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6.6A Convertible debt with a cash conversion feature—before adoption of ASU 2020-06
Publication date: 31 Oct 2020
us Financing guide
In traditional, share-settled convertible debt, no cash is received upon conversion. If the investor exercises its conversion option, the full number of shares underlying the debt instrument is received. In contrast, a convertible debt instrument with a cash conversion feature allows, or requires, the reporting entity to settle its obligation upon conversion, in whole or in part, in a combination of cash or stock at the investor or issuers’ option or mandatorily. ASC 470-20 provides specific accounting guidance for convertible debt instruments with a cash conversion feature provided the conversion option is not separated under the guidance in ASC 815-15-25-1. See FG 6.4A for information on when a conversion option should be separated from its host debt instrument.
If convertible debt with a cash conversion feature contains an embedded derivative other than the embedded conversion option (e.g., a change in control put option), that embedded derivative should be evaluated under the guidance in ASC 815 to determine whether it should be accounted for separately before the guidance in ASC 470-20 is applied. Therefore, when evaluating whether an embedded put or call option should be accounted for separate from the host debt instrument, the discount created by separating the conversion option under the guidance in ASC 470-20 should not be considered. See FG 1.6.1 for information on embedded put and call options in debt instruments and FG 6.10.1A for information on contingent interest features.
Question FG 6-3A discusses if a reporting entity should apply the cash conversion guidance in ASC 470-20 to convertible debt instrument that permits the reporting entity to settle a portion of its debt in cash upon conversion, if it does not intend to use the cash conversion alternative.
Question FG 6-3A
Should a reporting entity apply the cash conversion guidance in ASC 470-20 to a convertible debt instrument that permits the reporting entity to settle a portion of its debt in cash upon conversion if it does not intend to use the cash conversion alternative?
Should a reporting entity apply the cash conversion guidance in ASC 470-20 to a convertible debt instrument that permits the reporting entity to settle a portion of its debt in cash upon conversion if it does not intend to use the cash conversion alternative?
PwC response
Yes. We believe that the scoping language of the cash conversion subsection of ASC 470-20 is intentionally broad. Any instrument with the possibility of partial cash settlement (or settlement in other assets), even for a small portion of the total conversion value, and regardless of intent to cash settle, should be accounted for using this guidance.
ASC 470-20-15-5 provides exceptions to the scope of the cash conversion guidance.
The Cash Conversion Subsections do not apply to any of the following instruments:
a. A convertible preferred share that is classified in equity or temporary equity.
b. A convertible debt instrument that requires or permits settlement in cash (or other assets) upon conversion only in specific circumstances in which the holders of the underlying shares also would receive the same form of consideration in exchange for their shares.
c. A convertible debt instrument that requires an issuer’s obligation to provide consideration for a fractional share upon conversion to be settled in cash but that does not otherwise require or permit settlement in cash (or other assets) upon conversion.
Although ASC 470-20-15-5 exempts equity-classified convertible preferred shares from the cash conversion guidance in ASC 470-20, the guidance does apply to convertible preferred shares that are classified as liabilities for financial reporting purposes.
6.6.1A Initial measurement and recognition—before adoption of ASU 2020-06
Convertible debt with a cash conversion feature should be separated into a debt component and an equity component. This is done by:
• Determining the carrying amount of the debt component based on the fair value of a similar debt instrument excluding the embedded conversion option. Typically, an income valuation approach, or a present value calculation, is used to calculate the fair value of the debt liability. To perform this calculation, the issuer should determine (1) the expected life of the debt (see FG 6.6.1.1A for further information), and (2) the borrowing rate of a nonconvertible debt instrument (see FG 6.6.1.2A for further information)
• Recognizing the equity component by ascribing the difference between the proceeds and the fair value of the debt liability to additional paid-in capital
• Reporting the difference between the principal amount of the debt and the amount of the proceeds allocated to the debt component as a debt discount, which is subsequently amortized through interest expense over the instrument’s expected life using the interest method
Convertible debt instruments that are separated into a debt and equity component in accordance with the guidance in ASC 470-20 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.
