6.3 Initial Accounting

6.3.1 Separation of Liability and Equity Components

ASC 470-20

25-22 The liability and equity components of a convertible debt instrument within the scope of the Cash Conversion Subsections shall be accounted for separately. Recognition of a convertible debt instrument within the scope of the Cash Conversion Subsections is not addressed by paragraph 470-20-25-12.

25-23 The issuer of a convertible debt instrument within the scope of the Cash Conversion Subsections shall do both of the following:

First, determine the carrying amount of the liability component in accordance with the guidance in paragraph 470-20-30-27.
Second, determine the carrying amount of the equity component represented by the embedded conversion option in accordance with the guidance in paragraph 470-20-30-28.

The issuer of a convertible debt instrument within the scope of the CCF guidance in ASC 470-20 is required to (1) separate the instrument into liability and equity components and (2) allocate the issuance proceeds and transaction costs that are attributable to the instrument between the two components. In a manner consistent with the illustrative example in ASC 470-20-55-75, the equity component is presented within equity as APIC.

To measure the components, the issuer uses a “liability-first” allocation approach as follows:

Determine the carrying amount of the liability component (before the allocation of any transaction costs) on the basis of the fair value of a hypothetical nonconvertible debt instrument (see Section 6.3.2).
Determine the carrying amount of the equity component (before allocation of any transaction costs) by using a residual approach — that is, allocate to the equity component the amount of the instrument’s issuance proceeds that remain after allocation to the liability component (see Section 6.3.3).
Allocate qualifying transaction costs between the liability and equity components in proportion to the allocation of proceeds between each component in steps 1 and 2 (see Section 6.3.4).

If an outstanding convertible debt instrument that is not within the scope of the CCF guidance is modified so that it becomes subject to it, the CCF guidance is applied prospectively (see Section 6.5.3.4). If an outstanding debt instrument with a CCF was not within the scope of the CCF guidance because the conversion feature was required to be bifurcated as a derivative instrument under ASC 815-15 and the instrument subsequently becomes subject to the CCF guidance because the conversion feature no longer requires bifurcation under ASC 815-15, the issuer should reclassify the current carrying amount (fair value) of the conversion feature to equity and continue to amortize any debt discount (see ASC 470-20-35-20 and ASC 815-15-35-4 as well as Section 6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

6.3.2 Initial Measurement of the Liability Component

6.3.2.1 Hypothetical Nonconvertible Debt

ASC 470-20

30-27 The carrying amount of the liability component shall be determined for purposes of paragraph 470-20-25-23 by measuring the fair value of a similar liability (including any embedded features other than the conversion option) that does not have an associated equity component.

When allocating issuance proceeds between the liability and equity components of convertible debt under the CCF guidance in ASC 470-20, the issuer measures the initial carrying amount of the liability component as the fair value of a hypothetical nonconvertible debt instrument — that is, a comparable liability without an equity component, adjusted for any transaction costs that are allocable to the liability component (see Section 6.3.4). Such a hypothetical nonconvertible debt instrument has terms and features that exactly match those of the actual convertible debt instrument issued except for (1) the conversion feature (i.e., the equity component) and (2) any features that are nonsubstantive at issuance. For instance, the hypothetical nonconvertible debt has the same coupon rate as the convertible debt instrument. Other than the equity conversion feature, the terms of the hypothetical nonconvertible debt include all substantive terms and features of the actual convertible debt (such as any substantive embedded put or call options) embedded in the instrument irrespective of whether they must be bifurcated under ASC 815-15.

The terms of some convertible debt instruments contain exercise contingencies, such as provisions that permit the conversion feature to be exercised if (1) the underlying stock trades above a specified price (e.g., 130 percent of par), (2) the convertible debt trades for an amount below its if-converted value (e.g., 98 percent of its if-converted value), or (3) a fundamental change (e.g., a change of control) occurs. An exercise contingency that solely affects the exercisability of the conversion option should be analyzed as part of the equity conversion feature. Therefore, such a feature would not be part of the terms of the hypothetical nonconvertible debt instrument that is used to measure the liability component’s fair value.

