Chapter 10 — Equity Transactions and Disclosures

10.7 Conversions

10.7.1 General

When a debt instrument is converted into an equity instrument (i.e., common stock or preferred stock), or when preferred stock is converted into common stock, the transaction could be subject to any of the following:

Conversion accounting.
Induced conversion accounting.
Extinguishment accounting.
Troubled debt restructuring accounting.

The sections below discuss conversion accounting, induced conversion accounting, and extinguishment accounting. For a discussion of the accounting for troubled debt restructurings, see Chapter 11 of Deloitte’s Roadmap Issuer’s Accounting for Debt.

10.7.2 Conversion Accounting

ASC 470-20

Contractual Conversion

40-4 If a convertible debt instrument accounted for in its entirety as a liability under paragraph 470-20-25-12 is converted into shares, cash (or other assets), or any combination of shares and cash (or other assets), in accordance with the conversion privileges provided in the terms of the instrument, upon conversion the carrying amount of the convertible debt instrument, including any unamortized premium, discount, or issuance costs, shall be reduced by, if any, the cash (or other assets) transferred and then shall be recognized in the capital accounts to reflect the shares issued and no gain or loss is recognized.

When a debt or preferred security is converted into common shares in accordance with its original contractual terms, no gain or loss is recognized upon conversion. This treatment is referred to in practice as “conversion accounting.” If the debt or preferred security is converted only into common shares and there was no separately recognized equity component for the instrument that was converted, the common shares issued are initially recognized at an amount equal to the net carrying amount of the instrument that was converted. However, as described in the table below, special considerations apply in certain situations.

Table 10-7

Situation	Accounting Considerations
Convertible instrument settled wholly or partially in cash	For certain convertible debt instruments, the issuing entity is allowed or required to settle a conversion wholly or partially in cash. When conversion accounting applies, the entity does not recognize any gain or loss upon conversion. However, the amounts recognized to the capital accounts for the common shares issued must be reduced to reflect cash paid upon conversion. Note that an entity’s election to settle the conversion of a debt instrument partially or entirely in cash often requires the entity to bifurcate the conversion feature. For more information about the accounting in this situation, see Section 12.3.2 of Deloitte’s Roadmap Issuer’s Accounting for Debt.
Convertible instrument issued at a substantial premium	When a convertible instrument is issued at a substantial premium, the premium is initially recognized in equity. Therefore, the total amount recognized in the capital accounts used to recognize the common shares issued upon conversion of the instrument will include the initial amount recognized in equity for this premium. For more information, see Section 7.6.3 of Deloitte’s Roadmap Issuer’s Accounting for Debt.
Convertible instrument contains a separately recognized equity component (other than one arising from a substantial premium)	A convertible instrument may contain a separately recognized equity component in either of the following circumstances: The conversion option was previously reclassified from a derivative liability to equity. The convertible instrument was modified or exchanged in a transaction that did not result in extinguishment but in which the fair value of the embedded conversion option increased. In these circumstances, before the common shares issued upon conversion are recognized, the following must be performed: For convertible debt instruments, the discount recognized as a result of the separate equity component must be immediately amortized to expense, with an offsetting increase to the carrying amount of the instrument. The adjusted net carrying amount of the instrument and the separate equity component must then be removed, and the capital accounts increased, to reflect the common shares issued, with no gain or loss recognized. See also Section 12.5 of Deloitte’s Roadmap Issuer’s Accounting for Debt. For convertible preferred stock instruments, the discount recognized as a result of the separate equity component must be immediately recognized as a dividend, with an offsetting increase to the carrying amount of the instrument. Then the adjusted net carrying amount of the instrument and the separate equity component must be removed, and the capital accounts increased, to reflect the common shares issued, with no gain or loss recognized. See also Section 3.2.2.5.4.2 of Deloitte’s Roadmap Earnings per Share.
Convertible debt instrument was recognized at fair value through earnings	If a convertible debt instrument was previously accounted for at fair value, with changes in fair value recorded in earnings in accordance with the fair value option in ASC 825, the net carrying amount of the instrument on the date of conversion, along with any amount previously recognized in other comprehensive income for the instrument, should be removed, with an offsetting entry to the capital accounts to reflect the common shares issued.
Convertible instrument contains a bifurcated embedded conversion feature	There is no specific guidance in U.S. GAAP on the treatment of a conversion of a convertible instrument that contained a bifurcated conversion option that was accounted for under ASC 815-15. Therefore, in practice, multiple accounting approaches are acceptable. For more information, see Section 3.2.2.5.4.1 of Deloitte’s Roadmap Earnings per Share.

