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For convertible debt, the test to determine whether a debt modification or extinguishment has occurred is more complicated than the 10% test described in FG 3.4. ASC 470-50-40-10 prescribes a two-step approach for determining whether a convertible debt modification should be accounted for as a modification or an extinguishment.

ASC 470-50-40-10

From the debtor’s perspective, an exchange of debt instruments between or a modification of a debt instrument by a debtor and a creditor in a nontroubled debt situation is deemed to have been accomplished with debt instruments that are substantially different if the present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument. If the terms of a debt instrument are changed or modified and the cash flow effect on a present value basis is less than 10 percent, the debt instruments are not considered to be substantially different, except in the following two circumstances:
a.  A modification or an exchange affects the terms of an embedded conversion option, from which the change in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange.
b.  A modification or an exchange of debt instruments adds a substantive conversion option or eliminates a conversion option that was substantive at the date of the modification or exchange. (For purposes of evaluating whether an embedded conversion option was substantive on the date it was added to or eliminated from a debt instrument, see paragraphs 470-20-40-7 through 40-9.)

ASC 470-50-40-10 does not address legal modifications or exchanges of debt instruments in which the embedded conversion option is separated and accounted for as a derivative under ASC 815 prior to modification, subsequent to modification, or both. The accounting for these transactions depends on the specific facts and circumstances.

6.8.1A Analysis of modifications and exchanges—before adoption of ASU 2020-06

To determine whether a modification or exchange of a convertible debt instrument should be accounted for as a modification or an extinguishment, a reporting entity should perform a two-step analysis.

6.8.1.1A Step 1: evaluate the change in cash flows—before adoption of ASU 2020-06

The first step a reporting entity should perform is the 10% test discussed in FG 3.4. The 10% test should not include any changes in fair value of the embedded conversion option.
If there is an extinguishment under Step 1, there is no need to conduct the additional tests in Step 2. However, if Step 1 does not indicate an extinguishment, the reporting entity should proceed to the tests in Step 2 to determine if extinguishment accounting is required.

6.8.1.2A Step 2: evaluate the change in the conversion option—before adoption of ASU 2020-06

If the change in the fair value of the embedded conversion option is greater than 10% of the carrying amount of the original debt instrument immediately before the modification, the modification should be accounted for as an extinguishment. The fair value of the embedded conversion option is generally calculated using an option pricing model, such as the Black-Scholes-Merton model, based on the terms of the embedded conversion option and inputs such as market interest rates, the reporting entity’s stock price, the volatility of the reporting entity’s stock price, and the expected dividend yield on the reporting entity’s stock.
If the modification adds or removes a substantive conversion option from the original debt instrument, the modification should be accounted for as an extinguishment.
See FG 3.7 for information on debt extinguishment accounting. See FG 6.6.5A for information on derecognition of convertible debt with a cash conversion feature. If a modification or exchange requires the application of extinguishment accounting and the new instrument does not require or permit cash settlement upon conversion, the new instrument is no longer subject to the cash conversion guidance in ASC 470-20.

6.8.2A Convertible debt modification accounting—before adoption of ASU 2020-06

When a convertible debt instrument is modified or exchanged in a transaction that is not accounted for as an extinguishment, an increase in the fair value of the embedded, unseparated conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) should reduce the carrying amount of the convertible debt instrument (increasing debt discount or reducing debt premium) with a corresponding increase in additional paid-in capital. This additional discount should be amortized over the remaining term of the convertible debt. However, a decrease in the fair value of an embedded conversion option resulting from a modification should not be recognized.
The reporting entity should reassess the convertible debt to determine whether (1) the embedded conversion option should be separated and accounted for as a derivative under the guidance in ASC 815 or (2) it is within the scope of the cash conversion guidance in ASC 470-20. A reporting entity should not recognize a BCF or reassess an existing BCF upon a modification or exchange that is accounted for as a modification.

6.8.2.1A Modification of convertible debt with cash conversion feature—before adoption of ASU 2020-06

When convertible debt with a cash conversion feature is modified in a transaction that is not accounted for as an extinguishment, a new effective interest rate should be determined to amortize the remaining debt discount. If the modification affects the embedded conversion option so that it no longer requires or permits cash settlement, the liability and equity components should continue to be accounted for separately.
In addition, the reporting entity should reassess the convertible debt to determine whether the embedded conversion option should be separated and accounted for as a derivative under the guidance in ASC 815. See FG 5.4.5 for further information.
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