6.3.2.2 Nonsubstantive Features

ASC 470-20

30-29 An embedded feature that is determined to be nonsubstantive at the issuance date shall not affect the initial measurement of the liability component.

Determining Whether an Embedded Feature Is Nonsubstantive

30-30 Solely for purposes of applying the initial measurement guidance in paragraphs 470-20-30-27 through 30-28 and the subsequent measurement guidance in paragraph 470-20-35-15, an embedded feature other than the conversion option (including an embedded prepayment option) shall be considered nonsubstantive if, at issuance, the entity concludes that it is probable that the embedded feature will not be exercised. That evaluation shall be performed in the context of the convertible debt instrument in its entirety.

The terms of the hypothetical nonconvertible debt used to measure the liability component’s fair value exclude any feature of the actual convertible debt instrument (e.g., an embedded prepayment, call, or put option) that is considered nonsubstantive as of the issuance date. The determination of whether a feature is nonsubstantive is based on an evaluation as of the issuance date of the likelihood that the feature will not be exercised. To make this assessment, the entity considers all the terms of the actual convertible debt instrument, including the embedded conversion feature, rather than the terms of the hypothetical nonconvertible debt. A feature is nonsubstantive if it is probable, at issuance, that it will not be exercised.

Example 6-6

Put Feature

A convertible debt security has a maturity date that is 20 years from the issuance date and an embedded put feature that is exercisable at par three months after the issuance date. The issuer concludes that, as of the issuance date, it is probable that the put feature will not be exercised. Accordingly, the terms of the hypothetical nonconvertible debt do not incorporate the put feature and it is ignored in the fair value measurement of the liability component.

The guidance on nonsubstantive features in ASC 470-20 does not exempt such features from the requirement in ASC 815-15 to evaluate whether they must be bifurcated as embedded derivatives (see Section 2.3). Thus, an embedded feature in a convertible debt instrument subject to the CCF guidance in ASC 470-20 may have to be bifurcated as an embedded derivative under ASC 815-15 even if it is considered nonsubstantive under ASC 470-20. Further, the issuer would separate the embedded feature from the liability component of the convertible debt even though it would determine the fair value of that component without taking into account the feature under ASC 470-20.

A provision of a convertible debt instrument within the scope of the CCF guidance in ASC 470-20 might allow the holder to require the issuer’s repayment of the debt if a change in control occurs. If it is determined that a change-in-control provision is substantive, the entity should consider the provision in its initial measurement of the liability component’s fair value and its assessment of the hypothetical nonconvertible debt’s expected life for use in the amortization of any debt discount and issuance costs. A change-in-control provision would be considered nonsubstantive if, as of the issuance date, it was probable that a change-in-control event would not occur or, for other reasons, it was probable that the feature would not be exercised. In determining whether the change-in-control provision is nonsubstantive, an entity should assess the convertible debt instrument in its entirety and consider all relevant terms and provisions (i.e., including the conversion option). The original determination of whether the change-in-control event is likely to occur should not be reassessed unless the terms of the debt agreement are modified.

6.3.2.3 Fair Value Measurement

ASC 470-20

55-73 . . . Depending on the terms of the instrument (for example, if the instrument contains prepayment features other than the embedded conversion option) and the availability of inputs to valuation techniques, it may be appropriate to determine the fair value of the liability component using an expected present value technique (an income approach)[,] a valuation technique based on prices and other relevant information generated by market transactions involving comparable liabilities (a market approach) or both an income approach and a market approach.

In measuring the fair value of the liability component on the basis of the terms of hypothetical nonconvertible debt, an entity applies the fair value measurement guidance in ASC 820-10. Under that guidance, the measurement objective is “to estimate the price at which an orderly transaction to . . . transfer the liability would take place between market participants at the measurement date under current market conditions.” As stated in ASC 820-10-35-16AA, to meet this objective, the issuer should “maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” Depending on the terms of the hypothetical nonconvertible debt and the availability of inputs, either an income approach (e.g., the present value of the cash flows of the nonconvertible debt over its expected life discounted by using the issuer’s nonconvertible debt borrowing rate) or a market approach (e.g., using quoted prices for similar nonconvertible debt held by other parties as assets) or both may be appropriate.

