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6.4A Analysis of the embedded conversion option—before adoption of ASU 2020-06
Publication date: 31 Oct 2020
us Financing guide
ASC 815, Derivatives and Hedging, provides guidance on when an embedded component should be separated from its host instrument and accounted for separately as a derivative.
An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:
a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
b. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
c. A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
This guidance applies to conversion options (and other embedded components such as call and put options or contingent interest) embedded in convertible debt instruments. Many convertible debt instruments contain a conversion option with multiple exercise triggers or contingent events that must occur for a conversion option to become operable. Each exercise trigger may also lead to certain settlement adjustments. These convertible debt instruments are often referred to as “CoCos,” which is shorthand for contingently convertible debt. Some of the more common exercise triggers include (1) a sales price condition, (2) a trading price condition, (3) a notice of redemption, and (4) certain corporate events (e.g., a change of control). Typically, if after performing the analysis of one exercise trigger, it is determined that it should be separately accounted for as a derivative, then the entire conversion option should be separated and accounted for as a single derivative.
6.4.1A Clearly and closely related conversion options—before adoption of ASU 2020-06
When considering whether an embedded equity-linked component is clearly and closely related to its host instrument, a reporting entity should first determine whether the host is an equity host or a debt host. Instruments classified as debt, such as convertible debt instruments, are considered debt hosts. An embedded equity-linked component is generally not considered clearly and closely related to a debt host.
6.4.2A Conversion option–derivative definition–before adoption of ASU 2020-06
To determine whether a conversion option meets the definition of a derivative, its terms should be evaluated under the guidance in ASC 815-10-15-83. Typically, the criterion that ultimately determines whether or not a conversion option meets the definition of a derivative is the net settlement criterion. If the equity securities underlying the embedded conversion option are readily convertible to cash, such as publicly traded common shares, the embedded conversion option is likely to meet the net settlement criterion to be considered a derivative. If the equity securities underlying the conversion option are not readily convertible to cash, and the conversion option requires gross physical settlement of the underlying shares, the embedded conversion option may not meet the net settlement criterion, and therefore would not meet the definition of a derivative. If the conversion option permits settlement by delivery of net shares (a variable number of shares with a value equal to the intrinsic value of the conversion option) or cash, then it meets the definition of a derivative. See FG 5.4.2 and DH 2.3.5.3 for further information on the concept of readily convertible to cash and DH 2.3.5 for further information on other forms of net settlement.
If an embedded conversion option meets the definition of a derivative, a reporting entity should assess whether it qualifies for the scope exception for certain contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).
6.4.2.1A Conversion option–issuer own equity scope exception—before adoption of ASU 2020-06
ASC 815-10-15-74(a) provides a scope exception to the derivative accounting required under ASC 815, for certain contracts involving a reporting entity’s own equity.
Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:
a. Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock
2. Classified in stockholders’ equity in its statement of financial position.
An embedded component is considered indexed to a reporting entity’s own stock if it meets the requirements specified in ASC 815-40-15. See FG 5.6.2A for information on those requirements.
Application to convertible debt
To apply the requirements for equity classification to a conversion option embedded in a convertible debt instrument, the issuer should first determine whether the convertible debt instrument is considered “conventional.” ASC 815-40-25-39 describes a conventional convertible debt instrument as one “in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).”
If convertible debt is considered conventional, the reporting entity only needs to consider the stated settlement alternatives (i.e., who controls the settlement and whether the settlement will be in shares or cash) to determine whether the embedded conversion option meets the requirements for equity classification. The additional requirements for equity classification in ASC 815-40-25-10 and ASC 815-40-55-2 through ASC 815-40-55-6 are not applicable. If the convertible debt instrument is not conventional, the reporting entity should consider all of the requirements for equity classification in ASC 815. See FG 5.6.2A and FG 5.6.3A for information on those requirements.
ASC 815-40-25-39 through ASC 815-40-25-41 explain the application of the criteria in ASC 815-40-25-10 to conventional convertible debt.
Question FG 6-1A discusses whether a convertible debt instrument that contains a “make-whole” provision is considered a conventional convertible debt instrument.
Question FG 6-1A
Is a convertible debt instrument that provides for an adjustment to the number of shares deliverable upon conversion via a “make-whole” provision or table (i.e., a provision designed to compensate investors for unanticipated changes to the issuer), as is market standard practice, considered a conventional convertible debt instrument?
Is a convertible debt instrument that provides for an adjustment to the number of shares deliverable upon conversion via a “make-whole” provision or table (i.e., a provision designed to compensate investors for unanticipated changes to the issuer), as is market standard practice, considered a conventional convertible debt instrument?
PwC response
No. Generally, an adjustment to the conversion option for anything other than standard anti-dilution provisions (e.g., adjustments for stock splits, rights offerings, dividends, or spin-offs) precludes a convertible debt instrument from being considered conventional. The fact that such a provision is standard practice is not relevant in determining whether an instrument is conventional as defined in ASC 815-40-25-39.
