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6.8 Conversion accounting—after adoption of ASU 2020-06
Publication date: 31 Dec 2022
us Financing guide
If a convertible debt instrument (where the conversion option was not bifurcated) is converted into a reporting entity’s common or preferred stock pursuant to the terms of a conversion option in the instrument, it is not an extinguishment; the convertible debt is settled in exchange for equity and no gain or loss is recognized upon conversion. Conversely, the exchange of common or preferred stock for debt that does not contain a conversion right in its original terms or does not occur pursuant to the terms of a conversion option is an extinguishment (unless it is considered an induced conversion). Such an exchange may also be considered a troubled debt restructuring. See FG 3.3 for information on troubled debt restructurings.
ASC 470-20-40-4 provides guidance on accounting for conversions consistent with the original terms of a convertible debt instrument accounted for as a liability in its entirety.
If a convertible debt instrument accounted for in its entirety as a liability under paragraph 470-20-25-12 is converted into shares, cash (or other assets), or any combination of shares and cash (or other assets), in accordance with the conversion privileges provided in the terms of the instrument, upon conversion the carrying amount of the convertible debt instrument, including any unamortized premium, discount, or issuance costs, shall be reduced by, if any, the cash (or other assets) transferred and then shall be recognized in the capital accounts to reflect the shares issued and no gain or loss is recognized.
We believe debt issuance costs should be treated similar to debt discount or premium; therefore, we believe the carrying amount should include unamortized debt issuance costs. Interest expense should be accrued (or imputed, in the case of a zero coupon convertible debt instrument) up to the date of conversion. If the accrued interest is not paid in cash upon conversion, then it should also be included in the carrying amount of the debt upon conversion. Interest is accrued at the pre-tax amount.
Generally, conversion accounting is only appropriate when the conversion option has not been separated from the debt and accounted for as a derivative based on the guidance in ASC 815.
Example FG 6-3 illustrates conversion accounting when convertible debt is accounted for entirely as a liability and settled upon conversion entirely in shares.
EXAMPLE FG 6-3
Conversion accounting when convertible debt is accounted for entirely as a liability and settled entirely in shares
Conversion accounting when convertible debt is accounted for entirely as a liability and settled entirely in shares
FG Corp issues convertible debt that will be settled upon conversion entirely in shares, and concludes that the convertible debt should be accounted for as a liability in its entirety.
Debt issuance costs are $30 and are recorded as additional debt discount on the balance sheet.
FG Corp’s stock price is $20 at the date the convertible debt is issued. FG’s common stock has a par value of $1 per share. The debt is issued at par.
The convertible debt has the following terms:
|
|
Principal amount
|
$1,000
|
Coupon rate
|
5% paid semi-annually on June 30 and December 31
|
Years to maturity
|
5 years
|
Conversion price
|
$25
|
Two years after FG Corp issues the debt, investors exercise their conversion options. FG Corp’s stock price is $35 at the conversion date. FG Corp has amortized $11 of debt issuance costs by the conversion date; therefore, there are $19 of unamortized debt issuance costs.
This example ignores the effects of accrued interest and income taxes for simplicity.
How should FG Corp record the conversion of its convertible debt?
Analysis
To derecognize the convertible debt and unamortized debt issuance costs, and recognize the common stock issued upon conversion, FG Corp should record the following entry.
Dr. Convertible debt
|
$1,000 |
|
Cr. Deferred debt issuance costs
|
$19 |
|
Cr. Common stock – par value
|
$40 |
|
Cr. Additional paid-in capital
|
$941 |
Example FG 6-4 illustrates conversion accounting when convertible debt is accounted for entirely as a liability. Upon conversion the principal amount is settled in cash and the conversion spread in shares.
EXAMPLE FG 6-4
Conversion accounting when convertible debt is accounted for entirely as a liability with principal amount settled in cash and the remainder in shares.
Conversion accounting when convertible debt is accounted for entirely as a liability with principal amount settled in cash and the remainder in shares.
FG Corp issues convertible debt that will be settled upon conversion with the principal amount paid in cash and the conversion spread in shares. Any fractional shares will be settled in cash. FG Corp concludes that the convertible debt should be accounted for as a liability in its entirety.