6.3.2.4 Application of an Income Approach

ASC 470-20

35-15 Embedded features that are determined to be nonsubstantive at the issuance date shall not affect the expected life of the liability component. Paragraph 470-20-30-30 provides guidance on assessing whether an embedded feature other than the conversion option (including an embedded prepayment option) shall be considered nonsubstantive at issuance for purposes of this paragraph.

If the issuer initially measures the fair value of the hypothetical nonconvertible debt by using an income approach, its estimate of fair value reflects the contractual cash flows through the expected life of the hypothetical nonconvertible debt discounted by using the issuer’s nonconvertible debt borrowing rate.

6.3.2.4.1 Estimating Expected Life

Because the initial and subsequent measurements of the liability component are based on the fair value of a similar liability that does not have an associated equity component (ASC 470-20-30-27 and ASC 470-20-35-13), an entity disregards the conversion option and any other nonsubstantive embedded features in estimating the liability component’s expected life. This is the case even though the conversion option may affect the likelihood that other substantive features would be exercised or triggered. For example, an investor may be less likely to exercise a put option embedded in a debt instrument if its exercise would cause a loss of any intrinsic or time value associated with a conversion option embedded in the same instrument. Nevertheless, when estimating the expected life of the liability component, the issuer should assume that no conversion option exists.

The terms of some conversion options contain exercise contingencies (e.g., holders can only exercise an option if the last reported sales price of the issuer’s common stock is greater than or equal to 130 percent of the conversion price). If an exercise contingency solely affects the exercisability of the conversion option, the contingency should be considered part of the conversion option in the estimation of the hypothetical nonconvertible debt’s expected life. Accordingly, an issuer would not consider such an exercise contingency when determining the expected life of the convertible debt instrument’s liability component.

If there is a substantive put feature that holders can exercise at par before the debt’s maturity date, the expected life of the hypothetical nonconvertible debt is usually shorter than its contractual term. Such hypothetical debt has the same coupon rate as the convertible debt instrument, which typically is lower than current market rates for similar nonconvertible debt. Provided that (1) interest rates are not expected to decrease significantly and (2) no other embedded features (other than the conversion feature) are sufficiently valuable to induce the investor to continue holding the hypothetical nonconvertible debt instrument, the investor would be expected to exercise the put option at its first available opportunity because the coupon rate is below market rates. Accordingly, if hypothetical nonconvertible debt contains a substantive put feature whose exercise amount is equal to or in excess of par, the debt’s expected life usually extends only until the earliest date on which the investor can put the debt to the issuer. (This observation might not be valid, however, if the exercise amount of the put feature is less than the principal amount of the debt.) Conversely, the existence of a call or prepayment feature payable at par typically does not affect such debt’s expected life; unless there was a significant decrease in interest rates, the issuer would not call a debt instrument that was issued at a coupon rate below market rates.

If a convertible debt instrument contains substantive noncontingent mirror-image put and call options that are exercisable on the same date and at the same price, it is highly likely that either the put or call option would be exercised on that date provided that the instrument had not been previously converted. If the fair value of the liability component is below the exercise price, the holder may be likely to put the hypothetical nonconvertible debt; and if the fair value of the liability component exceeds the exercise price, the issuer may be likely to call the hypothetical nonconvertible debt. In this case, the expected life does not extend beyond the exercise date of the put and call options.

The existence of nonsubstantive features (see Section 6.3.2.2) does not affect the issuer’s estimate of the expected life. For example, a put option that is only exercisable upon a fundamental change would not affect the expected life of the liability component if the issuer, as of the issuance date, concludes that it is probable that such a fundamental change will not occur. An embedded feature is nonsubstantive if, at issuance, it is probable that it will not be exercised (see ASC 470-20-30-30).

