4.5 Equity-for-Debt Exchange
Entities sometimes enter into transactions involving the exchange of redeemable
securities classified in equity (or in temporary equity by SEC
registrants, as discussed in ASC 480-10-S99-3A) for mandatorily
redeemable securities classified as liabilities pursuant to ASC
480-10-25-4 (an “equity-for-debt exchange”). For example, an entity
that seeks to defer redemption of outstanding preference shares that
are currently redeemable at their holders’ option for cash may offer
those holders an exchange of existing preference shares for new
preference shares that are mandatorily redeemable at a later
date.
Assuming that the exchange is not akin to a troubled-debt restructuring, the
issuer should account for such an equity-for-debt
exchange as a reacquisition (extinguishment) of
the equity-classified securities and an issuance
of new liability-classified securities. The
redemption of the equity-classified securities
should be accounted for as a treasury stock
transaction under ASC 505, with no gain or loss
recognized in net income. The liability-classified
securities should be initially recognized and
measured at fair value in accordance with ASC
480-10-30-1. To the extent that the initial fair
value of the liability differs from the carrying
amount of the extinguished equity-classified
securities and the extinguished securities
represent preferred shares, the difference should
be deducted from or added to income available to
common stockholders in the calculation of EPS. ASC
260-10-S99-2 provides SEC registrants with
guidance on how redemptions of equity-classified
preferred securities affect the calculation of
EPS.
In some situations, entities analyze modifications or exchanges of
equity-classified redeemable securities by
analogizing to ASC 470-50 or other accounting
literature (see Section 3.2.6 of
Deloitte’s Roadmap Earnings per
Share). However, such analogies are
typically applied when the redeemable securities
both before and after the modification or exchange
are classified in equity (including temporary
equity); they do not apply to equity-for-debt
exchanges.
Example 4-9
Exchange of Preferred Securities
Company R, an SEC registrant, has 1 million outstanding shares of Series A redeemable convertible preferred stock. Company R issued the Series A stock on January 1, 20X1, at its par value of $20 per share, or $20 million in issuance proceeds. The stock is convertible into 5 million shares of R’s common stock (conversion ratio of 5:1 or $4 per share) at the option of each holder at any time and is mandatorily redeemable on June 30, 20X6.
Company R determined that the Series A stock should not be classified as a
liability under ASC 480 because redemption is
contingent on the holders’ not exercising their
conversion option. Because R is an SEC registrant,
it applied the guidance in ASC 480-10-S99-3A and
classified the preferred stock in temporary
equity. Company R also determined that the
conversion feature does not need to be bifurcated
or separately recognized as a derivative
instrument.
In June 20X6, R reached an agreement with holders on December 31, 20X5, to
exchange the 1 million shares of its Series A
stock for 4 million shares of new, Series B
nonconvertible preferred stock in a transaction
that was not akin to a troubled-debt
restructuring. Company R determines that the fair
value of the Series B stock is $21 million. The
Series B stock is not convertible into R’s common
stock but is mandatorily redeemable at par in
February 20X9. The company determines that the new
stock must be classified as a liability under ASC
480.
Company R should account for the exchange of the stock classified as temporary
equity for the stock classified as a liability as
a treasury stock repurchase of the stock
classified as temporary equity and the issuance of
new liability-classified stock measured at the
fair value of the newly issued
liability-classified stock. Below are sample
journal entries.
On January 1, 20X1, R issues the Series A preferred shares for an amount equal to their aggregate par value — $20 million.
Journal Entry — January 1, 20X1
On December 31, 20X5, R issues Series B preferred shares in exchange for the
Series A stock. The aggregate fair value of the
Series B preferred shares is $21 million, so R
recognizes a liability of $21 million. Since the
fair value of the consideration paid to repurchase
the Series A stock (i.e., the Series B preferred
stock) is $1 million more than the Series A
carrying amount, R records a debit to retained
earnings in the amount of $1 million and deducts
$1 million from net earnings in calculating EPS to
arrive at income available to common
stockholders.
Journal Entry — December 31, 20X5
Company R should reflect the $1 million
difference as an adjustment to the numerator in
the calculation of EPS in accordance with ASC
260-10-S99-2.