Debt issuance costs are $30 and are recorded as additional debt discount on the balance sheet.
FG Corp’s stock price is $20 at the date the convertible debt is issued. FG’s common stock has a par value of $1 per share. The debt is issued at par.
The convertible debt has the following terms:
|
|
Principal amount
|
$1,000
|
Coupon rate
|
5% paid semi-annually on June 30 and December 31
|
Years to maturity
|
5 years
|
Conversion price
|
$25
|
Two years after FG Corp issues the debt, investors exercise their conversion options. FG Corp’s stock price is $35 at the conversion date. FG Corp has amortized $11 of debt issuance costs through the conversion date; therefore, there are $19 of unamortized debt issuance costs.
The shares to be issued are 11.43 ($400 conversion spread intrinsic value / $35 stock price at conversion). FG Corp will issue 11 shares and pay $15 ($35 stock price at conversion * 0.43 shares) in lieu of issuing fractional shares.
This example ignores the effects of accrued interest and income taxes for simplicity.
How should FG Corp record the conversion of its convertible debt?
Analysis
To derecognize the convertible debt and unamortized debt issuance costs, and recognize cash paid for the principal amount and fractional shares upon conversion, FG Corp should record the following entry.
Dr. Convertible debt
|
$1,000 |
|
Dr. Additional paid-in capital
|
$34 |
|
Cr. Deferred debt issuance costs
|
$19 |
|
Cr. Cash
|
$1,015 |
To recognize common stock issued upon conversion, FG Corp should record the following entry.
Dr. Additional paid-in capital
|
$11 |
|
Cr. Common stock – par value
|
$11 |
Example FG 6-5 illustrates conversion accounting when convertible debt is accounted for entirely as a liability and upon conversion, the issuer elects to settle entirely in cash.
EXAMPLE FG 6-5
Conversion accounting when convertible debt is accounted for entirely as a liability. Upon conversion the issuer elects to settle the conversion entirely in cash.
Conversion accounting when convertible debt is accounted for entirely as a liability. Upon conversion the issuer elects to settle the conversion entirely in cash.
FG Corp issues convertible debt and concludes that it should be accounted for as a liability in its entirety. Upon conversion, the issuer elects to settle the instrument entirely in cash (which is specifically permitted by the contractual terms of the instrument), but there is a 40-day period between when notice of conversion is given and when the instrument converts. During this 40-day period, the holder’s election to convert and the issuer’s decision to settle the instrument in cash cannot be changed; those elections are irrevocable once made.
Debt issuance costs are $30 and are recorded as additional debt discount on the balance sheet.
FG Corp’s stock price is $20 at the date the convertible debt is issued. FG’s common stock has a par value of $1 per share. The debt is issued at par.
The convertible debt has the following additional terms:
|
|
Principal amount
|
$1,000
|
Coupon rate
|
5% paid semi-annually on June 30 and December 31
|
Years to maturity
|
5 years
|
Conversion price
|
$25
|
Two years after FG Corp issues the debt, the investors provide notice of exercise of their conversion options. The next day, FG Corp elects to settle the instruments 100% in cash. However, cash settlement will not occur for a period of 40 trading days and will be based upon an average of the daily volume weighted average price (VWAP) over that period. As noted above, the election to cash-settle the instrument is irrevocable.
FG Corp’s stock price is $33 at the time of the election to cash settle. The VWAP over the 40-day period is $35. FG Corp has amortized $12 of debt issuance costs by the settlement date; therefore, unamortized debt issuance costs are $18. This example ignores the effects of accrued interest and income taxes for simplicity.
How should FG Corp record the issuance and ultimate conversion of its convertible debt?
Analysis
FG Corp would record the following entries.