Issuance costs should be allocated to the debt and equity components in proportion to the allocation of proceeds to those components. Allocated costs should be accounted for as debt issuance costs (capitalized and amortized to interest expense using the interest method) and equity issuance costs (charged to equity), respectively.
6.6.1.1A Determining the expected life—before adoption of ASU 2020-06
To calculate the fair value of convertible debt exclusive of its embedded conversion option, an issuer should estimate the instrument’s expected life. When determining the expected life, all substantive embedded features, other than the embedded conversion option, should be considered. ASC 470-20-30-30 provides guidance on whether an embedded feature is nonsubstantive.
Solely for purposes of applying the initial measurement guidance in paragraphs 470-20-30-27 through 30-28 and the subsequent measurement guidance in paragraph 470-20-35-15, an embedded feature other than the conversion option (including an embedded prepayment option) shall be considered nonsubstantive if, at issuance, the entity concludes that it is probable that the embedded feature will not be exercised. That evaluation shall be performed in the context of the convertible debt instrument in its entirety.
An issuer should consider the effect of any prepayment features, such as put and call options, on the expected life of the debt liability. The method of determining the expected life of a debt liability with puts and calls described in ASC 470-20 is to consider whether it would be rational to exercise a call (or for the investor to exercise a put) if it were embedded in a nonconvertible debt instrument with the same terms as the convertible debt instrument being evaluated. The hypothetical nonconvertible debt instrument is an instrument that (1) pays the same coupon rate as the convertible debt instrument and (2) was issued at a discount to par value, to compensate for the low coupon rate when compared to nonconvertible debt rates.
When considering puts and calls embedded in debt instruments:
• A borrower would generally not call a nonconvertible debt instrument at par with a low coupon and issued at a significant discount. Therefore, such a nonconvertible debt instrument generally has an expected life equal to its contractual life.
• Conversely, an investor would generally put a nonconvertible debt instrument with a low coupon and issued at a significant discount back to the borrower as soon as possible. Therefore, a debt instrument which the investor can put back to the issuer generally has an expected life from the issuance date to the first put date.
• A debt instrument which the reporting entity can call and the investor can put on the same date generally has an expected life equal to the period from issuance to the simultaneous put and call date.
Figure FG 6-3A provides a summary of the likely effect of put and call options on the estimated life of the convertible debt liability in applying the guidance.
Figure FG 6-3A
Summary of likely effect of puts and calls on the estimated life of a nonconvertible debt instrument
Summary of likely effect of puts and calls on the estimated life of a nonconvertible debt instrument
Description |
Likely estimated life |
Matures in 10 years Issuer call in 5 years Investor put in 5 years |
5 years |
Matures in 10 years Issuer call in 5 years Investor put in 7 years |
7 years |
Matures in 10 years Issuer call in 7 years Investor put in 5 years |
5 years |
Matures in 10 years No issuer call Investor put in 5 years |
5 years |
Matures in 10 years Issuer call in 5 years No investor put |
10 years |
The expected life should not be reassessed in subsequent reporting periods.
Question FG 6-4A discusses if an issuer should consider the effect of a feature that allows an investor to put a debt instrument upon a fundamental change when determining the expected life of a convertible debt instrument within the scope of the cash conversion guidance in ASC 470-20.
Question FG 6-4A
Should an issuer consider the effect of a feature that allows an investor to put a debt instrument upon a fundamental change (commonly referred to as a change-in-control put option) when determining the expected life of a convertible debt instrument within the scope of the cash conversion guidance in ASC 470-20?
Should an issuer consider the effect of a feature that allows an investor to put a debt instrument upon a fundamental change (commonly referred to as a change-in-control put option) when determining the expected life of a convertible debt instrument within the scope of the cash conversion guidance in ASC 470-20?
