7.6 Derecognition
7.6.1 Conversions
ASC 470-20
40-1 For instruments with beneficial conversion features all of the unamortized discount remaining at the date
of conversion shall be recognized immediately at that date as interest expense or as a dividend, as appropriate,
including both of the following amounts:
- The discount originated by the beneficial conversion option accounting under paragraph 470-20-25-5
- The discount from an allocation of proceeds under this Subtopic to other separable instruments included in the transaction.
40-2 If a convertible debt instrument containing an embedded beneficial conversion feature is converted, and
the amount of discount amortized exceeds the amount the holder realized because conversion occurred at an
earlier date, no adjustment shall be made to amounts previously amortized.
If a convertible debt instrument with a separated BCF is converted in accordance
with its original conversion terms, all of the remaining unamortized discount
(both the discount from the allocation of proceeds to other separable
instruments included in the transaction and the discount originated by the BCF)
as of the conversion date is recognized immediately on that date. (This is
different from the treatment of any unamortized discount on traditional
convertible debt, which is credited to equity; see Section 4.5.2.) For a convertible debt
instrument, the amount is recognized as interest expense (Dr: Interest expense;
Cr: Debt discount).
If conversion occurs under the original terms of the debt, the adjusted carrying amount (i.e., the previous net carrying amount adjusted for the remaining unamortized discount as of the conversion date) is credited to equity to reflect the shares issued. If the conversion represents an induced conversion as described in ASC 470-20-40-13 (see Section 4.5.4), the issuer also recognizes an inducement expense (or dividend) equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of the securities issuable in accordance with the original conversion terms. In this circumstance, the sum of the adjusted carrying amount and the inducement expense would be credited to equity to reflect the shares issued.
This accounting does not apply to any of the following:
- A conversion that represents a TDR (see Section 4.5.7).
- A conversion upon the issuer’s exercise of a call option if the feature was not substantive at issuance. Although a noncontingent BCF generally would be considered substantive at issuance, the issuer should evaluate a contingent BCF to determine whether it was nonsubstantive (see Section 4.5.3). If the conversion feature was nonsubstantive at issuance and conversion occurs upon the issuer’s exercise of a call option, the issuer should apply extinguishment accounting (see Section 7.6.2).
- A settlement of debt that uses a variable number of the issuer’s equity shares equal in value to the amount of the debt.
- A conversion that occurs in accordance with the terms of a share-settled redemption feature (see Section 2.4).
- An exchange of debt into the shares of a third party (see Section 2.7).
See Appendix B for a discussion of the accounting upon conversion for situations in which the conversion feature was separated as a derivative instrument under ASC 815-15 and conversion occurs in accordance with the original terms.
7.6.2 Extinguishments
For a discussion of the circumstances in which a conversion or exchange of convertible debt for the issuer’s equity shares should be accounted for as an extinguishment, see Section 4.5.5. Below is a discussion of the accounting for an extinguishment of convertible debt that contains a separated BCF.
ASC 470-20
40-3 If a convertible debt instrument containing an embedded beneficial conversion feature is extinguished before conversion, the amount of the reacquisition price to be allocated to the repurchased beneficial conversion feature shall be measured using the intrinsic value of that conversion feature at the extinguishment date. The residual amount, if any, would be allocated to the convertible security. Thus, the issuer shall record a gain or loss on extinguishment of the convertible debt security. For guidance on classification of any gain or loss from extinguishment, see Section 470-50-45.
EITF Issue 00-27 (Nonauthoritative Text)
Issue 12 — If a convertible
instrument that included a beneficial conversion
option . . . is extinguished prior to its stated
maturity date, how [the BCF guidance] should be
applied to the reacquisition of the embedded
conversion option.
Issue 12(a) — Whether it is
appropriate to allocate a portion of the
reacquisition price to the conversion option based
on the intrinsic value of that option at the
extinguishment date if no separate accounting for
the conversion option under [the BCF guidance] has
occurred.
34. The Task Force reached a tentative
conclusion that no portion of the reacquisition price
should be allocated to the conversion option if that
option had no intrinsic value required to be accounted
for under [the BCF guidance].
Issue 12(b) — How the requirement to
allocate a portion of the reacquisition price to the
beneficial conversion option for convertible debt
should be applied if the intrinsic value of that
option at the date of extinguishment is greater than
the originally measured intrinsic value.
