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6.9A Conversion accounting—before adoption of ASU 2020-06
Publication date: 31 Oct 2020
us Financing guide
If a convertible debt instrument accounted for entirely as a liability is converted into a reporting entity’s common or preferred stock pursuant to a conversion option in the instrument, it is not an extinguishment; the convertible debt is settled in exchange for equity and no gain or loss is recognized upon conversion. Conversely, the exchange of common or preferred stock for debt that does not contain a conversion right in its original terms is an extinguishment. Such an exchange may also be considered a troubled debt restructuring. See FG 3.3 for information on troubled debt restructurings.
ASC 470-20-40-4 provides guidance on accounting for conversions consistent with the original terms of a convertible debt instrument accounted for as a liability in its entirety.
If a convertible debt instrument does not include a beneficial conversion feature, the carrying amount of the debt, including any unamortized premium or discount, shall be credited to the capital accounts upon conversion to reflect the stock issued and no gain or loss is recognized.
We believe debt issuance costs should be treated similar to debt discount or premium; therefore, we believe the carrying amount should include unamortized debt issuance costs. Cash interest expense should be accrued (or imputed, in the case of a zero coupon convertible debt instrument) up to the date of conversion. If the accrued interest is not paid in cash upon conversion, then it should also be included in the carrying amount of the debt upon conversion. Interest is accrued at the pre-tax amount.
Conversion accounting is only appropriate when the conversion option has not been separated from the debt and accounted for as a derivative based on the guidance in ASC 815 or separately accounted for under the guidance in the cash conversion or beneficial conversion feature subsections of ASC 470-20.
Example FG 6-4A illustrates conversion accounting when convertible debt is accounted for entirely as a liability.
EXAMPLE FG 6-4A
Conversion accounting when convertible debt is accounted for entirely as a liability
Conversion accounting when convertible debt is accounted for entirely as a liability
FG Corp issues convertible debt that will be settled upon conversion entirely in shares, and concludes that the convertible debt should be accounted for as a liability in its entirety.
Debt issuance costs are $10 and are recorded as additional debt discount on the balance sheet.
FG Corp’s stock price is $85 at the date the convertible debt is issued. FG’s common stock has a par value of $1 per share. The debt is issued at par.
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 |
Two years after FG Corp issues the debt, investors exercise their conversion options. FG Corp’s stock price is $110 at the conversion date. FG Corp has amortized $4 of debt issuance costs by the conversion date; therefore, there are $6 of unamortized debt issuance costs.
This example ignores the effects of accrued interest and income taxes for simplicity.
How should FG Corp record the conversion of its convertible debt?
Analysis
To derecognize the convertible debt and unamortized debt issuance costs, and recognize the common stock issued upon conversion, FG Corp should record the following entry.
Dr. Convertible debt |
$1,000 |
|
Cr. Deferred debt issuance costs |
$6 |
|
Cr. Common stock – par value |
$10 |
|
Cr. Additional paid-in capital (common stock) |
$984 |
As discussed in ASC 470-20-40-5(a), the conversion of a debt instrument that becomes convertible upon the reporting entity’s exercise of a call option should be accounted for using the conversion accounting model if, at issuance, the debt instrument contains a substantive conversion feature.
6.9.1A Conversion of debt with nonsubstantive conversion option—before adoption of ASU 2020-06
ASC 470-20-40-5(b) provides guidance on the conversion of a debt instrument that becomes convertible upon the reporting entity’s exercise of a call option when the conversion option is nonsubstantive.
No substantive conversion feature. If the debt instrument did not contain a substantive conversion feature as of its issuance date (as defined in paragraphs 470-20-30-9 through 30-12), the issuance of equity securities shall be accounted for as a debt extinguishment. That is, the fair value of the equity securities issued should be considered a component of the reacquisition price of the debt.
To be considered substantive, a conversion option should be at least reasonably possible of being exercised in the future. Many conversion options meet that definition and are substantive. However, a conversion option which (1) is exercisable only upon exercise of the reporting entity’s call option at par, or (2) has an extremely high conversion price relative to the price of the underlying shares at inception may not be substantive.
ASC 470-20-40-7 through ASC 470-20-40-9 provide guidance on determining whether a conversion option is substantive.
6.9.2A Induced conversion—before adoption of ASU 2020-06
An induced conversion is a transaction in which a reporting entity offers additional shares or other consideration (“sweeteners”) to investors to incentivize them to convert their convertible instrument. For example, a reporting entity may reduce the original conversion price or issue additional consideration (e.g., cash or warrants) not provided for in the original conversion terms to debt holders that agree to convert during a limited offer period. ASC 470-20-40-13 and ASC 470-20-40-14 provide guidance on which transactions are induced conversions.
The guidance in paragraph 470-20-40-16 applies to conversions of convertible debt to equity securities pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the terms of the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. That guidance applies only to conversions that both:
a. Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
b. Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.
A conversion includes an exchange of a convertible debt instrument for equity securities or a combination of equity securities and other consideration, whether or not the exchange involves legal exercise of the contractual conversion privileges included in terms of the debt. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.
ASC 470-20-40-16 requires a reporting entity to recognize an expense equal to the fair value of the shares or other consideration issued to induce conversion (i.e., the fair value of all consideration transferred in excess of the fair value of the securities transferred pursuant to the original conversion terms).