PwC response
Perhaps. The issuer should assess whether the change in control put is a substantive feature at the issuance date. If, at issuance, it is probable that an event that will trigger the change in control put will not occur, the change in control put should be deemed nonsubstantive and disregarded for purposes of determining the expected life. However, if the change-in-control put option is considered substantive, its effect should be considered when determining the expected life.
Figure FG 6-3A illustrates a literal application of the guidance in ASC 470-20 on determining the expected life of a debt instrument. Following this guidance can produce anomalous results. For example, applying the guidance to a convertible debt instrument with a contractual life of ten years that is puttable by the investor in year five will result in an expected life of five years. In that case, the issuer should amortize the discount created by separating the debt into its components over five years; however, investors will likely leave the debt outstanding for the full ten years because they will consider the value of the conversion option. This will result in an above market interest expense (equal to the coupon in the convertible debt and the amortization of the discount created by separating the debt into its components) over the first five years and a below market interest expense (equal to the coupon on the convertible debt) over the last five years.
6.6.1.2A Determining the nonconvertible debt rate—before adoption of ASU 2020-06
To determine the interest rate of a similar nonconvertible debt instrument, an issuer should first consider the interest rate on its own nonconvertible debt. If that debt is similar to the convertible debt being evaluated, in terms of issuance date, tenor, and seniority, it may be appropriate to use the interest rate on its own nonconvertible debt without making any adjustments to it. If there are differences in issuance date, tenor, or seniority, an issuer should consider these differences in determining the nonconvertible debt rate.
If the issuer does not have similar nonconvertible debt, it should consider market rates for nonconvertible debt instruments with terms similar to the convertible debt being evaluated that have been issued by companies with similar credit quality to the issuer.
A reporting entity may want to consider the use of a valuation specialist to help determine the interest rate for similar nonconvertible debt instruments. This is especially true for high-yield issuers who may not have sufficient market data regarding nonconvertible debt rates available due to low credit quality.
6.6.2A Subsequent accounting—before adoption of ASU 2020-06
As discussed in FG 6.6.1A, convertible debt with a cash conversion feature should be separated into a debt component and an equity component. FG 6.6.2.1A and FG 6.6.2.2A provide information on the amortization of the resulting debt discount and subsequent measurement requirements for a separated equity component.
6.6.2.1A Amortization of debt discount—before adoption of ASU 2020-06
The discount created by separating the convertible debt instrument into its debt and equity components should be amortized using the interest method. The amortization period should be the expected life of a similar nonconvertible debt instrument (considering the effects of any embedded features other than the conversion option, such as prepayment options). See FG 6.6.1.1A for information on determining the expected life. The amortization period is not reassessed in subsequent reporting periods.
Periodic reported interest expense for convertible debt with a cash conversion feature includes (1) the instrument’s coupon and (2) the current period’s amortization of the debt discount. Therefore, the accounting interest expense will be higher than the cash coupon on the convertible debt.
Question FG 6-5A discusses how a reporting entity should record interest expense on convertible debt with a cash conversion period if it remains outstanding after the debt discount amortization period.
Question FG 6-5A
A reporting entity issues convertible debt with a cash conversion feature with a term of seven years. The reporting entity decides to amortize the discount created by separating its convertible debt instrument over a period of five years because the debt is puttable by investors at the end of the fifth year.
The put is not exercised, and the debt remains outstanding after five years. How should the reporting entity record interest expense on the convertible debt instrument in years six and seven?
A reporting entity issues convertible debt with a cash conversion feature with a term of seven years. The reporting entity decides to amortize the discount created by separating its convertible debt instrument over a period of five years because the debt is puttable by investors at the end of the fifth year.
The put is not exercised, and the debt remains outstanding after five years. How should the reporting entity record interest expense on the convertible debt instrument in years six and seven?
PwC response
Once the debt discount recorded at issuance has been fully amortized, the reporting entity should record only the cash coupon on the convertible debt as interest expense. ASC 470-20 does not permit adjustments to the amortization period or expected life of a convertible debt instrument after issuance.
