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When a reporting entity concludes that a conversion option should be separated from its host debt instrument and accounted for as a derivative, it should be accounted for as a freestanding derivative instrument under the guidance in ASC 815. That is, classified on the balance sheet as a derivative liability at fair value with any changes in its fair value recognized currently in the income statement. The host contract should be accounted for using the guidance applicable to nonconvertible debt.
ASC 815-15-30-2 through ASC 815-15-30-6 provide guidance on allocating the carrying amount of a hybrid instrument between the host contract and the derivative. That guidance requires the derivative to be initially measured at fair value, with the host contract carried at a value equal to the difference between the previous carrying amount of the hybrid instrument and the fair value of the derivative. Therefore, there is no gain or loss from the initial recognition and measurement of an embedded derivative that is accounted for separately from its host contract. When the embedded derivative is an option, ASC 815-15-30-6 requires it to be separated and recorded at its fair value based on its stated contract terms. The allocation of proceeds to the separated derivative will typically create a discount or premium on the associated host debt instrument.
The embedded derivative should be reassessed each reporting period to determine whether the embedded component subsequently meets the own stock scope exception. See FG 6.5.2A for information on the reclassification of previously separated conversion options.

6.5.1A Derecognition of debt with separated conversion option—before adoption of ASU 2020-06

When a conversion feature has been separated from a convertible debt instrument and accounted for as a derivative liability, there is no equity conversion feature remaining in the debt for accounting purposes. Therefore, while there may be a legal conversion of the debt, for accounting purposes we believe that both liabilities (i.e., the debt host and the separated derivative liability) should be subject to extinguishment accounting, because they are being surrendered in exchange for common shares. As such, a gain or loss upon extinguishment of the two liabilities equal to the difference between the recorded value of the liabilities and the fair value of the consideration issued to extinguish them should be recorded.
To account for the conversion of a convertible instrument when the conversion option has been separated and accounted for as a derivative liability, a reporting entity should perform the following steps:
•   Update the valuation of the separated conversion option to the date the instrument is legally converted
•   Adjust the carrying amount of the host debt instrument to reflect amortization of any premium or discount associated with the host debt instrument up to the date the instrument is legally converted
•   Amortize debt issuance costs to the date the instrument is legally converted
•   Ensure that the carrying amount of the host debt instrument reflects all components of book value, including the unamortized portion of any premiums or discounts on the debt host recorded as an adjustment to the debt host and any unamortized debt issuance costs, and accrued interest. These items collectively represent the net carrying amount of the debt host used to measure the extinguishment gain or loss
•   Calculate the difference between the reacquisition price and the net carrying amount of the debt by comparing the fair value of the consideration (i.e., cash and shares) issued upon conversion to the sum of the updated net carrying amounts of the (1) separated conversion option liability and (2) debt host. Record any difference as an extinguishment gain or loss in the income statement
When updating the valuation of the separated conversion option to the date the instrument is legally converted, reporting entities may adjust the separated conversion option to either its intrinsic value or fair value as of the conversion date. Adjusting the separated conversion option to its intrinsic value reflects the investor’s decision to truncate the term of the option by exercising it early. The foregone time value is recorded as part of the change in fair value of the derivative liability recorded in the income statement, but not as part of the extinguishment transaction. Adjusting the separated conversion option to its fair value allocates the time value foregone by the investor to the gain or loss on extinguishment, rather than the change in the fair value of the derivative liability. Under either approach, the total income statement impact is the same.
Example FG 6-1A illustrates how to account for the derecognition of a convertible debt instrument with a separated conversion option.
EXAMPLE FG 6-1A
Derecognition of convertible debt with a separated conversion option
FG Corp issues convertible debt that is required to be settled upon conversion entirely in cash. FG Corp concludes that the embedded conversion option should be separated from the debt and accounted for as a derivative liability under the guidance in ASC 815. The host debt instrument is accounted for as a liability.
FG Corp determines the fair value of the embedded conversion option to be $200.
FG Corp’s stock price is $85 at the date the convertible debt is issued. The debt is issued at par and for this example, there are no debt issuance costs.
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
$100
Number of shares underlying conversion option
10
One year after FG Corp issues the convertible debt, investors exercise their conversion options when the stock price is $110. FG Corp delivers $1,100 in cash ($110 current stock price multiplied by 10 shares underlying the conversion option) to investors.
The fair value of the embedded conversion option is $380 at the conversion date, one year after issuance and prior to exercise.
This example ignores the effects of accrued interest and income taxes for simplicity.
How should FG Corp record (1) issuance of the convertible debt and (2) conversion of the convertible debt?
Analysis
To recognize the conversion option (at fair value of $200) and the debt host contract (remaining proceeds) upon issuance of the convertible debt, FG Corp should record the following journal entry.
Dr. Cash
$1,000
Cr. Debt host instrument
$800
Cr. Derivative liability (separated conversion option)
$200
At the end of the first year, FG Corp should (1) update the valuation of the separated conversion option to its fair value of $380 and (2) amortize the debt discount by recording the following journal entry.
Dr. Loss on derivative liability
$180
Dr. Interest expense (amortization of discount)
$32
Cr. Debt host instrument
$32
Cr. Derivative liability (separated conversion option)
$180
To derecognize the host debt instrument and separated conversion option upon conversion, FG Corp should record the following entries.
First, FG Corp should adjust the value of the separated conversion option. Management elects to adjust the value to its intrinsic value of $100 at the conversion date (stock price of $110 less the conversion price of $100 multiplied by 10 shares). As noted above, adjusting the separated conversion option to its fair value would also have been acceptable.
Dr. Derivative liability (separated conversion option)
$280
Cr. Gain on derivative liability
$280
Next, FG Corp should extinguish the debt host instrument and derivative liability and recognize a loss on extinguishment.
Dr. Debt host instrument
$832
Dr. Derivative liability (separated conversion option)
$100
Dr. Loss on debt extinguishment
$168
Cr. Cash
$1,100

6.5.2A Reclassification of separated conversion option—before adoption of ASU 2020-06

ASC 815-15-35-4 provides guidance that addresses a reporting entity’s accounting for a previously separated conversion option that no longer meets the criteria for separate accounting.

ASC 815-15-35-4

If an embedded conversion option in a convertible debt instrument no longer meets the bifurcation criteria in this Subtopic, an issuer shall account for the previously bifurcated conversion option by reclassifying the carrying amount of the liability for the conversion option (that is, its fair value on the date of reclassification) to shareholders’ equity. Any debt discount recognized when the conversion option was bifurcated from the convertible debt instrument shall continue to be amortized.

ASC 815-15-40-1 and ASC 815-15-40-4 address a reporting entity’s accounting upon conversion or extinguishment of an instrument which has previously been separated.

ASC 815-15-40-1

If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

ASC 815-15-40-4

If a convertible debt instrument with a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to the guidance in paragraph 815-15-35-4 is extinguished for cash (or other assets) before its stated maturity date, the entity shall do both of the following:
a.  The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
b.  The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.

ASC 815-15-50-3 requires a reporting entity to disclose (1) a description of the principal changes causing the embedded conversion option to no longer require separate accounting and (2) the amount of the liability for the conversion option reclassified to stockholder’s equity.
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