Question FG 6-7A discusses what is considered a “limited period of time” as used in ASC 470-20-40-13.
Question FG 6-7A
What is a “limited period of time” as used in ASC 470-20-40-13?
What is a “limited period of time” as used in ASC 470-20-40-13?
PwC response
We believe that when evaluating the effective time period of a change in conversion privileges, the reporting entity’s intent in offering the sweetener should be to induce prompt conversion of the convertible instrument. When this assessment is made, the inducement period should be considered in relation to the period in which the instrument is convertible without the sweetener.
Question FG 6-8A discusses whether an investor’s offer to surrender a convertible instrument in exchange for more shares of stock than it is entitled to under the original conversion terms should be accounted for as an induced conversion or extinguishment.
Question FG 6-8A
If an investor offers to surrender a convertible instrument in exchange for more shares of stock than it is entitled to under the original conversion terms and the offer is valid for a limited period of time, should the reporting entity account for the transaction as an induced conversion or extinguishment?
If an investor offers to surrender a convertible instrument in exchange for more shares of stock than it is entitled to under the original conversion terms and the offer is valid for a limited period of time, should the reporting entity account for the transaction as an induced conversion or extinguishment?
PwC response
The reporting entity should account for the transaction as an induced conversion. The party that makes the offer should not affect the accounting; thus, inducement accounting is not affected by which party makes the offer.
Question FG 6-9A discusses whether an offer to allow investors to tender their convertible instruments in exchange for cash and shares with a total value greater than the value of the shares the investor is entitled to under the original conversion terms should be accounted for as an induced conversion or as an extinguishment.
Question FG 6-9A
A reporting entity extends an offer to investors, for a limited period of time, to allow investors to tender their convertible instruments (that contractually require gross physical settlement in shares) in exchange for cash and shares. The total value of consideration that could be received is greater than the value of the shares that the investor is entitled to under the original conversion terms; however, the number of shares the investor will receive is less than the number of shares it is entitled to under the original conversion terms.
Should the reporting entity account for the transaction as an induced conversion or as an extinguishment?
A reporting entity extends an offer to investors, for a limited period of time, to allow investors to tender their convertible instruments (that contractually require gross physical settlement in shares) in exchange for cash and shares. The total value of consideration that could be received is greater than the value of the shares that the investor is entitled to under the original conversion terms; however, the number of shares the investor will receive is less than the number of shares it is entitled to under the original conversion terms.
Should the reporting entity account for the transaction as an induced conversion or as an extinguishment?
PwC response
The reporting entity should account for the transaction as an extinguishment. ASC 470-20-40-13(b) requires all equity securities issuable pursuant to the original conversion privileges to be issued for the conversion to be an induced conversion. If fewer shares are issued, this condition is not met, and extinguishment accounting should be applied.
Induced conversion–convertible debt with a cash conversion feature
ASC 470-20-40-26 provides induced conversion guidance for convertible debt with a cash conversion feature that differs from the induced conversion guidance for other convertible instruments.
An entity may amend the terms of an instrument within the scope of the Cash Conversion Subsections to induce early conversion, for example, by offering a more favorable conversion ratio or paying other additional consideration in the event of conversion before a specified date. In those circumstances, the entity shall recognize a loss equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of consideration issuable in accordance with the original conversion terms. The settlement accounting (derecognition) treatment described in paragraph 470-20-40-20 is then applied using the fair value of the consideration that was issuable in accordance with the original conversion terms. The guidance in this paragraph does not apply to derecognition transactions in which the holder does not exercise the embedded conversion option [emphasis added].
The requirement for an investor to exercise its conversion option for a transaction to be an induced conversion conflicts with the induced conversion guidance otherwise applicable to all convertible instruments in ASC 470-20-40-14, which does not require the conversion option to be exercised.
A conversion includes an exchange of a convertible debt instrument for equity securities or a combination of equity securities and other consideration, whether or not the exchange involves legal exercise of the contractual conversion privileges included in terms of the debt [emphasis added]. The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.
Given this conflict in the accounting literature, we believe a reporting entity should consider its specific facts and circumstances to determine whether the substance of its derecognition transaction involving convertible debt with a cash conversion feature is an induced conversion or an extinguishment. However, we believe the following transactions that are related to a limited time offer and involve additional consideration should be accounted for as induced conversions.
• Transactions in which the investor legally exercises its conversion option early (ASC 470-20-40-26)
• Transactions in which the investor does not exercise its conversion option, but the number of shares delivered is equal to or greater than the notional number of shares underlying the conversion option (i.e., bond principal divided by the conversion price) (ASC 470-20-40-13, ASC 470-20-40-14 and ASC 470-20-40-15)
As discussed in ASC 470-20-40-26, when a reporting entity induces conversion of convertible debt with a cash conversion feature, it should:
• Recognize an inducement charge equal to the difference between (1) the fair value of the consideration delivered to the investor and (2) the fair value of the consideration issuable under the original conversion terms
• Allocate the fair value of the consideration issuable under the original conversion terms to the debt and equity components using the derecognition guidance described in FG 6.6.5A
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