6.6.2.2A Subsequent measurement of equity component—before adoption of ASU 2020-06
The separated equity component should not be remeasured, provided it continues to meet the requirements for equity classification (i.e., it does not have to be accounted for as a derivative under the guidance in ASC 815). See FG 5.6.3A for further information on whether the instrument meets the requirements for equity classification.
Temporary (mezzanine) equity classification
SEC registrants should present some portion of the separated equity component as temporary (or mezzanine) equity in periods in which the instrument is convertible or redeemable for cash or other assets. The amount recorded in temporary equity is equal to the amount of cash (or other assets) an investor would receive upon conversion or redemption less the amount of liability recorded for the debt component.
ASC 480-10-S99-3A provides guidance on when an instrument is considered convertible or redeemable for cash or other assets.
• Debt is currently convertible if the investor is able to exercise its conversion option and require the reporting entity to settle in cash or other assets. For contingently convertible debt, this would typically be the case if, at the balance sheet date, the contingency has been met. For debt without a conversion contingency, the debt may be convertible at any time. The terms of the instrument must require the reporting entity to settle in cash or other assets. If it is in the reporting entity’s control to settle in cash, other assets, or equity, a portion of the separated equity component is not required to be presented as mezzanine equity.
• Debt is currently redeemable if (1) the investor holds a put option that is currently exercisable for cash or other assets or (2) the debt instrument matures in the current period.
Question FG 6-6A addresses whether some portion of an immediately convertible cash conversion bond should be recorded as temporary equity.
Question FG 6-6A
FG Corp issues an immediately convertible cash conversion bond with a principal amount of $1,000. The principal amount must be settled in cash and the conversion spread in shares. Based on the guidance in ASC 470-20, FG Corp determines that the bond should be separated into a $700 debt liability and a $300 equity component. Should FG Corp record some portion of the $300 equity component as temporary equity?
FG Corp issues an immediately convertible cash conversion bond with a principal amount of $1,000. The principal amount must be settled in cash and the conversion spread in shares. Based on the guidance in ASC 470-20, FG Corp determines that the bond should be separated into a $700 debt liability and a $300 equity component. Should FG Corp record some portion of the $300 equity component as temporary equity?
PwC response
Yes. At issuance, FG Corp should record $300 of the equity component as temporary equity. Since the bond is immediately convertible, FG Corp could be required to deliver $1,000 of cash to the investor if they immediately convert; therefore, FG Corp should have a combined liability and temporary equity balances equal to $1,000. As FG Corp accretes the liability balance over time (in accordance with the guidance in ASC 470-20), it should reclassify a portion of the temporary equity balance to permanent equity such that the combined liability and temporary equity balances remain equal to $1,000.
Although technically not required for private entities, mezzanine equity presentation is strongly encouraged, especially in those circumstances where there is not a high likelihood that the capital is in fact permanent. If mezzanine presentation is not elected, separate presentation from other items within equity should be considered.
6.6.3A Earnings per share—before adoption of ASU 2020-06
Most cash conversion debt instruments are included in diluted earnings per share using a method similar to the treasury stock method described in ASC 260, Earnings per Share (ASC 260-10-55-84 through ASC 260-10-55-84B provide an illustration of the treasury stock method). However, when determining the earnings per share treatment of a debt instrument that may settle in any combination of cash or stock at the issuer’s option, an issuer should consider the guidance on instruments settleable in cash or shares. See FSP 7.5.6.3 for information on the earnings per share treatment of cash conversion debt instruments and FSP 7.5.7.1 for information on instruments settleable in cash or shares.
6.6.4A Convertible debt with a cash conversion feature example—before adoption of ASU 2020-06
Example FG 6-2A illustrates the initial recognition and measurement and subsequent accounting of convertible debt with a cash conversion feature.