Dr. Cash
|
$1,000 |
|
Cr. Debt
|
$1,000 |
|
Dr. Deferred debt issuance costs
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$30 |
|
Cr. Cash
|
$30 |
To record the issuance of the convertible debt and issuance costs
Following the irrevocable notice of conversion, when FG Corp makes an irrevocable election to settle the entire instrument in cash, a derivative must be separated from the debt. The conversion option now becomes a forward sale contract which would not be eligible for the “own stock” scope exception as it is required to be settled in cash. The derivative is essentially a forward sale against average VWAP for 40 trading days. In separating a non-option embedded derivative from the host contract under ASC 815-15-25-1, the terms of that non-option embedded derivative should be determined in a manner that results in its fair value generally being equal to zero (see ASC 815-15-55-160 through ASC 815-15-55-164). As a result, there is no accounting entry required on the date FG Corp makes its irrevocable election to settle in cash. For the purposes of this example, we have assumed that there are no differences between the spot and forward prices.
FG Corp’s stock price on the date of irrevocable election to settle in cash was $33. The average of the daily VWAP over the 40-day period was $35. As a result, the forward sale contract would become an $80 liability ($1,000/$25) x $2=$80.
FG Corp would record the following entries.
Dr. Loss
|
$80 |
|
Cr. Derivative liability
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$80 |
To record the change in fair value of the derivative during the 40-day settlement period
Dr. Debt
|
$1,000 |
|
Dr. Derivative Liability
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$80 |
|
Dr. APIC
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$338 |
|
Cr. Deferred debt issuance costs
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$18 |
|
Cr. Cash
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$1,400 |
To derecognize the convertible debt, unamortized debt issuance costs, and derivative liability, and recognize the cash paid upon conversion
Although the conversion represents the settlement of a bifurcated derivative, we believe that the application of conversion accounting is appropriate, rather than extinguishment accounting because, in this situation, the separation of the derivative is incidental to the settlement of the convertible debt instrument. In other fact patterns, where the conversion option or other bifurcated derivative is other than incidental to settlement, we believe that extinguishment accounting should be applied. See FG 6.5.1 for additional information.
EXAMPLE FG 6-6
Conversion accounting when convertible debt is issued with a substantial premium and settled entirely in shares
Conversion accounting when convertible debt is issued with a substantial premium and settled entirely in shares
FG Corp issues convertible debt that will be settled upon conversion entirely in shares. The principal amount of the debt is $1,000 and proceeds received were $1,120 in cash. FG Corp concludes that the convertible debt was issued at a substantial premium.
FG Corp’s stock price is $20 at the date the convertible debt is issued. FG’s common stock has a par value of $1 per share. The debt is issued at par.
The convertible debt has the following terms:
|
|
Principal amount
|
$1,000
|
Coupon rate
|
5% paid semi-annually on June 30 and December 31
|
Years to maturity
|
5 years
|
Conversion price
|
$25
|
Two years after FG Corp issues the debt, investors exercise their conversion options. FG Corp’s stock price is $35 at the conversion date.
At issuance, FG Corp concludes that the conversion feature is not required to be bifurcated and there are no other embedded features in the convertible debt.
This example ignores the effects of debt issuance costs, accrued interest and income taxes for simplicity.
How should FG Corp record the issuance and conversion of its convertible debt?
Analysis
To record the convertible debt with a substantial premium at issuance, FG Corp should record the following entry.
Dr. Cash
|
$1,120 |
|
Cr. Convertible debt
|
$1,000 |
|
Cr. Additional paid-in capital
|
$120 |
To derecognize the convertible debt and recognize the common stock issued upon conversion, FG Corp should record the following entry.
Dr. Convertible debt
|
$1,000 |
|
Cr. Common stock – par value
|
$40 |
|
Cr. Additional paid-in capital
|
$960 |
As discussed in ASC 470-20-40-5(a), the conversion of a debt instrument that becomes convertible upon the reporting entity’s exercise of a call option should be accounted for using the contractual conversion accounting model if, at time of issuance, the debt instrument contains a substantive conversion feature and the instrument is converting pursuant to its contractual terms.
6.8.1 Conversion of debt with nonsubstantive conversion option—after adoption of ASU 2020-06
ASC 470-20-40-5(b) provides guidance on the conversion of a debt instrument that becomes convertible upon the reporting entity’s exercise of a call option when the conversion option is nonsubstantive.
No substantive conversion feature. If the debt instrument did not contain a substantive conversion feature as of time of issuance, the issuance of equity securities shall be accounted for as a debt extinguishment. That is, the fair value of the equity securities issued should be considered a component of the reacquisition price of the debt.
