6.2 Traditional Convertible Debt

6.2 Convertible Debt That Must Be Settled in Common Stock

6.2.1 Background

This section discusses convertible debt instruments that have each of the following characteristics:

Upon conversion, the issuer is required to deliver common shares to the holder (i.e., neither the issuer nor the holder can elect to have any portion of a conversion settled in cash).
The holder benefits from an appreciation in the fair value of the issuing entity’s common shares from the issuance date of the instrument, and the conversion feature is substantive.
The holder is not required to convert the security into common shares.

Such convertible debt instruments are also referred to as “traditional convertible debt instruments.”

In some situations, the issuing entity is required to separate the embedded conversion option from the host debt contract under ASC 815-15. In other situations, the issuing entity accounts for the convertible debt instrument at fair value through earnings. Unless otherwise noted, this section only addresses traditional convertible debt instruments that are accounted for at amortized cost in their entirety. Sections 6.6.3 and 6.6.4 address additional considerations related to situations in which the issuing entity has separated the embedded conversion option as a derivative instrument or has elected to account for the convertible debt instrument at fair value through earnings.

6.2.2 Basic EPS

Provided that a traditional convertible debt instrument does not meet the definition of a participating security, the impact on basic EPS is attributable to (1) a reduction of the numerator (i.e., net income) resulting from the recognition of interest expense or an adjustment to the numerator resulting from the recognition of a gain or loss on extinguishment and (2) an increase in the denominator once the convertible debt instrument has been settled in exchange for common stock (i.e., an increase in the weighted-average common shares outstanding calculated from the date the security is exchanged for common stock). If a traditional convertible debt instrument meets the definition of a participating security, the entity must apply the two-class method to calculate basic EPS (see Chapter 5).

Interest expense consists of the stated interest coupon on the debt and the amortization or accretion of any discount or premium. The table below describes common types of discounts or premiums on traditional convertible debt instruments and the general accounting requirements for recognizing interest expense and settlements. This table is not intended to represent an exhaustive list of the accounting guidance applicable to the subsequent measurement or derecognition of traditional convertible debt instruments. It is only intended to describe the impact that traditional convertible debt instruments commonly have on the numerator in the calculation of basic EPS. In this table, it is assumed that the conversion feature was substantive as of the issuance date.

Table 6-1

Character	Description	Accounting Treatment1
Original issue discount or premium	A traditional convertible debt instrument may have an original issue discount or premium related to (1) an issuance for proceeds that differ from the principal amount, (2) an allocation of proceeds between the convertible debt instrument and other financial instruments, or (3) the recognition of the convertible debt instrument at fair value as a result of a modification or exchange involving the instrument that is accounted for as an extinguishment under ASC 470-50. Note that in this table, it is assumed that the embedded conversion option has not been bifurcated from the convertible debt instrument. See Section 12.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt for discussion of the accounting for a conversion of a convertible debt instrument with a bifurcated conversion option. See Section 3.2.6.5 for discussion of when an embedded conversion option is reclassified from a derivative liability to a component of stockholders’ equity.	The discount or premium is amortized to interest expense over the term of the debt in accordance with the interest method, as specified in ASC 835-30-35-2. Discounts on debt instruments that are puttable upon the passage of time at the option of the holder are amortized to the first put date. Any unamortized discount or premium remaining as of the date on which a traditional convertible debt instrument is converted into common stock in accordance with its original conversion terms is subsumed into the carrying amount of the common stock in accordance with ASC 470-20-40-4, with no gain or loss recognized in earnings. If a traditional convertible debt instrument is extinguished before maturity for cash or other assets, any unamortized discount or premium remaining on the date of extinguishment is recognized in earnings as an extinguishment gain or loss in accordance with ASC 470-50-40-2.
Discount arising from a separately recognized equity component related to a modification or exchange involving the embedded conversion option that is not accounted for as an extinguishment	Under ASC 470-50-40-15, an entity must recognize an increase in the fair value of an embedded conversion option resulting from a modification or exchange that is not accounted for as an extinguishment as a reduction of the carrying amount of the debt instrument (an increase in a debt discount or a reduction of a debt premium), with a corresponding increase in APIC.	The discount or premium on a traditional convertible debt instrument after the recognition of the increased fair value of the embedded conversion option is amortized to interest expense over the term of the debt in accordance with the interest method, as specified in ASC 835-30-35-2. Discounts on debt instruments that are puttable upon the passage of time at the option of the holder are amortized to the first put date. The Codification does not specifically address the accounting for any unamortized discount remaining as of the date on which a traditional convertible debt instrument is converted into common stock in accordance with its original conversion terms. Given the similarities with the guidance in ASC 815-15-40-1,2 an entity should recognize any unamortized discount remaining on the date of conversion immediately as interest expense. The Codification does not specifically address the accounting for traditional convertible debt instruments that are extinguished before maturity for cash or other assets. Given the similarities with the guidance in ASC 815-15- 40-4,3 an entity should allocate an amount of the reacquisition price to the repurchased equity component. Generally, this amount would equal the value that was previously recognized for that separate equity component. The remaining reacquisition price should be allocated to the debt to determine the amount of gain or loss on extinguishment.

See Section 6.6.1 for a discussion of the impact of an induced conversion.

6.2.3 Diluted EPS

Provided that a traditional convertible debt instrument does not represent a participating security, the if-converted method4 is used to reflect the impact of the embedded conversion option on diluted EPS. Under the if-converted method, an entity must adjust both the numerator and denominator. Since an entity using the if-converted method assumes that a convertible debt instrument was converted into common shares at the beginning of the reporting period (or the date of issuance, if later), the numerator is adjusted to reverse any recognized interest expense (including any amortization of discounts discussed in Table 6-1), net of tax.5 The common shares issuable upon conversion are added to the denominator on the basis of the most favorable conversion terms available to the holder. Except in the case of certain contingently convertible debt instruments, the if-converted method, if dilutive, must be applied even if the embedded conversion option is out-of-the-money. See Section 4.4 for further discussion of the if-converted method. Section 4.9.3 discusses the application of the if-converted method to year-to-date calculations of diluted EPS.

Footnotes

No specific adjustments are made to the numerator in the calculation of basic EPS, since interest expense is recognized in net income.

ASC 815-15-40-1 addresses the accounting upon conversion of a convertible debt instrument that contains a discount as a result of a prior reclassification of the embedded conversion option from a derivative liability to stockholders’ equity.

ASC 815-15-40-4 addresses the accounting upon redemption of a convertible debt instrument that contains a discount as a result of a prior reclassification of the embedded conversion option from a derivative liability to stockholders’ equity.

If a traditional convertible debt instrument meets the definition of a participating security, the issuing entity must apply the more dilutive of the if-converted method or the two-class method to calculate diluted EPS. See Section 5.5.4 for more information.

An entity should not adjust the numerator to add the amount of interest expense that would have been accelerated into earnings as of the conversion date for a traditional convertible debt instrument that contains a separately recognized equity component.

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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.