35. The Task Force reached a tentative
conclusion that [the BCF guidance] does not provide for
a different measurement of the amount of the
reacquisition price that is allocated to the
reacquisition of the conversion option if the intrinsic
value of the conversion option is greater at the
extinguishment date than the amount measured at the
commitment date. In other words, the amount of the
reacquisition price allocated to the conversion option
is always calculated based on the option’s intrinsic
value at the extinguishment date, which could result in
a reduction in additional paid-in capital that exceeds
the amount recorded in additional paid-in capital for
the beneficial conversion option when the instrument was
issued. . . .
If a convertible debt instrument with a recognized BCF is extinguished instead of being converted, a
portion of the consideration paid by the issuer to reacquire the instrument is allocated to the BCF; that
is, a portion of the reacquisition price is treated as a repurchase of the BCF. Unless ASC 470-20-30-8
applies (see below), the amount allocated to the BCF is the intrinsic value of the conversion feature
on the extinguishment date, which is computed by multiplying (1) any excess of the conversion-date
fair value of the common stock or other securities into which the instrument is convertible over the
effective conversion price by (2) the number of shares into which the instrument is convertible (see
Section 7.3.2). The resulting amount is debited to APIC, with no gain or loss recognized. (ASC 260-10-
S99-2 does not apply to the settlement of the equity component for a convertible debt instrument that
permits conversion into the issuer’s common stock.) The residual amount of the consideration paid is
allocated to the reacquisition of the debt instrument; the difference between this amount and the net
carrying amount is the debt extinguishment gain or loss.
Example 7-22
Reacquisition of Convertible Debt With a BCF
Issuer A buys back outstanding convertible debt that has a current net carrying amount of $95 for $100 in
cash. At issuance, the issuer recognized a BCF of $2 related to the debt. However, the intrinsic value of the
conversion feature computed on the basis of the current share price is $7. Issuer A records the following
journal entry upon the reacquisition of the debt:
In a manner consistent with the EITF’s tentative conclusions on Issue 12 of EITF Issue 00-27, this guidance (1) is appropriate to apply even if the
extinguishment-date intrinsic value exceeds the commitment-date intrinsic value
and (2) is not applied if the instrument did not contain a recognized BCF as of
the conversion date. Accordingly, upon the extinguishment of a convertible debt
instrument that contained a contingent BCF that had not been triggered as of the
extinguishment date, no portion of the amount of consideration paid would be
allocated to the reacquisition of the contingent BCF. However, if the BCF’s
intrinsic value exceeds the portion of the proceeds allocated to the convertible
instrument upon initial recognition, the amount of the reacquisition price that
should be allocated to the intrinsic value would be limited by the amount
initially assigned to the BCF in accordance with ASC 470-20-30-8. In addition,
the BCF’s extinguishment-date intrinsic value cannot exceed the total proceeds
related to the extinguishment.
Apart from the allocation of a portion of the reacquisition price to the BCF, a debt extinguishment gain or loss on a convertible debt that contains a BCF is determined in a manner consistent with the approach for traditional convertible debt (see Section 4.5.5).
7.6.2.1 Illustration — Extinguishment of Convertible Debt With a 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: . . .
g. Extinguishment of convertible debt that includes a beneficial conversion feature (Case G).
Case G: Extinguishment of Convertible Debt That Includes a Beneficial Conversion Feature
55-61 This Case illustrates the guidance in paragraph 470-20-40-3.
55-62 Both of the following conditions exist at the commitment date:
- Proceeds for sale of zero coupon convertible debt are $100.
- Intrinsic value of beneficial conversion feature is $90.
55-63 At the commitment date, the issuer records $90 as discount on the debt with the offsetting entry to additional paid-in-capital. The remainder ($10) is recorded as debt and is accreted to its full face value of $100 over the period from the issuance date until the stated redemption date of the instrument (3 years). The debt is subsequently extinguished one year after issuance.
55-64 All of the following conditions exist at the extinguishment date:
- The reacquisition price is $150.
- The intrinsic value of the beneficial conversion feature at the extinguishment date is $80.
- The carrying value of debt is $22.
The net carrying value of the debt one year after issuance is calculated using the effective interest method to amortize the debt discount over three years.
55-65 At the date of extinguishment, the extinguishment proceeds should first be allocated to the beneficial conversion feature ($80). The remainder ($70) is allocated to the extinguishment of the convertible security.
55-66 Entry to record the extinguishment.