10.7.3 Induced Conversion Accounting

Some instruments are converted into common shares as a result of changes in conversion privileges or because additional consideration is paid to holders to induce prompt conversion of the instrument into equity. In these situations, entities must evaluate whether to account for the settlement of the convertible instrument as an induced conversion or an extinguishment.

When induced conversion accounting applies to the conversion of a convertible debt or preferred stock instrument into common stock, the issuing entity must first account for the inducement and then apply conversion accounting. Therefore, assuming that none of the situations in Table 10-7 apply, the entity would initially recognize common shares issued as (1) the net carrying amount of the convertible instrument plus (2) the inducement charge recognized less (3) the fair value of any inducement consideration provided other than common shares (e.g., cash or warrants). If the inducement is related to the conversion of a debt instrument, the inducement charge is recognized in earnings. If the inducement is related to the conversion of a preferred stock instrument, the inducement charge is generally recognized as a dividend.

For more information about the application of induced conversion accounting, see Section 12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt and Section 3.2.2.6.3 of Deloitte’s Roadmap Earnings per Share.

10.7.4 Extinguishment Accounting

ASC 470-50

Extinguishments of Debt

40-2 A difference between the reacquisition price of debt and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. If upon extinguishment of debt the parties also exchange unstated (or stated) rights or privileges, the portion of the consideration exchanged allocable to such unstated (or stated) rights or privileges shall be given appropriate accounting recognition. Moreover, extinguishment transactions between related entities may be in essence capital transactions.

40-2A In an early extinguishment of debt for which the fair value option has been elected in accordance with Subtopic 815-15 on embedded derivatives or Subtopic 825-10 on financial instruments, the net carrying amount of the extinguished debt shall be equal to its fair value at the reacquisition date. In accordance with paragraph 825-10-45-6, upon extinguishment an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive income for the extinguished debt that resulted from changes in instrument-specific credit risk.

40-3 In an early extinguishment of debt through exchange for common or preferred stock, the reacquisition price of the extinguished debt shall be determined by the value of the common or preferred stock issued or the value of the debt — whichever is more clearly evident.

An entity may settle an outstanding liability by issuing its own equity instruments (e.g., common or preferred shares). Unless conversion (or induced conversion) accounting applies, these types of settlements are accounted for as extinguishments. Examples in which extinguishment accounting is applied to settlements of liabilities that are exchanged for equity instruments include the following:

Debt that is converted into common stock upon the issuer’s exercise of a call option in a convertible debt instrument that did not contain a substantive conversion feature as of its issuance date (see Section 12.3.3 of Deloitte’s Roadmap Issuer’s Accounting for Debt).
Issuances of equity shares to repay a share-settled debt instrument in accordance with its contractual terms (see Section 6.3 as well as Section 8.4.7.2.5 of Deloitte’s Roadmap Issuer’s Accounting for Debt).
Conversions of convertible instruments that are in accordance with terms that differ from the contractual conversion privileges and that do not meet the conditions to be accounted for as induced conversions.

When a liability is extinguished in exchange for equity instruments, the entity recognizes the equity instruments issued in the appropriate capital accounts at their issuance-date fair value.15 With one exception, a gain or loss on extinguishment is recognized for the difference between the fair value of the equity instruments issued and the net carrying amount of the liability that is extinguished.16

Footnotes

In certain circumstances, it may also be appropriate to recognize direct costs of issuance (see Section 10.2.2.2) as a reduction of equity.

As discussed in Section 6.3, for certain share-settled debt arrangements in which the fair value option is not elected, the shares issued are recognized at an amount equal to the net carrying amount of the instrument that is settled and no gain or loss on extinguishment is recorded.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.