Chapter 6 — Convertible Debt
Chapter 6 — Convertible Debt
6.1 Background
This chapter, which supplements the discussion in Chapters 3 and 4, addresses considerations related to basic
and diluted EPS that apply to convertible debt instruments, including those with
embedded put and call options. In this chapter, it is assumed that the debt
instrument was not issued in a share-based payment arrangement.
As discussed in Section 4.4.1, ASC 260-10-20 defines a convertible security as “[a] security that is convertible into another security based on a conversion rate.” By definition, a convertible security may be converted into common shares or other securities of the issuer. This chapter only discusses convertible securities classified as liabilities that are convertible into the issuer’s common shares (also referred to as “convertible debt instruments”).
Convertible debt instruments that are discussed in this chapter include:
-
Convertible debt that must be settled in common stock (Section 6.2).
-
Convertible debt that may be settled in cash or common stock (Section 6.3).
-
Mandatorily convertible debt (Section 6.4).
-
Stock-settled debt (Section 6.5).
Other considerations that may be relevant to convertible debt instruments are discussed in Section 6.6. See also Section 4.4.3 for the implications related to diluted EPS when a debt instrument is only contingently convertible.
For a comprehensive discussion of the issuer’s accounting for convertible debt
instruments, see Section
7.6 of Deloitte’s Roadmap Issuer’s Accounting for 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
1
No specific adjustments are made
to the numerator in the calculation of basic EPS,
since interest expense is recognized in net
income.
2
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.
3
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.
4
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.
5
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.
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.
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
6
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.
7
Because these items are recorded in net income, no specific adjustments
should be made to the numerator in the calculation of basic EPS.
6.4 Mandatorily Convertible Debt
6.4.1 Background
An entity may issue a debt instrument that is mandatorily convertible into common stock. The conversion may occur on a fixed maturity date or upon the occurrence of an event that is certain to occur. Although the instrument will be converted into common stock, it is still classified as a liability instrument.
6.4.2 Basic EPS
Although conversion into common shares will occur upon the mere passage of time, the common shares issuable upon conversion should not be included in the denominator in the calculation of basic EPS. If the convertible debt instrument is a participating security, the two-class method should be applied to calculate basic EPS (see Chapter 5). If the two-class method is not applied, no adjustments should be made to the numerator or denominator (i.e., the impact on basic EPS will result from the reduction in net income for interest expense recognized on the instrument). It is inappropriate to apply the if-converted method to calculate basic EPS.
6.4.3 Diluted EPS
An entity should apply the if-converted method to determine the dilutive effect
of a debt instrument that is mandatorily convertible into common shares (or the
more dilutive of the if-converted or the two-class method of calculating diluted
EPS if the instrument is a participating security). In applying the if-converted
method, an entity should calculate the dilutive impact on the basis of the
conversion terms that are most advantageous to the holder, as required by ASC
260-10-45-21. Furthermore, an entity must assume conversion into shares even if
the entity or holder could elect to have the instrument partially or fully
settled in cash.
6.5 Stock-Settled Debt
A financial instrument issued in the form of debt or equity that embodies an
unconditional obligation that the issuing entity must settle by issuing a variable
number of common shares equal to a fixed monetary amount must be classified as a
liability under ASC 480-10-25-14 and is often referred to as “stock-settled debt.”
Although a stock-settled debt instrument does not provide the holder with any
potential “upside” from increases in the issuing entity’s common stock, it meets the
definition of a convertible security; therefore, the if-converted method of
calculating diluted EPS must be applied to such an instrument. In applying the
if-converted method, an entity should include in the denominator the number of
common shares that would be issuable to settle the instrument on the basis of the
conversion terms that are most advantageous to the holder, as required by ASC
260-10-45-21.
If the issuing entity or the holder has the option of settling such a debt
instrument in either cash or a variable number of
common shares of an equivalent value, the issuing
entity must also apply the if-converted method,
because an entity cannot overcome the presumption
of share settlement. See Example
4-13 for an illustration of
stock-settled debt.
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.