6.3.2.4.2 Estimating Nonconvertible Debt Borrowing Rate

The nonconvertible debt borrowing rate is the interest rate the issuer would have to pay on the hypothetical nonconvertible debt. Typically, entities do not have outstanding publicly traded or recently issued nonconvertible debt with terms that are identical to those of the hypothetical instrument. Therefore, they might need to determine the market interest rate that currently could reasonably be expected for such an instrument. Two common approaches are to calculate the hypothetical nonconvertible debt’s interest rate on the basis of (1) similar outstanding debt issued by the entity or (2) similar debt issued by other similar entities.

If the entity determines that it is appropriate to consider the current market rates on its outstanding debt (e.g., term loans or lines of credit) to calculate the interest rate of the hypothetical nonconvertible debt instrument, it should consider (1) any differences between such debt and the hypothetical nonconvertible debt (e.g., call or put options, or the level of seniority) and (2) market changes (e.g., interest rate changes or changes in the entities’ credit ratings) after the issuance of such debt. If any differences exist, the entity must appropriately adjust the debt’s interest rate.

Alternatively, an entity may estimate the borrowing rate of the hypothetical debt by referring to the current market interest rates for similar debt issued by other similar entities. To be considered similar, those other entities must have, for example, comparable credit ratings and access to the market in which the entity’s own debt was issued. The entity should also consider differences in the other entities’ credit spreads and general access to debt that arise from being in different industry sectors. If any differences exist, the entity must appropriately adjust the other entities’ borrowing rate to determine the market interest rate for the hypothetical nonconvertible debt instrument.

If an entity purchases a call option on its own equity concurrently with issuing convertible debt that is within the scope of the CCF guidance, the option’s fair value may provide relevant information for determining the nonconvertible debt borrowing rate that is used under an income approach to estimate the liability component’s fair value. Paragraph B9 of FSP APB 14-1 states, in part:

[C]onvertible debt instruments issued in the United States often contain contingent interest provisions that enable the issuer to receive an income tax deduction based on its nonconvertible debt borrowing rate. Some entities purchase call options on their own stock concurrently with the issuance of convertible debt, and the two instruments are integrated for tax purposes, resulting in a tax deduction that may be similar to their nonconvertible debt borrowing rate. Consequently, many issuers of convertible debt instruments within the scope of [the CCF guidance] are obtaining some of the information that may be used to estimate the fair value of the liability component in order to adequately support deductions taken on their U.S. federal income tax returns.

6.3.3 Initial Measurement of the Equity Component

ASC 470-20

30-28 The carrying amount of the equity component represented by the embedded conversion option shall be determined for purposes of paragraph 470-20-25-23 by deducting the fair value of the liability component from the initial proceeds ascribed to the convertible debt instrument as a whole.

In the allocation of proceeds between the liability and equity components of a convertible instrument within the scope of the CCF guidance in ASC 470-20, the equity component is not measured directly but instead represents a residual amount that is determined by deducting (1) the amount allocated to the liability component from (2) the initial proceeds attributable to the convertible debt (see Section 6.3.5). As noted in paragraph B8 of FSP APB 14-1 (which quotes paragraph BC30 of IAS 32), this approach “removes the need to estimate inputs to, and apply, complex option pricing models to measure the equity component.” Further, an adjustment is made to the initial carrying amount for any transaction costs allocable to the equity component (see Section 6.3.4).

If an issuer of convertible debt purchases a call option on its own equity concurrently with the issuance of the convertible debt, the issuer cannot assume that the initial measurement of the equity component under the CCF guidance in ASC 470-20 would equal the fair value of the purchased call option. For instance, the fair value of the purchased option may differ from the amount of the proceeds allocable to the equity component because of (1) market pricing inefficiencies, (2) differences in the creditworthiness of the counterparties to the debt and the purchased call option, or (3) differences in terms or other features included in the debt and the purchased call option. Notwithstanding these differences, the call option’s fair value may be an input into the determination of the liability component’s fair value (see Section 6.3.2.4.2).