To be considered substantive, a conversion option should be at least reasonably possible of being exercised in the future. Many conversion options meet that definition and are substantive. However, a conversion option which (1) is exercisable only upon exercise of the reporting entity’s call option at par, or (2) has an extremely high conversion price relative to the price of the underlying shares at inception may not be substantive.
ASC 470-20-40-7 through ASC 470-20-40-9 provide guidance on determining whether a conversion option is substantive.
By definition, a substantive conversion feature is at least reasonably possible of being exercised in the future. If the conversion price of an instrument at issuance is extremely high so that conversion of the instrument is not deemed at least reasonably possible as of its issuance date, then the conversion feature would not be considered substantive.
For purposes of determining whether a conversion feature is reasonably possible of being exercised, the assessment of the holder's intent is not necessary. Therefore, even if such an instrument included a conversion feature that provided for conversion due solely to the passage of time (for example, the instrument will become convertible at a date before its maturity date), it would be inappropriate to conclude that the conversion feature is substantive. Also, an instrument that became convertible only upon the issuer's exercise of its call option does not possess a substantive conversion feature.
Methods that may be helpful in assessing whether a conversion feature is substantive include the following:
- The fair value of the conversion feature relative to the fair value of the debt instrument. Comparing the fair value of a conversion feature to the fair value of the debt instrument (that is, the complete instrument as issued) may provide evidence that the conversion feature is substantive.
- The effective annual interest rate per the terms of the debt instrument relative to the estimated effective annual rate of a nonconvertible debt instrument with an equivalent expected term and credit risk. Comparing the effective annual interest rate of the debt instrument to the effective annual rate the issuer estimates it could obtain on a similar nonconvertible instrument may provide evidence that a conversion feature is substantive.
- The fair value of the debt instrument relative to an instrument that is identical except for which the conversion option is not contingent. Comparing the fair value of the debt instrument to the fair value of an identical instrument for which conversion is not contingent isolates the effect of the contingencies and may provide evidence about the substance of a conversion feature. If the fair value of the debt instrument is similar to the fair value of an identical convertible debt instrument for which conversion is not contingent, then it may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
- Qualitative evaluation of the conversion provisions. The nature of the conditions under which the instrument may become convertible may provide evidence that the conversion feature is substantive. For example, if an instrument may become convertible upon the occurrence of a specified contingent event, the likelihood that the contingent event will occur before the instrument's maturity date may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
6.8.2 Induced conversion—after adoption of ASU 2020-06
An induced conversion is a transaction in which a reporting entity offers additional shares or other consideration (“sweeteners”) to investors to incentivize them to convert their convertible instrument. For example, a reporting entity may reduce the original conversion price or issue additional consideration (e.g., cash or warrants) not provided for in the original conversion terms to debt holders that agree to convert during a limited offer period. ASC 470-20-40-13 and ASC 470-20-40-14 provide guidance on which transactions are induced conversions.
The guidance in paragraph 470-20-40-16 applies to conversions of convertible debt to equity securities pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the terms of the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. That guidance applies only to conversions that both:
- Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
- Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.
A conversion includes an exchange of a convertible debt instrument for equity securities or a combination of equity securities and other consideration, whether or not the exchange involves legal exercise of the contractual conversion privileges included in terms of the debt. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.
If a transaction qualifies as an induced conversion, ASC 470-20-40-16 requires a reporting entity to recognize an expense equal to the fair value of the shares or other consideration issued to induce conversion (i.e., the fair value of all consideration transferred in excess of the fair value of the consideration that would be transferred pursuant to the original conversion terms).
Induced conversion–convertible debt with a cash conversion feature-after adoption of ASU 2020-06
Two of the more popular types of convertible debt instruments either require or permit the reporting entity to settle the instrument upon conversion either partially or fully in cash. A convertible debt instrument that upon conversion requires the reporting entity to settle the principal amount in cash and permits the reporting entity to settle the conversion spread in either cash or shares is commonly referred to as “Instrument C.” A convertible debt instrument that allows the reporting entity to settle the instrument in cash or shares in any combination upon conversion is commonly referred to as “Instrument X.” The settlement flexibility provided by these instruments, in particular Instrument X, can make it difficult to determine whether induced conversion accounting or extinguishment accounting should apply.
