6.6 Other Considerations

6.6.1 Induced Conversions of Convertible Debt

6.6.1.1 Basic EPS

ASC 470-20-40 contains specific guidance on recognizing an induced conversion of a convertible debt instrument. Under this guidance, an entity must recognize a loss equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of the consideration issuable in accordance with the original conversion terms. In recognizing an inducement, an entity will not be required to adjust the calculation of basic EPS because the loss on inducement will already be reflected in the numerator. For additional discussion of induced conversion accounting, see Section 12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt.

6.6.1.2 Diluted EPS

In the calculation of diluted EPS under the if-converted method, a recognized inducement loss should be added back to the numerator. By analogy to the guidance in ASC 260-10-S99-2, when an SEC registrant effects an induced conversion of only a portion of a class of outstanding convertible debt instruments, the entity should, in determining whether the if-converted method is dilutive for a financial reporting period, consider the convertible debt instruments converted in accordance with an inducement offer separately from other convertible debt instruments of the same class that are not converted under such an offer.

Connecting the Dots

When convertible debt instruments are converted during a financial reporting period in accordance with an inducement offer, an entity that is using the if-converted method assumes that the instruments were converted at the beginning of the reporting period, or on the date of issuance if later, on the basis of the stated conversion terms. Because the numerator adjustment will reflect a reversal of the additional consideration provided under the inducement offer, the application of the if-converted method during a period in which an induced conversion has occurred will typically be antidilutive for the convertible debt instruments that were converted under such an offer.

In the calculation of diluted EPS for an Instrument C convertible debt instrument, any recognized inducement loss should not be added back to (reversed from) the numerator.

6.6.2 Nonsubstantive Conversion Options

ASC 470-20-40-5 addresses the accounting for an issuance of common shares “to settle a debt instrument (pursuant to the instrument’s original conversion terms) that became convertible [only upon the issuing entity’s] exercise of a call option.” According to this guidance, the issuing entity must evaluate whether the debt instrument contained a substantive conversion feature as of its issuance date. If the debt instrument did not contain a substantive conversion feature as of its issuance date, any settlement through the issuance of common stock should not be treated as a conversion for accounting purposes but should be accounted for as a debt extinguishment, with a gain or loss recognized in earnings (i.e., the fair value of the common shares issued would equal the reacquisition price that is compared with the carrying amount to determine the gain or loss on extinguishment).

Although it is not common for debt instruments to contain nonsubstantive embedded conversion features, if such a feature exists and it can be exercised by the holder only if the issuing entity exercises an option to call the debt before its maturity, the entity is not required to apply the if-converted method to calculate diluted EPS in all financial reporting periods. Rather, since the entity controls the ability to avoid issuing common shares by virtue of its right not to exercise the call option, the entity should, in considering the implications related to diluted EPS, if any, take into account the fact that it controls exercise of the call option. If, however, the holder of a debt instrument has the right to exercise a conversion feature that is considered nonsubstantive as of the issuance date, the entity should evaluate the conversion feature as an embedded put option. The same accounting would apply if the conversion feature only became substantive after the issuance date. In both circumstances, the put option is treated in the same manner as stock-settled debt and the if-converted method applies, as discussed in Section 6.5.

6.6.3 Embedded Conversion Option Is Separated Under ASC 815-15

An entity may be required to separate the embedded conversion option in a convertible debt instrument under ASC 815-15 and account for the embedded conversion option at fair value through earnings. Separately accounting for the embedded conversion option as a derivative liability does not obviate the need to include the dilutive effect of the instrument under ASC 260 by using the if-converted method unless the issuing entity is always required to settle a conversion entirely in cash (see Example 6-1 below). When the embedded conversion option is accounted for as a derivative liability, with changes in fair value recognized in earnings, in addition to other adjustments to the numerator (e.g., to add back interest expense), the mark-to-market adjustment recognized in earnings during the financial reporting period must be reversed and treated as an adjustment to the numerator in accordance with ASC 260-10-55-36A, provided that an entity determines that the combined effect of the numerator and denominator adjustments is dilutive after considering the antidilution sequencing requirements of ASC 260. When the if-converted method is not dilutive, an entity does not adjust the numerator or denominator in calculating diluted EPS.

Example 6-1

Implications Related to Diluted EPS for Instrument A

Company D issued convertible debt in the form of Instrument A. Upon conversion, D must satisfy the entire obligation in cash equivalent to the conversion value; therefore, D has separated the embedded conversion option as a derivative under ASC 815-15.

