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12.7A Balance sheet classification — debt with cash conversion option — before adoption of ASU 2020-06
Publication date: 31 May 2022
us Financial statement presentation guide
Upon conversion of traditional convertible debt, the lender receives common stock of the borrower, not cash. If the lender exercises its conversion option, it receives the full number of shares underlying the debt. In contrast, a convertible bond with a cash conversion feature allows the borrower to settle its obligation upon conversion, in whole or in part, in a combination of cash or stock either mandatorily or at the borrower's option. Convertible debt with cash conversion features are accounted for under the cash conversion subsections of ASC 470-20.
Excerpt from ASC 470-20-15-4 through 15-5
The guidance in the Cash Conversion Subsections applies only to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement, unless the embedded conversion option is required to be separately accounted for as a derivative instrument under Subtopic 815-15.
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The Cash Conversion Subsections do not apply to any of the following instruments:
- A convertible preferred share that is classified in equity or temporary equity.
- A convertible debt instrument that requires or permits settlement in cash (or other assets) upon conversion only in specific circumstances in which the holders of the underlying shares also would receive the same form of consideration in exchange for their shares.
- A convertible debt instrument that requires an issuer's obligation to provide consideration for a fractional share upon conversion to be settled in cash but that does not otherwise require or permit settlement in cash (or other assets) upon conversion.
ASC 470-20-45-3 indicates that the guidance in the cash conversion subsections of ASC 470-20 does not affect classification of the debt as current or noncurrent. Instead, reporting entities should consider all terms of the convertible debt instrument (including the equity component) when determining the proper classification. Therefore, regardless of the life used for amortization purposes, a borrower's determination of the classification of the liability component of the debt instrument should be based on the terms of the debt as a whole.
Some of the features in debt with a cash conversion feature may permit the lender to exercise the conversion feature at any time. They may also contain non-contingent terms that, upon conversion, require the debt principal to be settled in cash and the remaining amount to be settled in shares or cash at the borrower's option. Typically, the debt principal settlement equals the accreted value, and the remainder represents the conversion spread (i.e., the value of the stock underlying the conversion option in excess of the accreted value). When these features exist, the debt is essentially demand debt, because the lender can unilaterally choose to convert the debt at any time, and the reporting entity would be compelled to pay cash.
Therefore, the convertible debt equal to the debt principal (or accreted value) should be classified as current because of the holder's legal ability to demand payment in cash, consistent with the guidance in ASC 470-10-45-10. The fact that the conversion feature may be out-of-the-money at the balance sheet date does not change the fact that the holder may convert at any time, and the reporting entity cannot predict future stock prices that could affect the amount of cash to be paid upon conversion at some point in the next 12 months (or current operating cycle). Therefore, we believe that the entire recorded amount of the debt should be classified as current, unless the reporting entity satisfies the requirements in ASC 470-10-45-14 regarding the ability and intent to refinance the debt on a long-term basis.
With respect to contingently convertible debt securities with a cash settlement feature, if the contingency has been met as of the balance sheet date, the instruments would require current classification if the holder has the right to demand payment of the principal amount in cash once the contingent event occurs. If the contingency has not been met at the balance sheet date but is met prior to financial statement issuance, the debt principal should continue to be classified as noncurrent debt at the balance sheet date.
Example FSP 12-8A illustrates the classification of debt when the lender has a contingent cash conversion option.
EXAMPLE FSP 12-8A
Classification of debt with a contingent cash conversion option
Classification of debt with a contingent cash conversion option
FSP Corp, a calendar year entity, issues convertible debt that is within the scope of the cash conversion subsections of ASC 470-20. The instrument has a stated life of 10 years, but allows the lender to put it back to the borrower at the end of 5 years. In addition, the instrument also allows the lender to convert the instrument for 90 days after a specific market price trigger is exceeded. If not converted within the 90-day period, it will cease to be convertible, unless the market price contingency is met at the end of the 90 days, after which a new three month conversion period will apply. If the lender chooses to convert, the principal amount will be settled in cash and the conversion spread will be settled in cash or shares (at FSP Corp’s discretion).
FSP Corp determines the expected life of the debt component is 5 years. Accordingly, FSP Corp will amortize the debt issuance costs allocated to the debt component over 5 years using the interest method.
At March 31 of the second year, the market price trigger is met, which allows (but does not require) the lender to convert the debt until June 30. The lender decides not to convert the debt by June 30, and on June 30 the market price trigger is not met. Therefore, the debt ceases to be convertible by the lender on June 30.
What are the classification considerations for FSP Corp on March 31 and June 30 of the second year?
Analysis
Even though the debt is no longer convertible at the lender's option, the debt is effectively demand debt during the reporting period ended March 31 and would require current classification at March 31. At June 30, FSP Corp should reclassify the debt to noncurrent, as the lender no longer has the right to convert the debt.
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