The structure of an agreement between a debt holder and an issuer is very important for many reasons, but is especially so when the issuer is anticipating an IPO. Complex convertible debt structures can complicate the IPO process and present additional challenges. This article describes the basic steps used to determine the proper accounting treatment for convertible debt. To gain a broader understanding of what convertible debt is and how it is used, read our Overview of Startup Financing article.
Convertible debt is commonly made up of an underlying debt agreement (often called the “host”, which includes routine terms such as repayment and maturity) and a combination of some of the following elements:
- A conversion option into either cash or equity shares, often held by the debt holder, though it can be held by the issuer conversely.
- Embedded redemption (put and/or call) features that allow the issuer to redeem the debt and/or the holder to cause repayment of the debt.
- Contingent features that cause the stated interest rate to change based on factors that may occur during the debt term.
- Down-round price protection provisions to protect earlier investors in the event a new round of financing occurs at a lower price level.
- Make-whole provisions that compensate the holder in the event the issuer chooses to prepay the debt.
- Standard anti-dilution provisions
- Term-extending options
A debt host that includes some of the elements above is known as a hybrid instrument.
The terms and structure of your debt can play a large role in the accounting treatment it requires. For instance, convertible debt that requires net cash settlement, or that gives the holder of the debt the power to choose net cash settlement or settlement in shares, may be classified as a liability, whereas those instruments that give the debt issuer the power to choose net cash settlement or settlement in shares, or require physical or net share settlement, may be classified as equity. In addition, embedded features that must be separated (i.e., bifurcated) from the underlying debt host for accounting purposes may be subject to fair value measurement and mark-to-market adjustments each period, impacting reported earnings and requiring valuation experts to determine the valuation of such instrument.
There are many issues to consider when determining the proper accounting treatment for convertible debt. This article provides a high-level overview of the accounting decision-making process and identifies how and where each issue comes into play. To gain a deeper understanding of the complications of convertible debt, check out our convertible debt complexities article where the complexities are covered in greater detail.
Convertible debt often has embedded features that need to be bifurcated and accounted for differently than the debt host. The following steps provide a framework to evaluate various aspects of common debt arrangements to determine (a) if bifurcation of embedded features is necessary, (b) the accounting treatment of the embedded features if separated from the debt host, and (c) the accounting treatment for the debt host whether or not bifurcation is necessary.
The evaluation process described below in steps 1-5 must be repeated for each embedded feature in a convertible instrument.
Step 1: Fair value election
While fairly uncommon, debt should first be evaluated to determine whether it is required to be measured at fair value. More commonly, an entity may elect to measure the instrument at fair value under the fair value option.
ASC 815-15-25-1(b) informs us that hybrid instruments that are measured at fair value with their entire changes in fair value reported in net income are not subject to derivative accounting. To elect the fair value option, however, it is necessary to first determine whether or not the hybrid instrument has an embedded feature that would require bifurcation. If bifurcation is necessary, the election to measure the entire hybrid instrument at fair value can be made to avoid accounting for the debt host and embedded feature separately, unless the instrument is classified as equity —including temporary equity. This would include instruments with a beneficial conversion feature, or those that fall within the cash conversion guidance. It is important to note that the election for initial and subsequent fair value measurement of a hybrid instrument is irreversible.
ASC 825 informs us that upon electing the fair value option, and at each future reporting date, a company must report in earnings any unrealized gains and losses related to the instrument for which the election has been made. This also means that all upfront costs and fees for this instrument must be reported in earnings as they are incurred, rather than being deferred.
Put simply, by making the fair value election you should be able put your time and energy towards complying with the guidance in ASC 820 Fair Value Measurement rather than worrying about complicated derivative accounting guidance.
Step 2: Determine whether the debt qualifies as conventional convertible debt.
The criteria to qualify as conventional convertible debt are straightforward but due to their strict definitions, they are not likely to be met. The qualifications are as follows:
- At the discretion of the issuer of the debt, the holder can obtain the value of the option only when exercised through a fixed number of shares or through the receipt of cash with equal value to the fixed number of shares. This criterion does allow for standard anti-dilution provisions, but price protection provisions and other conversion price adjustments would disqualify the convertible debt from being “conventional.”
- The holder of the debt can exercise the option only upon the passage of time or if a contingent event occurs.
It is very common to see ratchet anti-dilution adjustments in convertible debt instruments, and it is unlikely for the issuer of the debt to be the party with the power to choose cash or share settlement. Due to the fact that both of these features are in violation of the first of the two criteria, it is not common for convertible debt to qualify as conventional.
Under the scenario that your debt meets the stated qualifications, it will not need to be bifurcated. The only additional analysis needed would be to determine if a beneficial conversion feature exists.
If the debt qualifies as conventional convertible debt, skip to step 5(b) to learn more about the beneficial conversion feature. Otherwise, move on to step 3.
Step 3: Determine if there are any features that qualify as an embedded derivative
ASC 815-15-25-1 requires that an embedded feature be evaluated for the following three criteria to determine if bifurcation and derivative treatment are appropriate:
- The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
- The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
- A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
Criterion C above refers to Section 815-10-15 for determining whether the feature would be classified as a derivative instrument subject to derivative accounting. This means that for an embedded feature to qualify as an embedded derivative, it must first qualify as a derivative when evaluated as a freestanding instrument and not an embedded feature. To qualify as a derivative, the follow criteria must be met:
- The feature must have an underlying and a notional and/or payment provision
- There must be no initial investment, with the exception of an investment that is less than the expected market value of the feature.
