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:
Coupon rate |
5% paid semi-annually on June 30 and December 31 |
Years to maturity |
5 years |
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.
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 |
|