6.3 Convertible Debt That May Be Settled in Cash or Common Stock

6.3.1 Background

There are four types of convertible debt instruments whose stated conversion terms require or allow the issuing entity to settle a conversion either partially or entirely in cash. These four convertible debt instrument types are as follows:6

Instrument A — Upon conversion, the issuer must satisfy the entire obligation in cash equivalent to the conversion value. The entire obligation comprises (1) the accreted value of the debt obligation plus (2) the conversion spread.
Instrument B — Upon conversion, the issuer may satisfy the entire obligation in either common stock or cash equivalent to the conversion value. The entire obligation comprises (1) the accreted value of the debt obligation plus (2) the conversion spread.
Instrument C — Upon conversion, the issuer must satisfy the accreted value of the debt obligation (the amount accrued to the benefit of the holder, excluding the conversion spread, or the principal amount of the debt) in cash and may satisfy the conversion spread in either common stock or cash.
Instrument X — Upon conversion, the issuer may satisfy the accreted value of the obligation (the amount accrued to the benefit of the holder, excluding the conversion spread, or the principal amount of the debt) in either cash or common stock and may satisfy the conversion spread in either common stock or cash (i.e., the issuer can pay any combination of cash or common stock to achieve conversion).

An issuing entity must either separate the embedded conversion option under ASC 815-15 or apply the fair value option to Instrument A (see Example 6-1). Unless the embedded conversion option must be separated under ASC 815-15, Instruments B, C, and X are accounted for in the same manner as traditional convertible debt instruments. However, the EPS accounting considerations differ for Instrument C convertible debt instruments.

The remaining discussion in Section 6.3 focuses on the considerations related to basic and diluted EPS for Instruments B, C, and X (referred to collectively as “cash convertible debt instruments”) when the issuing entity has not separated the embedded conversion option under ASC 815-15 and has not elected to apply the fair value option to such instruments. Sections 6.6.3 and 6.6.4 address considerations related to situations in which the issuing entity has separated the embedded conversion option under ASC 815-15 or has elected to apply the fair value option to such instruments.

6.3.2 Basic EPS

Provided that a cash convertible debt instrument does not represent a participating security, basic EPS is affected as a result of (1) a reduction of the numerator (i.e., net income) due to the recognition of interest expense or an adjustment to the numerator due to the recognition of a gain or loss on extinguishment7 and (2) an increase in the denominator if 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 the cash 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).

Modifications or exchanges involving cash convertible debt instruments may affect the carrying amount of the instrument and the effective interest rate used to amortize the discount between the carrying amount and principal amount of the instrument. Thus, a modification or exchange could also affect the numerator in the calculation of basic EPS. See Section 6.6.1 for a discussion of the impact of an induced conversion.

6.3.3 Diluted EPS

6.3.3.1 General

ASC 260-10

Contracts That May Be Settled in Stock or Cash

45-45 The effect of potential share settlement shall be included in the diluted EPS calculation (if the effect is more dilutive) for an otherwise cash-settleable instrument that contains a provision that requires or permits share settlement (regardless of whether the election is at the option of an entity or the holder, or the entity has a history or policy of cash settlement). An example of such a contract accounted for in accordance with this paragraph and paragraph 260-10-45-46 is a written call option that gives the holder a choice of settling in common stock or in cash. An election to share settle an instrument, for purposes of applying the guidance in this paragraph, does not include circumstances in which share settlement is contingent upon the occurrence of a specified event or circumstance (such as contingently issuable shares). In those circumstances (other than if the contingency is an entity’s own share price), the guidance on contingently issuable shares should first be applied, and, if the contingency would be considered met, then the guidance in this paragraph should be applied. Share-based payment arrangements that are payable in common stock or in cash at the election of either the entity or the grantee shall be accounted for pursuant to this paragraph and paragraph 260-10-45-46, unless the share-based payment arrangement is classified as a liability because of the requirements in paragraph 718-10-25-15 (see paragraph 260-10-45-45A for guidance for those instruments). If the payment of cash is required only upon the final liquidation of an entity, then the entity shall include the effect of potential share settlement in the diluted EPS calculation until the liquidation occurs.

45-46 A contract that is reported as an asset or liability for accounting purposes may require an adjustment to the numerator for any changes in income or loss that would result if the contract had been reported as an equity instrument for accounting purposes during the period. That adjustment is similar to the adjustments required for convertible debt in paragraph 260-10-45-40(b).

Contracts That May Be Settled in Stock or Cash

55-32 Adjustments shall be made to the numerator for contracts that are asset or liability classified, in accordance with Section 815-40-25, but for which the potential common shares are included in the denominator in accordance with the guidance in paragraph 260-10-45-45. For purposes of computing diluted EPS, the adjustments to the numerator are only permitted for instruments for which the effect on net income (the numerator) is different depending on whether the instrument is accounted for as an equity instrument or as an asset or liability (for example, those that are within the scope of Subtopics 480-10 and 815-40).

A conversion of a cash convertible debt instrument in accordance with its original conversion terms may be settled in cash, common stock, or a combination thereof. Nevertheless, diluted EPS must always be calculated on the basis of share settlement. This is the case regardless of whether the issuer or the holder of the instrument can elect the form of settlement upon a conversion.