- The contract must allow for net settlement or provide a way to achieve the equivalent of net settlement (i.e. the use of a market mechanism or the delivery of an asset readily convertible to cash).
If all of the qualifications listed above are met, then the feature is an embedded derivative and you must continue to step 4. If the qualifications are not met, there is no need to bifurcate and separately account for the feature, and the debt should be recorded based either on the cash proceeds received, or on the allocated proceeds. Skip to step 5 to learn what additional guidance may still apply to your debt.
Step 4: Determine if any scope exceptions apply.
Per ASC 815-10-15-74, several scope exceptions may exclude the embedded feature from derivative accounting despite meeting the criteria listed above. They are described below:
- The feature is indexed to the company’s own stock and is classified as equity. To be indexed to its own stock, the feature has to meet the following two criteria:
- The feature must not have any exercise contingencies. If it does, they must be tied directly to the market for the stock or to the operations of the entity.
- Settlement must be equal to the difference between the fair value of the fixed number of shares and a fixed amount of debt, unless the variables that would alter the strike price or numbers of shares were inputs “to the fair value of a fixed-for-fixed forward or option on equity shares1.” The details of this specific criterion are outside the scope of this article, but take a look at our convertible debt complexities article for further understanding.
- The feature is subject to guidance found in ASC 718 or ASC 505-50.
- The feature is part of a contract to enter into a business combination.
- The feature is part of an acquisition contract to enter into a not-for-profit entity.
- The feature is part of a merger contract between two not-for-profit entities.
- The feature is part of a contract that requires cash settlement for a fixed number of shares and falls within the scope of paragraphs 480-10-30-3 through 30-5, 480-10-35-3, and 480-10-45-3.
To determine if the feature should be classified as equity, an in-depth analysis must be done. The basic principle underlying this analysis, however, is that there cannot be any settlement terms requiring the conversion to be settled in cash. For further understanding of the more in-depth analysis we’ve referenced, read through the related section in our convertible debt complexities article.
If the scope exceptions are met, the embedded feature need not receive separate derivative accounting treatment. If the feature in question is related to conversion and one of the scope exceptions was met, several more steps of analysis must be completed. These will be addressed in steps 5(a) – 5(c). If the feature is not related to conversion and the scope exceptions are satisfied, no further analysis is needed and the debt should be recorded based either on the cash proceeds received, or on the allocated proceeds. If the scope exceptions are not met, proceed to step 6.
Step 5(a): Cash Settlement Determination
Begin this step by evaluating whether the conversion feature can be settled in cash. If cash settlement is allowed, the cash conversion guidance found in ASC 815-15-55-76A must be followed. This typically results in separate accounting for the liability (debt) portion and the equity (conversion feature) portion. The debt will be allocated the portion of the proceeds that would be attributable to non-convertible debt containing all of the same features that are embedded in the convertible debt in question, except for the conversion feature. The remaining proceeds will be allocated to the conversion feature and will be recognized in additional paid-in capital. Any embedded features other than conversion must then be bifurcated from the liability portion as a single derivative.
If cash settlement is not allowed, continue to step 5(b).
Step 5(b): Evaluate the conversion feature for beneficial conversion
Determine whether the conversion feature is in the money at the commitment date. If the feature is in the money, there is a beneficial conversion and it will be necessary to “allocate the debt proceeds with an equity component receiving the intrinsic value of the beneficial conversion feature2.” To learn more about the beneficial conversion feature, check out the convertible debt complexities article where it is covered in greater depth.
If the feature is not a beneficial conversion, move to step 5(c).
Step 5(c): Evaluate the debt for a premium
Determine if a significant, or substantial premium is present. If such a feature is part of the debt structure, the portion of the proceeds attributable to the premium should be allocated to additional paid-in capital.
If none of the guidance found in steps 5(a)-5(c) have applied to the conversion feature in question, no special accounting treatment for that feature is necessary. Proceed to the important note found below step 6 to continue your reading.
Step 6: Bifurcate the qualifying embedded feature(s).
Having not been excluded from derivative accounting, the embedded derivative must be bifurcated from the host instrument and reported separately. This means that the debt proceeds allocated to the debt host must be reported separately from the proceeds that make up the fair value of the embedded feature.
Important note: If you are an SEC registrant, or if you foresee yourself filing with the SEC in the future, you will need to evaluate whether a portion of your embedded feature needs to be reported in temporary equity. To learn more about temporary equity, check out the convertible debt complexities article where it is covered in depth.
Convertible debt can become very complex, and understanding that complexity can be a real advantage to you. Take the time necessary to understand all of the issues associated with convertible debt, and apply the analysis described in this article to aid you as you structure debt instruments and evaluate debt arrangements proposed to you by potential investors.
- EY Financial Reporting Developments (FRD) – Issuer’s accounting for debt and equity financings
- FASB Accounting Standards Codification (ASC) 825 and 815 Journal of Accountancy.com – The Finer Points of Fair Value