7.6.3 Modifications and Exchanges
ASC 470-50
40-16 The issuer shall not recognize a beneficial conversion feature or reassess an existing beneficial
conversion feature upon a modification or exchange of convertible debt instruments in a transaction that is not
accounted for as an extinguishment.
If a convertible debt instrument is modified or exchanged for another instrument, the issuer applies
ASC 470-50 to determine whether the modification or exchange should be accounted for as a
modification or extinguishment of the original instrument (see Section 4.5.6) unless it is a TDR that
should be evaluated under ASC 470-60 (see Section 4.5.7).
ASC 470-50 does not explicitly address whether and, if so, how the separation
of a BCF affects an issuer’s assessment of whether the terms of a convertible
debt instrument that has been modified or exchanged are substantially different
from the terms of the original instrument. It is reasonable for an entity
applying the 10 percent cash flow test in ASC 470-50-40-10 to discount the cash
flows by using an original effective interest rate that reflects the separation
of a BCF (i.e., the discount rate is the effective interest rate of the original
debt instrument after separation of the BCF; see Section 7.4). In the determination of
whether the change in an embedded conversion option’s fair value is at least 10
percent of the original debt instrument’s carrying amount immediately before the
modification or exchange, it is acceptable to add back to the carrying amount
any discount created by a BCF since the purpose is to assess the significance of
the change in fair value relative to the instrument as a whole. In other words,
this test is performed as if the convertible debt instrument had never been
separated into component parts (i.e., it requires the use of a pro forma net
carrying amount of the convertible debt instrument as if separation had not
occurred).
If the exchange or modification is accounted for as an extinguishment because the new terms are
substantially different from those of the original instrument, a portion of the consideration paid by
the issuer (including the fair value of the new debt instrument) is allocated to the BCF before the
extinguishment gain or loss is computed. The amount allocated to the BCF is the intrinsic value of the
conversion feature on the extinguishment date (see Section 7.6.2).
If the exchange or modification is accounted for as a modification under ASC 470-50 because the new
terms are not substantially different from those of the original instrument, the issuer is precluded
from recognizing a new BCF or reassessing an existing BCF. Instead, the issuer applies the guidance in
ASC 470-50-40-14 and 40-15 to account for a change in the fair value of the conversion feature.
7.6.4 Reclassifications
ASC 470-20
35-8 This guidance applies to convertible instruments in which the beneficial conversion feature terminates after a specified time period.
35-9 If a convertible instrument is in the form of an equity share and the shares are required to be redeemed once the conversion feature expires, the financial instrument becomes a liability under the guidance in Topic 480 upon expiration of the conversion and paragraph 480-10-30-2 requires the issuer to reclassify an instrument that becomes mandatorily redeemable as a liability, measured initially at fair value with a corresponding reduction of equity (no gain or loss is to be recognized). That may entail an adjustment to paid-in capital if, upon reclassification, the fair value of the liability differs from the carrying amount of the previously convertible instrument. That instrument would be subsequently measured under the provisions of Topic 480.
If the terms of a convertible instrument in the legal form of an outstanding
share (e.g., a convertible preferred share) contain a mandatory redemption date,
the share may have to be reclassified from equity to a liability if or when the
conversion feature expires. ASC 480-10-25-7 requires a financial instrument for
which redemption is conditional (e.g., an instrument that is mandatorily
redeemable unless the holder exercises a conversion feature) to be reclassified
as a liability if redemption becomes certain to occur (e.g., because an embedded
conversion feature has expired). Under ASC 480-10, the reclassified instrument
would initially be measured at fair value (see Deloitte’s Roadmap Distinguishing Liabilities From
Equity).
Example 7-23
Mandatorily Redeemable Convertible Preferred Stock
ASC 480-10-55-11 contains an example of mandatorily redeemable convertible preferred stock. The holder has the right to convert the preferred stock into a fixed number of shares of common stock during the first 10 years. If the holder does not exercise the conversion feature, the instrument becomes mandatorily redeemable on a stated redemption date in 30 years. Because redemption is not certain to occur during the first 10 years, the instrument is not initially required to be classified as a liability under ASC 480-10 (provided that the conversion feature is substantive). However, the share must be reclassified as a liability as of the date the conversion feature expires in 10 years because redemption becomes certain to occur at that point.