In order to have an induced conversion, there must first be a conversion of the instrument in accordance with its contractual terms. This does not need to occur as a result of a legal exercise of the conversion option. ASC 470-20-40-4 clarifies that when, “a convertible debt instrument accounted for in its entirety as a liability ... is converted into shares, cash (or other assets), or any combination of shares and cash (or other assets), in accordance with the conversion privileges provided in the terms of the instrument…,” conversion accounting as described in FG 6.8 applies. This means that even when an instrument is settled entirely in cash, conversion accounting applies, provided that the original terms of the instrument allow for full cash settlement. After determining that the settlement of the instrument includes the issuance of at least the minimum contractually-required consideration specified in the original terms of the convertible instrument, a reporting entity should look to ASC 470-20-40-13 through ASC 470-20-40-14 to determine whether induced conversion accounting applies.
When the settlement of a convertible debt instrument does not include at least the minimum contractually-required consideration present in the original terms of the instrument, we believe that extinguishment accounting should apply. For example, if a convertible debt instrument that requires the principal amount to be settled in cash is settled with the principal amount partially settled in cash and partially settled in shares, extinguishment accounting should apply. In some cases, negotiated settlements of convertible debt instruments may involve changes to formulas that determine the ultimate settlement amount received in a manner other than reducing the conversion price. For example, as illustrated in Example FG 6-5 some convertible instruments with an option for cash settlements calculate settlement amounts based on the VWAP of the underlying shares for a period of time. Changes to how the VWAP is calculated may result in scenarios where holders of the convertible instruments may receive less consideration under the revised conversion terms as compared to the original conversion terms. Such situations should be carefully evaluated to determine if extinguishment accounting should apply
If a transaction of this nature does not qualify to be considered an induced conversion, an entity is required to apply extinguishment accounting. See FG 3.7.
Question FG 6-3
What is a “limited period of time” as used in ASC 470-20-40-13?
What is a “limited period of time” as used in ASC 470-20-40-13?
PwC response
We believe that when evaluating the effective time period of a change in conversion privileges, the reporting entity’s intent in offering the sweetener should be to induce prompt conversion of the convertible instrument. Generally, 30-60 days would be considered a limited period of time.
Question FG 6-4
If an investor offers to surrender a convertible instrument that upon conversion contractually requires gross physical settlement through the issuance of shares in exchange for more shares of stock than it is entitled to under the original conversion terms, and the offer is valid for a limited period of time, should the reporting entity account for the transaction as an induced conversion or extinguishment?
If an investor offers to surrender a convertible instrument that upon conversion contractually requires gross physical settlement through the issuance of shares in exchange for more shares of stock than it is entitled to under the original conversion terms, and the offer is valid for a limited period of time, should the reporting entity account for the transaction as an induced conversion or extinguishment?
PwC response
The reporting entity should account for the transaction as an induced conversion. The party that makes the offer should not affect the accounting; thus, inducement accounting is not affected by which party makes the offer.
Question FG 6-5
A reporting entity extends an offer to investors, for a limited period of time, to allow investors to tender their convertible instruments (that contractually require gross physical settlement in shares) in exchange for cash and shares. The total value of consideration that could be received is greater than the value of the shares that the investor is entitled to under the original conversion terms; however, the number of shares the investor will receive is less than the number of shares it is entitled to under the original conversion terms.
Should the reporting entity account for the transaction as an induced conversion or as an extinguishment?
A reporting entity extends an offer to investors, for a limited period of time, to allow investors to tender their convertible instruments (that contractually require gross physical settlement in shares) in exchange for cash and shares. The total value of consideration that could be received is greater than the value of the shares that the investor is entitled to under the original conversion terms; however, the number of shares the investor will receive is less than the number of shares it is entitled to under the original conversion terms.
Should the reporting entity account for the transaction as an induced conversion or as an extinguishment?
PwC response
The reporting entity should account for the transaction as an extinguishment. ASC 470-20-40-13(b) requires all equity securities issuable pursuant to the original conversion privileges to be issued for the conversion to be an induced conversion. If fewer shares are issued, this condition is not met and extinguishment accounting should be applied.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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