Background
Convertible debt instruments include a conversion feature that permits the debt to be converted into a fixed number of shares of the issuer. The terms of conversion features vary greatly but typically require the issuer to settle in one of the following ways:
- Traditional convertible debt: Settle the entire conversion value in shares.
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Cash convertible debt: Settle the accreted value in cash and the conversion premium in any combination of cash or shares, or settle the entire conversion value in any combination of cash or shares.
In some cases, an issuer of convertible debt will change the terms of the instrument to induce the holder to convert early. This inducement may be in various forms, including increasing the number of shares issuable or providing cash or other securities incremental to the value of the original conversion value.
Under existing guidance, which was written before the prevalence of cash convertible debt, such conversions are accounted for in one of the following ways, depending on how the instrument was changed to induce conversion:
- Extinguishment accounting. Record in earnings the difference between the reacquisition price and the net carrying amount of the debt.
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Induced conversion accounting. Record in earnings an expense equal to the fair value of the consideration issued in excess of the fair value of the securities issuable under the original conversion feature (the sweetener).
The distinction between extinguishment accounting and induced conversion accounting is critical as the loss recognized under extinguishment accounting may be significantly greater. This is because under induced conversion accounting, an expense is recognized only for the sweetener.
Before the issuance of Accounting Standards Update (ASU) 2020-06, “Debt – Debt With Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40),” separate guidance was applied to cash convertible debt. With the issuance of ASU 2020-06, this guidance was eliminated. As a result, questions in practice have arisen about the application of the existing guidance to cash convertible debt.
Breaking it down
Under the proposal, the issuer of a convertible debt instrument in the scope of Subtopic 470-20, “Debt – Debt With Conversion and Other Options,”1 would assess whether the amount and form of consideration to be transferred pursuant to the original conversion privileges are preserved to determine whether induced conversion accounting should be applied. The proposal also would require convertible debt instruments to contain a substantive conversion feature2 at issuance in order to apply induced conversion accounting.
Preservation of consideration
Under the current guidance in Subtopic 470-20, induced conversion accounting is applied only when amended conversion privileges are offered for a limited time and when the conversion results in the issuance of all equity securities as prescribed within the original contractual conversion privileges.
The proposal replaces the latter requirement with a requirement that the consideration issued upon conversion includes the form and amount that could have been issued pursuant to the terms of the existing debt instrument. As an example, if changed conversion privileges offered for a limited time resulted in the settlement of debt for $1 million in cash, induced conversion accounting would apply if conversion under the existing debt terms could have been settled through a cash payment of less than $1 million. If the existing debt terms required the issuer to issue shares, induced conversion accounting would be precluded.
If induced conversion accounting is applied under the proposal, an issuer would recognize in earnings an expense equal to the fair value of the consideration issued in excess of the fair value of the consideration issuable under the existing terms – that is, the terms in place before the inducement offer. Consistent with existing guidance, the proposal requires entities to measure the fair value of the shares and other consideration based on the fair value of the shares on the offer acceptance date, including cases where conversion terms under either the existing debt or the inducement offer are based on future share prices. As a result, volume-weighted average price formulas based on future prices would not affect the determination of the amount of cash or number of shares in the induced conversion assessment.
The proposal also precludes the application of the induced conversion accounting to inducement offers that index the amount of cash or number of shares to something other than the fair value of the underlying shares because the form of settlement would be changed.
Previous modifications
If within a year leading up to the inducement offer acceptance date the instrument has been exchanged or modified and not accounted for as an extinguishment in accordance with Subtopic 470-50, the terms used to determine whether induced conversion accounting would be applied would be those that existed a year before the acceptance date. The objective of this guidance is to prevent the potential for restructuring of conversion features for the purposes of avoiding extinguishment accounting.
Debt not currently convertible
Under the proposal, induced conversion accounting would be applied only to instruments that contained a substantive conversion feature at the time of issuance. The proposal clarifies that such instruments may include those that are not currently convertible due to an exercise contingency not being met or a specified exercise date that has not yet occurred. For example, a convertible debt instrument containing a substantive conversion option that is not convertible as of the offer acceptance date due to an exercise contingency not being met but that could become convertible upon the issuer’s exercise of a call option would apply induced conversion accounting assuming all other conditions are met.
Transition and effective date
Entities would be permitted to adopt changes either prospectively for settlements during the fiscal year (including interim periods) beginning after the effective date, or retrospectively for settlements as of the beginning of the first comparative reporting period following the adoption of ASU 2020-06. The effective date of the guidance will be determined based on stakeholder feedback, which is due on March 18, 2024.
Illustrative example: Determining whether induced conversion accounting applies
An entity issues convertible debt in the form of a $1,000 face value convertible bond with a conversion price of $10 per share. While the bond is convertible only upon the occurrence of certain events, the conversion feature is considered substantive under ASC 470-20-40-6 through 40-10 and does not require separate accounting. The contractual conversion terms require that the bond principal be settled in cash and the remaining spread settled in any combination of cash or shares at the issuer’s election.
One year after issuance and before the occurrence of any events permitting conversion, the entity extends the bondholder a conversion offer for a limited time consisting of $1,350 in cash and 25 shares. The fair value of the entity’s shares is $15 per share on the date that the offer is accepted, and the conversion terms have not been amended since issuance.
Preservation of the amount of consideration issuable
To determine whether the amount of consideration issuable under the original conversion privileges is preserved, the entity must compare the value of the original conversion privileges to that of the inducement offer, based on the share price as of the offer acceptance date. The original conversion privileges are based on an implied 100 shares ($1,000 face value divided by $10 per share) underlying the instrument at issuance. Therefore, the comparison is calculated as follows:
Amount of original conversion privileges = 100 shares x $15 per share = $1,500
Amount of inducement offer = $1,350 cash + (25 shares x $15 per share) = $1,725
As the amount of consideration transferred under the inducement offer exceeds that of the original conversion privileges, the amount of consideration issuable is preserved.
Preservation of the form of consideration issuable
Because the inducement offer includes an amount of cash consideration greater than the fixed cash component of the original conversion privileges – that is, $1,350 under the inducement offer compared to $1,000 principal cash settlement required under the original privileges – the cash consideration issuable is preserved.
To determine whether the equity issuable is preserved, the entity must determine the number of shares that would have been issued pursuant to the original conversion privileges if $350 ($1,350 total cash consideration less $1,000 to settle the principal) of the conversion premium was settled in cash. In that case, the remaining difference of $150 is then used to determine whether the equity issuable is preserved – that is, for the equity to be preserved, the number of shares that would have been issued under the original privileges (using the $150 difference and a value of $15 per share on the offer acceptance date) must not exceed the number of shares actually issued under the inducement offer.
Conversion premium = $1,500 amount of original conversion privileges - $1,000 principal = $500
Value of equity consideration under original privileges = $500 premium - $350 cash offered in excess of minimum cash required under original privileges = $150
Number of shares issuable under original privileges = $150 ÷ $15 per share = 10 shares
Because the number of shares issued under the inducement offer (25) is greater than the shares issuable under the existing privileges (10), the overall form of the original privileges is preserved.
Example conclusion
The settlement of the convertible debt should be accounted for as an induced conversion because the amount and form of consideration under the existing debt instrument was preserved, the conversion feature was considered substantive at issuance and did not require separate accounting, and the conversion offer was for a limited time. The fact that the conversion feature was not currently exercisable under the existing terms is irrelevant because the conversion feature was determined to be substantive.