7.6.5 Bifurcation of a Conversion Option
An entity that has issued a convertible debt instrument that contained a recognized initial or contingent BCF may be required to subsequently bifurcate the embedded conversion option because of a change in facts and circumstances — for example, if the issuer undertakes an IPO of its common stock and, as a result, the embedded conversion option meets the net settlement condition. The example below illustrates the accounting in this situation.
Example 7-24
Bifurcation of Conversion Option in Convertible Debt Instrument With a BCF
XYZ Company issued a four-year $10 million par value convertible debt instrument. The embedded conversion option was not separated at issuance because XYZ was a nonpublic company and the underlying shares were not readily convertible to cash. The convertible debt instrument contained a $4 million BCF on issuance, which reflected the difference between the conversion price of $7.14 and the $10 commitment-date fair value of XYZ common stock. On the issuance date, the fair value of the conversion option was $5 million.
At the end of year 2, XYZ undertakes an IPO of its common stock (i.e., the common stock is now readily
convertible to cash) and, as a result, separates the embedded conversion option because it does not meet
the exception in ASC 815-10-15-74(a). On that date, the following amounts pertained to the convertible debt
instrument:
For simplicity, no deferred debt issuance costs, issue premiums, or discounts are considered. In addition,
straight-line amortization is assumed.
As of the date the embedded conversion option requires separation from the host
debt contract, XYZ should initially recognize a
liability for the option at its fair value in accordance
with ASC 815-15-30-2. In addition, XYZ should account
for the extinguishment of the BCF in a manner similar to
the accounting for a reacquisition of such a feature
(see Section
7.6.2). However, for the reasons discussed
below, the amount allocated to the reacquisition of the
BCF should equal its intrinsic value on the issuance
date of the convertible debt instrument. XYZ Company
records the following journal entry:
After the journal entry is recorded, the carrying amount of the host debt contract is $5 million. The total
interest expense amortized into earnings equals $7 million ($2 million amortized before the separation of
the embedded conversion option and $5 million amortized afterward). Consequently, the total amount of
amortized interest equals the total amount that would have been amortized if a BCF had not existed on the
original issuance date. The portion of the option’s separation-date fair value that is subsequently amortized
reflects the fact that the portion of the fair value that represents the issuance-date intrinsic value ($2 million)
has already been amortized. The entire balance of the previously recorded APIC for the BCF is eliminated,
which is appropriate since the embedded conversion feature continues to exist but is no longer classified in
equity.
The accounting in the above example differs from the guidance in Issue 12 of EITF Issue 00-27 because Issue 00-27 discusses a convertible debt instrument that has been extinguished and, therefore, the accounting reflects such extinguishment (including situations in which the extinguishment occurs by a debtor that pays fair value for the convertible debt instrument and the BCF). An alternative view that would allocate an amount to the elimination of the BCF equal to the conversion option’s intrinsic value on the date it is separated as an embedded derivative would result in a reduction of the host debt contract’s carrying amount of only $200,000. In such a case, the carrying amount of the host debt contract would be $7.8 million and the total amortized interest expense would equal $4.2 million ($2 million amortized before separation of the embedded option and $2.2 million amortized afterward). Under this view, the issuer would thus be allowed to recognize a smaller total amortized interest expense than would have been recognized had the BCF never existed (irrespective of whether the embedded conversion option had been separated at inception or on the date of the IPO). Therefore, this alternative view would not be appropriate.
Given XYZ’s facts and circumstances, the following alternative views would also be unacceptable:
- An accounting method based on the debt host’s hypothetical carrying amount if the conversion option had been separated on the issuance date — It is not appropriate to record the reacquisition of the BCF so that the host carrying amount on the separation date would equal the amount that would have been recorded on that date if the conversion option had been separated since inception. The application of ASC 815-15 to the separation of an embedded derivative after the issuance of the hybrid financial instrument is not intended to result in a debt host contract amount that is the same as the amount that would have existed had the derivative been separated at inception.
- Failure to account for the reacquisition of the BCF — In some fact patterns, ignoring the reacquisition of the BCF could result in a total interest amortization that exceeds the proceeds received in the transaction, which would not be appropriate under ASC 470-20 or ASC 815.
- Application of the fair value option in lieu of the separation of the embedded conversion option — Because the separation of the embedded conversion option does not require the entire hybrid financial instrument to be recognized at fair value, the election of the fair value option under ASC 825-10 is not permitted. In XYZ’s case, there were no modifications or exchanges of the convertible debt instrument that required extinguishment accounting.
The accounting described above will vary depending on the specific facts and circumstances.