6.3.4 Transaction Costs

ASC 470-20

25-26 Transaction costs incurred with third parties other than the investor(s) and that directly relate to the issuance of convertible debt instruments within the scope of the Cash Conversion Subsections shall be allocated to the liability and equity components in accordance with the guidance in paragraph 470-20-30-31.

30-31 Transaction costs required to be allocated to the liability and equity components by paragraph 470-20-25-26 shall be allocated in proportion to the allocation of proceeds and accounted for as debt issuance costs and equity issuance costs, respectively.

Third-party costs that are directly related to the issuance of a convertible instrument within the scope of the CCF guidance are allocated to the liability and equity components in the same proportion as the proceeds allocation. Such transaction costs are limited to specific incremental costs that are directly attributable to issuing the convertible debt (see Section 3.5.3.1).

Accordingly, an issuer determines the amount of proceeds that should be allocated to the liability and equity components before allocating any transaction costs. For instance, if 80 percent of the issuance proceeds are allocated to the liability component and the remaining 20 percent to the equity component, 80 percent of the transaction costs would be allocated to the liability component and 20 percent to the equity component.

Transaction costs allocated to the liability component are accounted for as debt issuance costs in accordance with ASC 835-30. Under ASC 835-30-45-1A, such costs are reported on the balance sheet as a direct deduction from the carrying amount of the liability component rather than as a deferred charge upon issuance of the debt.

Transaction costs allocated to the equity component are recognized in APIC as equity issuance costs. Such costs are charged against the proceeds allocated to the equity component; that is, transaction costs allocated to the equity component are deducted from the amount of proceeds allocated to the equity component, and the net amount is recorded in equity.

6.3.5 Multiple-Element Transactions

ASC 470-20

25-24 If the issuance transaction for a convertible debt instrument within the scope of the Cash Conversion Subsections includes other unstated (or stated) rights or privileges in addition to the convertible debt instrument, a portion of the initial proceeds shall be attributed to those rights and privileges based on the guidance in other applicable U.S. generally accepted accounting principles (GAAP).

Sometimes, a convertible debt instrument is issued in a transaction that includes elements not attributable to the debt (e.g., other freestanding financial instruments; see Section 3.4). If the issuance of a convertible instrument within the scope of the CCF guidance in ASC 470-20 includes other rights or privileges, the issuer is required to allocate part of the initial proceeds related to those rights and privileges in a manner consistent with the guidance in ASC 835-30-25-6 before allocating proceeds and transaction costs to the liability and equity components. In these circumstances, the entity might also need to allocate a portion of the transaction costs to the other instruments or rights and privileges that are separately recognized.

6.3.6 Embedded Derivatives

ASC 815-15

55-76A The following steps specify how an issuer shall apply the guidance on accounting for embedded derivatives in this Subtopic to a convertible debt instrument within the scope of the Cash Conversion Subsections of Subtopic 470-20.

Step 1. Identify embedded features other than the embedded conversion option that must be evaluated under Subtopic 815-15.
Step 2. Apply the guidance in Subtopic 815-15 to determine whether any of the embedded features identified in Step 1 must be separately accounted for as derivative instruments. Paragraph 470-20-15-4 states that the guidance for a convertible debt instrument within the scope of the Cash Conversion Subsections of Subtopic 470-20 does not affect an issuer’s determination of whether an embedded feature shall be separately accounted for as a derivative instrument.
Step 3. Apply the guidance in paragraph 470-20-25-23 to separate the liability component (including any embedded features other than the conversion option) from the equity component.
Step 4. If one or more embedded features are required to be separately accounted for as a derivative instrument based on the analysis performed in Step 2, that embedded derivative shall be separated from the liability component in accordance with the guidance in this Subtopic. Separation of an embedded derivative from the liability component would not affect the accounting for the equity component.

