. If the adjusted conversion feature is out-of-the-money on the basis of the commitment-date stock price, no incremental BCF should be recognized.

Further, an implicit assumption in Example 5 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.

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: . . .

e. Convertible instrument contains fixed terms that change based on a future event (Case E).

f. Conversion is dependent on a future event and terms are variable (Case F). . . .

Case E: Convertible Instrument Containing Fixed Terms That Change Based on a Future Event

55-49 This Case illustrates the guidance in paragraphs 470-20-35-2 through 35-3 and 470-20-35-7.

55-50 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 80 percent of stock price at commitment date (that is, $40)
Fair value of common stock at commitment date equals $50 per share and if there is an initial public offering, the conversion feature adjusts to the lesser of $30 or 80 percent of the initial public offering price.

55-51 This Case has the following assumptions:

55-52 This instrument includes a basic beneficial conversion feature that is not contingent upon the occurrence of a future event and a contingent beneficial conversion feature. Accordingly, the intrinsic value of the basic beneficial conversion feature of $250,000 is calculated at the commitment date and recorded at the issuance date. 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.

55-54 Entry at date of issuance.

55-54A The terms of the convertible debt instrument do not permit the number of shares that would be received upon conversion if an initial public offering occurs to be calculated at the commitment date.

Case F: Conversion Dependent on a Future Event and Terms Are Variable

55-55 This Case illustrates the guidance in paragraph 470-20-35-2 through 35-3.

55-56 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 80 percent of stock price at commitment date (that is, $40)
Fair value of common stock at commitment date equals $50 per share
If the stock price increases at least 15 percent one year after an initial public offering, the conversion feature adjusts to 65 percent of the fair value of the common stock 1 year after the initial public offering.

55-57 The calculation is as follows.

55-58 The amount of the beneficial conversion feature is measured using the terms of the beneficial conversion feature that are operative at issuance, that is, the 20 percent discount. The intrinsic value of that beneficial conversion feature ($250,000) is calculated at the commitment date and recorded at the issuance date. 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.

55-60 Entry at date of issuance.

55-60A The terms of the convertible debt instrument do not permit the number of shares that would be received upon conversion if an initial public offering occurs to be calculated at the commitment date.

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