EXAMPLE FG 6-2A
Accounting for convertible debt with a cash conversion feature
Accounting for convertible debt with a cash conversion feature
FG Corp (a private company) issues convertible debt that will be settled upon conversion by delivering (1) cash up to the principal amount of the debt instrument and (2) net shares equal to any value due to the conversion option being in the money. FG Corp’s stock price is $85 at the date the convertible debt is issued.
The convertible debt has the following terms:
Principal amount |
$1,000 |
Coupon rate |
2% |
Years to maturity |
7 years |
Issuer call option |
2 years and thereafter |
Investor put option |
5 years and thereafter |
Conversion Price |
$100 |
Conversion terms |
Investors can convert in any quarter following a quarter in which FG Corp’s stock price traded at or above $110 for at least 45 days |
Conversion settlement |
Upon conversion, the investor will receive $1,000 in cash and net shares equal to any value due to the conversion option being in the money |
FG Corp concludes that the debt instrument is within the scope of the cash conversion guidance in ASC 470-20 and should be separated into its debt and equity components.
FG Corp determines that a nonconvertible debt instrument with the same terms would have an expected life of five years because its debt instrument is puttable by investors at the beginning of year six. Based on its analysis of 5-year nonconvertible debt with similar terms issued by companies with similar credit quality, FG Corp determines the coupon rate for a nonconvertible debt instrument with the same terms to be 8.02%. Using a present value calculation, FG Corp determines the initial carrying value of the debt to be $760. The proceeds allocated to the equity component is therefore $240 (the difference between the $1,000 proceeds and $760 debt liability).
FG Corp develops the following schedule of balances and amortization using the beginning debt liability balance calculated using an income valuation approach and the interest method of amortization.
This example ignores the effects of income taxes.
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Balance at beginning of period |
$760 |
$801 |
$845 |
$893 |
$944 |
Amortization of discount |
41 |
44 |
48 |
51 |
56 |
Balance at end of period |
$801 |
$845 |
$893 |
$944 |
$1,000 |
How should FG Corp record (1) the issuance of its convertible debt instrument and (2) amortization of the debt discount and payment of interest during the first year the debt is outstanding?
Analysis
To recognize the receipt of cash and separation of the convertible debt instrument into its debt liability and residual equity components, FG Corp should record the following journal entry.
Dr. Cash |
$1,000 |
|
Dr. Convertible debt discount |
$240 |
|
Cr. Convertible debt |
$1,000 |
|
Cr. Additional paid-in capital (conversion option) |
$240 |
To recognize the amortization of the debt discount and payment of interest during the first year the debt is outstanding, FG Corp should record the following journal entry.
Dr. Interest expense |
$61 |
|
Cr. Cash |
$20 |
|
Cr. Convertible debt discount |
$41 |
6.6.5A Derecognition (conversion or extinguishment)—before adoption of ASU 2020-06
The accounting for the derecognition of convertible debt with a cash conversion feature is the same whether the debt instrument is extinguished (repurchased) or converted. In either case, the reporting entity should allocate the fair value of the consideration transferred (cash or shares) and any transaction costs incurred between (1) the debt component—to reflect the extinguishment of the debt and (2) the equity component—to reflect the reacquisition of the embedded conversion option.
An issuer should first calculate the fair value of the debt immediately prior to its derecognition. This is generally done by re-calculating the carrying value of the debt instrument using an updated remaining expected life of the debt instrument and an updated nonconvertible debt rate assumption. A gain or loss on extinguishment equal to the difference between the calculated fair value of the debt immediately prior to its derecognition and the carrying amount of the debt component, including any unamortized debt discount or issuance costs, is recorded in the income statement.
The remainder of the consideration is allocated to the reacquisition of the equity component.
If any other stated or unstated rights and privileges exist, a portion of the consideration should be allocated to those rights and privileges and accounted for according to other applicable accounting guidance.
See FG 6.9.2A for information on induced conversions of cash conversion debt.
Example FG 6-3A illustrates the derecognition of a convertible debt with a cash conversion feature.