The if-converted method does not apply because settlement of the convertible debt instrument will not result in the issuance of any common stock. For Instrument A, no adjustments are required in the calculation of diluted EPS because the embedded conversion option does not meet the definition of potential common stock in ASC 260-10-20. Therefore, the numerator should not be adjusted for either (1) the mark-to-market adjustment recognized in earnings as a result of changes in the fair value of the embedded conversion option or (2) any interest expense recognized in earnings. Further, there is no incremental impact on the denominator in the calculation of diluted EPS. The same conclusion would apply if D had elected the fair value 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.

6.6.4 Convertible Debt Instrument Recognized at Fair Value

ASC 825 allows an entity to elect, on initial recognition, the fair value option for convertible debt instruments that do not contain any component that must be classified in stockholders’ equity (see ASC 825-10-15-5(f)). Entities may elect the fair value option in lieu of separating an embedded conversion option that would otherwise need to be accounted for separately under ASC 815-15.

Accounting for a convertible debt instrument at fair value does not obviate the need to include the dilutive effect of the instrument under ASC 260 by using the if-converted method unless the issuing entity is always required to settle a conversion entirely in cash (see Example 6-1). When a convertible debt instrument is accounted for at fair value, the mark-to-market adjustment recognized in earnings during the financial reporting period must be reversed and treated as an adjustment to the numerator in accordance with ASC 260-10-55-36A, provided that an entity determines that the combined effect of the numerator and denominator adjustments is dilutive after considering the antidilution sequencing requirements of ASC 260. When the if-converted method is not dilutive, an entity does not adjust the numerator or denominator in calculating diluted EPS.

Connecting the Dots

ASC 825-10-45-5 requires entities to “present separately in other comprehensive income the portion of the total change in the fair value” of a financial liability that is recognized at fair value through earnings that results from the change in instrument-specific credit risk. Since the credit component does not enter into the determination of net income, it should be excluded from any adjustment made to the numerator in the calculation of diluted EPS. This credit component would only be included in the adjustment to the numerator if the entity presented comprehensive income per share.

6.6.5 Put and Call Options Embedded in Debt Instruments

6.6.5.1 Background

Convertible debt instruments may contain contractual terms that allow the holder or issuing entity to require early redemption at a fixed or determinable amount. An entity must analyze such embedded put and call options under ASC 815-15 to determine whether they must be separated from the host debt contract and accounted for as a derivative instrument. If such embedded put and call options can or must be settled in common shares, the entity must also consider the implications related to diluted EPS. While this chapter focuses on convertible debt instruments, the sections below include discussion of redemption features in nonconvertible debt instruments.

6.6.5.2 Embedded Put Options

The table below summarizes considerations related to calculating diluted EPS for a nonconvertible debt instrument that contains an embedded put option that allows the counterparty to redeem the debt at a fixed or determinable amount either as of the reporting date or upon the mere passage of time. If the embedded put option is contingently exercisable by the counterparty, the entity should apply the guidance in this table if the embedded put option is or would be exercisable, provided that the conditions as of the reporting date remain unchanged in accordance with the contingently issuable share method of calculating diluted EPS (see Section 4.5). The accounting implications for convertible debt instruments that contain an embedded put option are discussed below this table.

Table 6-3

Form of Consideration on Settlement(a)	Party That Elects Settlement Form	Accounting Classification of Embedded Put Option	Assumed Settlement for EPS Purposes	Accounting for Diluted EPS
Cash	N/A	Not separated from host contract	Cash	No adjustment(b)
Common stock	N/A	Not separated from host contract	Shares	If-converted method(c)
Cash or common stock	Issuing entity	Not separated from host contract	Shares	If-converted method(c)
Cash or common stock	Holder	Not separated from host contract	Shares	If-converted method(c)
Cash	N/A	Separated as embedded derivative	Cash	No adjustment(b)
Common stock	N/A	Separated as embedded derivative	Shares	If-converted method(d)
Cash or common stock	Issuing entity	Separated as embedded derivative	Shares	If-converted method(d)
Cash or common stock	Holder	Separated as embedded derivative	Shares	If-converted method(d)
Notes to Table: (a) It is assumed that the monetary amount paid on settlement is the same, regardless of whether the settlement is in cash or common stock. (b) The embedded put option does not meet the definition of potential common stock in ASC 260-10-20. (c) Application of the if-converted method is consistent with the diluted EPS accounting for stock-settled debt (see Section 6.5). (d) In applying the if-converted method, an entity must adjust the numerator to remove the mark-to-market effect on net income during the financial reporting period from recognizing the embedded derivative at fair value, since no fair value amount would have been recognized if the put option had been settled at the beginning of the financial reporting period (or the date of issuance, if later).