If any feature other than the conversion feature is required to be bifurcated as an embedded derivative (e.g., an embedded put or call option), it is treated as part of the liability component in the separation of the liability and equity components under the CCF guidance in ASC 470-20. After separation of the liability component, the embedded derivative is bifurcated from the liability component at its fair value and has no effect on the accounting for the equity component. The portion of the amount attributable to the liability component that remains after bifurcation of the embedded derivative is allocated to the host liability component.

As indicated in ASC 470-20-15-4, the CCF guidance in ASC 470-20 does not affect the determination of whether an embedded feature should be separated and accounted for as a derivative instrument. Therefore, when evaluating whether any embedded feature other than the conversion option must be bifurcated from the convertible instrument, the issuer should not consider the separation of the equity component as having created a discount to the liability component under the CCF guidance in ASC 470-20. A discount could, however, be created from the allocation of proceeds to other separately recognized freestanding financial instruments issued in conjunction with a convertible debt instrument. For example, a discount created by the separation of an equity component under ASC 470-20 would not be treated as a discount in the evaluation of whether debt with an embedded put or call feature involves a substantial premium or discount under ASC 815-15-25-40 and ASC 815-15-25-42. Further, an entity would evaluate whether an embedded feature must be bifurcated under ASC 815-15 even if it is considered nonsubstantive under the CCF guidance in ASC 470-20.

6.3.7 Deferred Taxes

ASC 470-20

25-27 Recognizing convertible debt instruments within the scope of the Cash Conversion Subsections as two separate components — a debt component and an equity component — may result in a basis difference associated with the liability component that represents a temporary difference for purposes of applying Subtopic 740-10. The initial recognition of deferred taxes for the tax effect of that temporary difference shall be recorded as an adjustment to additional paid-in capital.

Depending on the applicable taxation requirements, the separation of an equity component under ASC 470-20 often causes the carrying amount of the liability component under GAAP (the book basis) to be different from the tax basis of the debt determined in accordance with ASC 740-10. In practice, such basis differences usually result in the recognition of a deferred tax liability under ASC 740-10 upon the issuance of an instrument within the scope of the CCF guidance in ASC 470-20 because the tax basis exceeds the book basis after the separation of an equity component under ASC 470-20.

Paragraph B13 of FSP APB 14-1 states, in part:

In some jurisdictions, the tax basis of a convertible debt instrument at initial recognition includes the entire amount of the proceeds received at issuance. As a result, a taxable temporary difference arises from the initial recognition of the equity component separately from the liability component. The Board decided that the initial recognition of deferred taxes for the tax effect of the temporary difference should be recorded as an adjustment to additional paid-in capital. That treatment is consistent with the [guidance on convertible debt with a beneficial conversion feature in ASC 740-10-55-51].

Example 6-7

Deferred Taxes on Debt With a CCF

A convertible debt instrument within the scope of the CCF guidance was issued for proceeds of $100. The tax basis of the debt under the applicable taxation requirements is the original issue price adjusted for any original issue discount or premium before any separation of an equity component for accounting purposes (i.e., the tax basis is $100). However, because of the application of the CCF guidance in ASC 470-20, the debt’s book basis (i.e., the carrying amount of the liability component) is $80 after separation of an equity component. If the issuer’s tax rate is 21 percent, it will recognize a deferred tax liability under ASC 740-10 of $4, or ($100 – $80) × 21%.

Because the separation of the equity component from the debt creates the basis difference in the debt, the establishment of a deferred tax liability for the basis difference results in a charge to the related components of shareholders’ equity (see ASC 740-20-45-11(c)). Thus, ASC 470-20-25-27 requires entities to record the recognition of deferred taxes as an adjustment to APIC, and the initial accounting entries are as follows:

For financial reporting purposes, interest expense in subsequent periods includes a noncash component that reflects the amortization of the debt discount created by the separation of the equity component. This noncash component of reported interest expense is not deductible for U.S. income tax purposes. As interest expense is recognized for the liability component after initial recognition, the deferred tax liability is reduced and a deferred tax benefit is recognized in earnings through the amortization of the debt discount.

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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.