When a reporting entity concludes that a conversion option should not be separated from its host debt instrument under ASC 815
, it should further evaluate whether the convertible debt was issued with a substantial premium. The Codification does not define substantial premium. Some may consider a premium equal to or greater than 10% of the par value of the host debt instrument to be substantial. However, a 10% premium is not a bright line; all relevant facts and circumstances should be considered to determine whether the premium is substantial. For example, if the premium is less than 10%, but the amortization of the premium would result in negative interest expense, the premium may still be considered substantial.
If a reporting entity concludes the convertible debt instrument was issued at a substantial premium, there is a presumption that the premium represents paid-in capital. In these cases, the convertible debt is reported by recording a liability at its principal or par amounts, and the excess proceeds are reported as additional paid-in capital.
addresses a reporting entity’s accounting upon issuance of a convertible debt instrument at a substantial premium.
If a convertible debt instrument is issued at a substantial premium, there is a presumption that such premium represents paid-in capital.
The portion of the proceeds of the convertible debt issuance classified as additional paid-in capital should not be subsequently remeasured. While there is no explicit guidance related to the conversion accounting for convertible debt issued at a substantial premium, we believe the guidance in ASC 470-20-40-4
should be applied, and no gain or loss should be recognized upon conversion. See FG 6.8
for further information on conversion accounting. There is also no explicit guidance related to the extinguishment of convertible debt issued at a substantial premium. We believe that when convertible debt issued at a substantial premium is extinguished (i.e., settled in a manner other than converting pursuant to its terms, but not an induced conversion), that the fair value of the consideration transferred should first be allocated to additional paid in capital based on the amount originally recorded in additional paid in capital, with the remaining consideration allocated to the reacquisition of the debt. The measurement of the gain or loss on the extinguishment of the debt should be calculated in accordance with ASC 470-50-40-2
. See FG 3.7
Example FG 6-2 illustrates how to account for the extinguishment of a convertible debt instrument with a substantial premium at issuance.
EXAMPLE FG 6-2
Extinguishment of convertible debt with a substantial premium at issuance
FG Corp issues convertible debt on January 1, 20X1 with a par amount of $1,000, an annual coupon rate of 3% and a maturity date of December 31, 20x5. The conversion feature is exercisable at any time and must be fully settled in shares (par value of $1 per share). The conversion feature is not required to be bifurcated pursuant to ASC 815
, and there are no other embedded features in the convertible debt. The conversion price is $10, and FG Corp received proceeds of $1,150 in cash.
FG Corp applies the substantial premium model to the convertible debt and recorded the following entries on January 1, 20x1:
Cr. Additional paid-in capital
On December 31, 20X3, FG Corp redeems the convertible debt by paying $1,200 in cash to the convertible debt holder.
How should FG Corp account for the extinguishment?
As the original conversion terms required share settlement in full, and the extinguishment was completed entirely in cash, induced conversion accounting would not apply since the settlement does not include the issuance of all equity securities pursuant to original terms.
FG Corp would apply extinguishment accounting under ASC 470-50-40-2
after allocating consideration paid to the amount initially recorded in APIC.
To account for the extinguishment, FG Corp would first allocate the consideration paid ($1,200) to the substantial premium originally recorded in APIC ($150). The remaining consideration would be attributed to the extinguishment of the debt. Consistent with the guidance in ASC 470-50-40-2
, any difference between the reacquisition price of the debt and the net carrying amount of the debt would be recognized in income. The remaining consideration of $1,050 would be compared to the carrying value of the recorded liability ($1,000) resulting in the recognition of a $50 extinguishment loss. The following entry would be recorded:
Dr. Convertible debt liability
Dr. Debt extinguishment loss
Convertible debt instruments that are separated into a debt and equity component in accordance with the guidance in ASC 470-20-25-13
are not eligible for the fair value option under ASC 825
, based on the guidance in ASC 825-10-15-5(f)
. ASC 825-10-15-5(f)
precludes application of the fair value option to financial instruments that are, in whole or in part, classified in equity by a reporting entity.