EXAMPLE FG 6-3A
Derecognition of a convertible debt with a cash conversion feature
Derecognition of a convertible debt with a cash conversion feature
FG Corp (a private company) issues convertible debt that will be settled upon conversion by delivering (1) cash up to the principal amount of the debt instrument and (2) net shares equal to any value due to the conversion option being in the money. FG Corp’s stock price is $85 at the date the convertible debt is issued.
The convertible debt has the following terms:
Principal amount |
$1,000 |
Coupon rate |
2% |
Years to maturity |
7 years |
Issuer call option |
2 years and thereafter |
Investor put option |
5 years and thereafter |
Conversion Price |
$100 |
Conversion terms |
Investors can convert in any quarter following a quarter in which FG Corp’s stock price traded at or above $110 for at least 45 days |
Conversion settlement |
Upon conversion, the investor will receive $1,000 in cash and net shares equal to any value due to the conversion option being in the money |
FG Corp concludes that the debt instrument is within the scope of the cash conversion guidance in ASC 470-20 and should be separated into its debt and equity components.
FG Corp determines that a nonconvertible debt instrument with the same terms would have an expected life of five years because its debt instrument is puttable by investors at the beginning of year six. Based on its analysis of 5-year nonconvertible debt with similar terms issued by companies with similar credit quality, FG Corp determines the coupon rate for a nonconvertible debt instrument with the same terms to be 8.02%. Using a present value calculation, FG Corp determines the initial carrying value of the debt to be $760. The proceeds allocated to the equity component is therefore $240 (the difference between the $1,000 proceeds and $760 debt liability).
FG Corp develops the following schedule of balances and amortization using the beginning debt liability balance calculated using an income valuation approach and the interest method of amortization.
This example ignores the effects of income taxes.
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Balance at beginning of period |
$760 |
$801 |
$845 |
$893 |
$944 |
Amortization of discount |
41 |
44 |
48 |
51 |
56 |
Balance at end of period |
$801 |
$845 |
$893 |
$944 |
$1,000 |
Three years after the issuance of its convertible debt instrument, FG Corp decides to exercise its call option. FG Corp’s stock price is $125 on the date it calls its convertible debt.
Once the debt instrument is called by FG Corp, investors can either (1) convert the debt instrument and receive cash and shares with a value equal to $1,250, which is the instrument’s conversion value, or (2) choose not to convert and receive $1,000 upon settlement of the call option. Investors choose to convert their debt instruments. FG Corp delivers $1,000 in cash and 2 shares (worth $125 each) for total consideration of $1,250.
FG Corp determines that the updated expected life of the debt instrument is equal to the remaining original expected life of the debt instrument, which is two years. Based on its analysis of 5-year nonconvertible debt with two years left to maturity with similar terms issued by companies with similar credit quality, FG Corp determines the coupon rate for a nonconvertible debt instrument with the same terms to be 6.10%.
Using a present value calculation, FG Corp determines the fair value of the debt component to be $925.
FG Corp allocates the $1,250 consideration transferred to investors as follows (1) $925 to extinguish the debt and (2) $325 to reacquire the embedded conversion option.
A loss on extinguishment of $32 is determined by calculating the difference between (1) the fair value of the debt component prior to conversion—$925 and (2) the carrying value of the debt instrument at the end of year three—$893 (see table above).
FG Corp’s common stock has a $1 par value.
How should FG Corp record the conversion by investors?
Analysis
To record the conversion by investors, FG Corp should record the following journal entry.
Dr. Convertible debt |
$1,000 |
|
Dr. Additional paid-in capital (conversion option) |
$325 |
|
Dr. Loss on extinguishment of convertible debt |
$32 |
|
Cr. Convertible debt discount |
$107 |
|
Cr. Cash |
$1,000 |
|
Cr. Common stock–par value |
$2 |
|
Cr. Additional paid-in capital (common stock) |
$248 |
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