Application to a contingent conversion option
A contingent conversion option includes a contingency that determines whether the investor has the right to convert into equity (e.g., convertible only in the event of a successful IPO). To determine whether this type of conversion option should be accounted for separately as a derivative, a reporting entity should consider whether it qualifies for the scope exception for contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).
If a conversion option contingency is tied to an event (e.g., an IPO), the contingency may not affect whether the embedded component is considered indexed to the issuer’s stock. If a conversion option contingency is tied to an observable index, the contingency precludes the embedded component from being considered indexed to the issuer’s stock, unless the contingency is based on (1) the issuer’s stock price, or (2) a measure referencing the issuer’s operations (e.g., EBITDA). The reporting entity must also evaluate all of the instrument’s settlement provisions and evaluate the conditions necessary for equity classification.
If an instrument’s conversion is tied to achieving a substantive contingency based on an event or index other than the issuer’s stock price, the instrument should not be included in diluted earnings per share until the contingency has been met. See FSP 7.5.6.4A for information on earnings per share for contingently exercisable instruments and FSP 12.7A for balance sheet classification considerations applicable to contingently convertible debt.
Application to an adjustment to a conversion option upon a fundamental change
Many convertible debt instruments provide for an adjustment to the number of shares deliverable if a fundamental change triggers an early conversion. To determine whether this type of conversion option should be accounted for separately as a derivative, a reporting entity should consider whether it qualifies for the scope exception for contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a). In accordance with ASC 815-40-15-7D, if the number of shares used to calculate an instrument’s settlement amount is not fixed, it could still be considered indexed to a reporting entity’s own stock if the only variables that could affect the settlement amount are inputs to the fair value of a fixed-for-fixed forward or option on equity shares (e.g., strike price, term, stock price volatility).
This provision is typically included primarily to compensate the investor for the time value of the option lost upon an unanticipated change, such as a change in control. Typically, the adjustment to the number of shares is included in a matrix of the issuer’s stock price and time to maturity. The number of shares to be received upon conversion decreases as the stock price increases and time to maturity decreases. However, because option time value is not linear, neither is the adjustment.
The example in ASC 815-40-55-45 and ASC 815-40-55-46 (excerpted in the following section) concludes that a provision that uses a “make-whole” table to calculate the adjustment to the number of shares delivered upon conversion in the event of a fundamental change should be considered indexed to the reporting entity’s own stock because the number of shares delivered is determined based upon the issuer’s stock price and time to maturity, both of which are inputs to a fair value measurement of a fixed-for-fixed option on equity shares.
In addition, make-whole tables typically include a cap on the number of shares the reporting entity could be required to deliver upon conversion, which addresses one of the requirements for equity classification in ASC 815-40-25. Provided the other requirements for equity classification in ASC 815-40 are met, a conversion option which provides an adjustment (based on the issuer’s stock price and time to maturity) to the number of shares delivered upon conversion in the event of a fundamental change would meet the requirements for the scope exception for contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).
Convertible debt instruments often contain put options that allow investors to put the debt to the issuer (for par or some other stated amount) upon a fundamental change. Depending on the terms, such a put option may comprise both a traditional put right and a contingently exercisable conversion right, as discussed in Question FG 6-2A. See FG 1.6.1 for information on evaluating put and call options embedded in debt instruments.
Question FG 6-2A
Should an option that, in the event of a fundamental change, allows an investor to put a convertible debt instrument to the reporting entity for cash equal to the greater of (1) the par value of the debt instrument or (2) the converted value of the debt instrument be separated from the convertible debt instrument?
Should an option that, in the event of a fundamental change, allows an investor to put a convertible debt instrument to the reporting entity for cash equal to the greater of (1) the par value of the debt instrument or (2) the converted value of the debt instrument be separated from the convertible debt instrument?
PwC response
The put option upon a fundamental change is really two options (1) a put option at par value and (2) a contingently exercisable conversion option, which must be settled in cash.
The put option at par value needs to be evaluated to determine whether it should be separated (see FG 1.6.1).
The entire embedded conversion option should be separated. A conversion option that must be settled in cash in circumstances beyond the reporting entity’s control is not eligible for the scope exception for certain contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a). Although the cash settlement provision is only included in the conversion option exercisable upon a fundamental change, if one settlement alternative fails to qualify for the scope exception, the entire conversion option should be separated and carried at fair value with changes in fair value recorded in the income statement.
Application to a conversion option with a trading price condition (parity provision)
Many convertible debt instruments with a contingent conversion option contain a provision that permits the investor to exercise the conversion option if the debt instrument is trading below a specified percentage, for example 98% of the parity value of the underlying shares (referred to as a “parity provision”). This provision is typically included to provide protection to the investor by allowing conversion in a scenario when they may want to convert, but would be unable to do so because other triggers for the contingent conversion have yet to be met. Theoretically, a convertible debt instrument should be worth more than the underlying shares because a convertible debt instrument provides a floor on the value to be received (absent an event involving the credit of the reporting entity, the investor will receive at least the par value of the debt instrument at maturity) as well as coupon payments over the life of the debt instrument. A parity provision is likely to only be triggered in periods of extreme market disruption that impact the value of the convertible debt instrument and shares.