ASC 260-10-45-21 must be considered for debt instruments that contain an embedded put option and a substantive embedded conversion option. ASC 260-10-45-21 states that diluted EPS “shall be based on the most advantageous conversion rate or exercise price from the standpoint of the security holder.” If a convertible debt instrument contains a substantive embedded conversion option and an embedded put option that the issuing entity must or may settle in common shares, in each financial reporting period, the issuing entity must consider whether it is more advantageous for the security holder to elect to exercise the embedded conversion option or the embedded put option. If it is more advantageous for the security holder to exercise the embedded conversion option, the impact of the convertible instrument on diluted EPS should be determined by applying the if-converted method on the basis of the terms of the conversion feature, if dilutive. Otherwise, the impact on diluted EPS should be determined on the basis of the guidance in the table above (i.e., by applying the if-converted method to the put option). The impact on diluted EPS will generally reflect the more dilutive of the two alternatives because the number of common shares that is assumed to be issued will generally be the greater of the number of common shares issuable in accordance with the terms of the (1) put option or (2) conversion option.

In applying the more dilutive impact of settlement of a convertible debt instrument under a conversion option or a put option, an entity may also need to adjust the numerator in accordance with ASC 260-10-55-36A. This adjustment may pertain to the embedded option that is not assumed to be settled in shares for diluted EPS. For example, assume that an entity that has issued a convertible debt instrument that is not in the form of Instrument C has determined that applying the if-converted method to the embedded conversion option is more advantageous to the holder than determining dilution on the basis of an assumed settlement of the embedded put option. Furthermore, assume that the embedded conversion option has not been separated as an embedded derivative under ASC 815-15 but the embedded put option has been separated as an embedded derivative. In this case, the calculation of diluted EPS under the if-converted method would also include an adjustment to the numerator to reverse the fair value amounts that affected net income as a result of marking to market the put option derivative liability. However, the entity’s calculation of diluted EPS would include these adjustments (i.e., the numerator adjustments related to applying the if-converted method and reversing the mark-to-market impact of the embedded put option and the denominator adjustment for the potential common shares issuable under the conversion option) only if the entity finds them to be dilutive after considering the antidilution sequencing requirements of ASC 260. This requirement applies regardless of whether the put option must or may be settled in cash or shares. However, if the embedded put option allows for settlement in shares and the effect of the if-converted method on the basis of an assumed share settlement of the embedded conversion option is antidilutive, the entity should determine whether the application of the if-converted method to the put option is dilutive.

Connecting the Dots

As discussed in Section 6.3.3.1.1, the calculation of diluted EPS under the if-converted method for an Instrument C convertible debt instrument is akin to the treasury stock method. Therefore, if a cash-settled embedded put option is separated as an embedded derivative, the numerator should not be adjusted to reverse the income statement effect of accounting for the embedded put option as a derivative liability, because the embedded put option pertains to the extinguishment of the host debt instrument and would be cash-settled. That is, ASC 260 prohibits an entity from making this adjustment to the numerator when applying the if-converted method to an Instrument C convertible debt instrument.

6.6.5.3 Embedded Call Options

Embedded call options that allow the issuing entity to redeem nonconvertible or convertible debt instruments that are not separated as embedded derivative instruments under ASC 815-15 will generally have no incremental impact on the calculation of diluted EPS. Regardless of whether an embedded call option, when exercised, may or must be settled in common shares, the call option generally does not affect the calculation of diluted EPS because it does not meet the definition of potential common stock in ASC 260-10-20. As defined, potential common stock represents “[a] security or other contract that may entitle its holder to obtain common stock during the reporting period or after the end of the reporting period.” An embedded call option does not entitle its holder, which is the issuing entity, to obtain common stock.

If, however, an entity has separated an embedded call option as a derivative instrument under ASC 815-15 and is applying the if-converted method to calculate diluted EPS, it must adjust the numerator to reverse the mark-to-market impact related to separating this embedded derivative liability if an entity determines that the combined effect of the numerator and denominator adjustments under the if-converted method is dilutive after considering the antidilution sequencing requirements of ASC 260. However, no such adjustment should be made to the numerator if the if-converted method is applied to reflect the dilution of the embedded conversion option in an Instrument C convertible debt instrument, since the embedded call option pertains to the extinguishment of the host debt instrument.

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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.