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 is settled upon conversion, in whole or in part, in a combination of cash or stock either mandatorily or at the borrower’s option.

Reporting entities should consider all terms of the convertible debt instrument when determining the proper balance sheet classification. Therefore, a borrower’s determination of the classification of the debt instrument should be based on the terms of the debt as a whole.

Certain debt with a cash conversion feature permits the lender to exercise the conversion feature at any time. The debt 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, current classification is required 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 (even if it is met prior to financial statement issuance), the debt principal should be classified as noncurrent debt at the balance sheet date.

Example FSP 12-8 illustrates the classification of debt when the lender has a contingent cash conversion option.

EXAMPLE FSP 12-8
Classification of debt with a contingent cash conversion option

FSP Corp, a calendar year entity, issues convertible debt with a cash settlement feature. 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 will amortize the debt issuance costs allocated to the debt component over 5 years (i.e., the first put date) 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?