6.3.3.1.1 Application of If-Converted Method to Cash Convertible Debt Instruments

An entity must apply the if-converted method to Instruments B, C, and X on the basis of the conversion terms that are most advantageous to the holder, as required by ASC 260-10-45-21. It is not appropriate for the entity to calculate diluted EPS on the basis that it will elect to cash-settle any portion of the cash convertible debt instruments that may be settled in cash or common stock. See Example 6-1 for an illustration of the accounting for diluted EPS for Instrument A.

The application of the if-converted method of calculating diluted EPS for Instrument C differs from that for Instruments B and X. For Instruments B and X, the numerator is adjusted to add back interest, net of tax, and the gross number of shares of common stock issuable upon conversion is added to the denominator. Because the principal amount of Instrument C must be settled in cash, the numerator is not adjusted in the calculation of diluted EPS for this instrument (see ASC 260-10-45-40(b)(1)). Rather, an entity uses the if-converted method to calculate diluted EPS by determining the number of shares needed to settle the conversion premium (i.e., the portion of the convertible debt instrument in excess of the principal amount that is settled in shares) and adding that amount to shares outstanding to calculate the denominator for diluted EPS purposes. The average market price is used to determine such dilution in accordance with ASC 260-10-45-21A. The effect would be dilutive if the average market price of the shares exceeds the conversion price. However, if the average market price of the shares was less than the conversion price, the conversion premium would be zero and there would be no dilutive effect.

See Section 4.4.3 for examples illustrating the calculations of diluted EPS for Instruments C and X.

Connecting the Dots

Although ASC 260 refers to the calculation of diluted EPS for an Instrument C convertible debt instrument under the if-converted method, this calculation is the same as that under the treasury stock method. Therefore, it is important for an entity to determine whether it is appropriate to calculate diluted EPS by using the approach that applies to an Instrument C convertible debt instrument. For example, assume that an entity issues a convertible debt instrument that becomes convertible, at the holder’s option, upon the mere passage of time (i.e., the conversion option is not contingently exercisable). Upon conversion of the instrument, the issuer must pay the principal amount in cash and may elect to settle the conversion spread in either common stock or cash. However, if the issuing entity’s common stock price exceeds 150 percent of the conversion price, the issuer has the right to call the convertible debt instrument for par (i.e., the issuer can force the holder to convert the instrument when its stock price exceeds 150 percent of the conversion price). Upon any conversion that is triggered as a result of this call option, the issuing entity has the right to settle the instrument in any combination of common stock or cash in a manner similar to how an Instrument X convertible instrument is settled. Diluted EPS for this convertible instrument should not be calculated in a manner similar to how an entity accounts for diluted EPS for an Instrument C convertible debt instrument. Because a market price trigger is ignored in the calculation of diluted EPS for a convertible debt instrument (see Section 4.4.3), the issuing entity must assume that it will obtain the right to settle any conversion entirely in shares. Therefore, the entity should account for diluted EPS in the same manner in which the if-converted method is applied to an Instrument X convertible debt instrument.

As another example, an Instrument C convertible debt instrument may be converted into an Instrument X convertible debt instrument at the option of the issuer or holder. Alternatively, an Instrument X convertible debt instrument may be converted into an Instrument C convertible debt instrument at the option of the issuer or holder. In both situations, the issuer is not required to settle the principal amount in cash; therefore, diluted EPS for these types of instruments should not be calculated in a manner similar to how an entity accounts for diluted EPS for an Instrument C convertible debt instrument.

Sections 6.6.3 and 6.6.4 discuss considerations related to situations in which an entity has issued Instrument B, C, or X and has either separated the embedded conversion option under ASC 815-15 or has applied the fair value option. See Section 4.9 for further discussion of the year-to-date calculations of diluted EPS.

Connecting the Dots

ASC 260-10-55-84 through 55-84B appear to indicate that in calculating year-to-date diluted EPS for Instrument C, an entity should use its average share price for the year. However, this approach would be inconsistent with the statement in the example that “[t]he conversion premium should be included in diluted earnings per share based on the provisions of paragraphs 260-10-45-45 through 45-46 and 260-10-55-32 through 55-36A.” These paragraphs require an entity to apply ASC 260-10-55-3, which states that in the calculation of year-to-date diluted EPS, “the number of incremental shares to be included in the denominator shall be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation.” Therefore, despite what ASC 260-10-55-84 through 55-84B appear to say, an entity should determine year-to-date diluted EPS for a convertible debt instrument that requires the issuer to pay the principal amount in cash by calculating a year-to-date average of the number of incremental shares included in each calculation of quarterly diluted EPS. Such an approach is consistent with the treasury stock method.

Footnotes

The names of the instruments are based on how they are commonly referred to in practice. For all four instruments, the “conversion spread” means (1) the number of common shares receivable on conversion according to the original conversion terms multiplied by the issuing entity’s common stock price less (2) the accreted value.

Because these items are recorded in net income, no specific adjustments should be made to the numerator in the calculation of basic EPS.

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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.