To determine whether a conversion option with a parity provision should be separated and accounted for as a derivative, a reporting entity should consider whether it qualifies for the scope exception for contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).
ASC 815-40-55-45 through ASC 815-40-55-46 analyze the application of the scope exception to an instrument with a market (trading) price trigger, a parity provision, and a merger provision.
>> Example 19: Variability involving contingently convertible debt with a market price trigger, parity provision, and merger provision
ASC 815-40-55-45
This Example illustrates the application of the guidance beginning in paragraph 815-40-15-5. Entity A issues a contingently convertible debt instrument with a par value of $1,000 that is convertible into 100 shares of its common stock. The convertible debt instrument has a 10-year term and is convertible at any time after any of the following events occurs:
a. Entity A’s stock price exceeds $13 per share (market price trigger).
b. The convertible debt instrument trades for an amount that is less than 98 percent of its if-converted value (parity provision).
c. There is an announcement of a merger involving Entity A.
The terms of the convertible debt instrument also include a make-whole provision. Under that provision, if Entity A is acquired for cash before a specified date, the holder of the convertible debt instrument can convert into a number of shares equal to the sum of the fixed conversion ratio (100 shares per bond) and the make-whole shares. The number of make-whole shares is determined by reference to a table with axes of stock price and time. That table was designed such that the aggregate fair value of the shares deliverable (that is, the fair value of 100 shares per bond plus the make-whole shares) would be expected to approximate the fair value of the convertible debt instrument at the settlement date, assuming no change in relevant pricing inputs (other than stock price and time) since the instrument’s inception. The embedded conversion option is considered indexed to Entity A’s own stock based on the following evaluation:
a. Step 1. The market price trigger and parity provision exercise contingencies are based on observable markets; however, those contingencies relate solely to the market prices of the entity’s own stock and its own convertible debt. Also, the merger announcement exercise contingency is not an observable market or an index. Therefore, Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
b. Step 2. An acquisition for cash before the specified date is the only circumstance in which the settlement amount will not equal the difference between the fair value of 100 shares and a fixed strike price ($1,000 fixed par value of the debt). The settlement amount if Entity A is acquired for cash before the specified date is equal to the sum of the fixed conversion ratio (100 shares per bond) and the make-whole shares. The number of make-whole shares is determined based on a table with axes of stock price and time, which would both be inputs in a fair value measurement of a fixed-for-fixed option on equity shares.
As described above, if the requirements for equity classification in ASC 815-40-25 are met, a parity provision typically meets the requirements for the scope exception for contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).
Application to debt convertible into stock of a consolidated subsidiary
In the consolidated financial statements, debt that is convertible into the stock of a substantive consolidated subsidiary (whether the convertible debt is issued by the parent or the subsidiary) should be accounted for in the same manner as debt that is convertible into the parent company’s stock. The same is not true for instruments indexed to the stock of an affiliate that is not a consolidated subsidiary or to the stock of an equity-method investee. The stock of an affiliate or equity-method investee is not considered the reporting entity’s own stock.
Although not specifically addressed, we believe that the guidance in ASC 815-40 also applies to convertible debt issued by a subsidiary that is convertible into the stock of the parent in the consolidated financial statements of the parent. However, in the separate financial statements of the subsidiary, debt convertible into the parent’s stock would generally not be considered indexed to the entity’s own stock.
See FG 5.6.2.4A for information on instruments indexed to the stock of a subsidiary or affiliate.
Application to instruments convertible into a variable number of shares
A debt instrument that can be settled by delivery of a variable number of shares should be evaluated to determine whether the embedded conversion option is in substance, a put option (redemption feature) designed to provide the investor with a fixed monetary amount, settleable in shares. For example, a reporting entity may issue a debt instrument that converts, either automatically or at the issuer’s option, into a variable number of shares upon the completion of a capital raising transaction. The number of shares received is determined by dividing the instrument’s outstanding principal and accrued interest balance by the fair value of the shares. This feature is in substance a put option, which should be evaluated under the guidance in ASC 815 to determine whether the put option should be separated and accounted for as a derivative. Oftentimes, the formula used to calculate the number of shares to be delivered will result in settlement of the convertible debt instrument at a premium. See FG 1.6.1 for information on evaluating put and call options embedded in debt instruments.
Application to down round features
As discussed in ASC 815-10-15-75A (subsequent to the adoption of ASU 2017-11), a conversion option embedded in a convertible debt instrument that includes a feature that meets the definition of a down round feature in the ASC Master Glossary does not preclude that conversion option from being considered indexed to the entity’s own stock.
See FG 5.6.2.2A for further information on antidilution and price protection provisions (including down round features).
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