Convertible Debt Complexities

Convertible debt instruments can be very complex, as they often incorporate elements of many types of financial instruments and thus require a broad understanding of accounting. This article will provide information about some of the more complicated elements of convertible debt. If you need a brief background on the general accounting for convertible debt, read our article on the topic. If you want a refresher on the different types of financing options, we have a few articles related to that topic: Types of Startup Investors, and Overview of Startup Financing. If you are ready to learn about some of the complexities of convertible debt, click on a title below to learn more about the selected topic.

Measurement at fair value

Measurement at fair value (ASC 820)

An entity should determine whether their debt is required to be measured at fair value, though this requirement is fairly uncommon. More commonly, an entity may elect to measure the instrument at fair value under the fair value option.

ASC 815-15-25-1B informs us that hybrid instruments that are measured at fair value, with changes in fair value being reported in net income, are not subject to derivative accounting. To qualify for the fair value election, however, it is necessary to first determine whether the hybrid instrument has an embedded feature that would require bifurcation. If a hybrid instrument has a feature that can be bifurcated, then the election to measure it at fair value can be made, unless the instrument is partially 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.

Derivative accounting scope exceptions

Derivative accounting scope exceptions

When determining whether an embedded feature falls within the purview of derivative accounting, three criteria must be met. Even after these criteria have been met, an entity must consider whether several scope exceptions found in ASC 815-10-15-74 are met, that would preclude derivative accounting. The first exception states that entities should not consider contracts to be derivative instruments if they are indexed to the reporting entities own stock and are classified as equity. The following two sections discuss these two criteria. The first section will address the second criterion for an embedded feature to be indexed to the company’s own stock. The second section will address the criteria for an embedded feature to be classified as equity.

Second criterion for embedded features to be indexed to their own stock

Second criterion for embedded features to be indexed to their own stock

In ASC 815-40-15-7C we learn that in order for an instrument to be indexed to its own stock, its settlement must be equal to the difference between the fair value of a fixed number of shares and a fixed amount of debt. This requirement for fixed shares and fixed debt has to be met in all circumstances, except for those in which the variables that alter the strike price or numbers of shares are inputs “to the fair value of a fixed-for-fixed forward or option on equity shares.1” With limited exception, if an instrument’s terms allow for adjustments to be made to the strike price or number of shares used to determine the settlement amount, regardless of how probable those adjustments are or whether the entity has control over the adjustment decision, the embedded feature would not qualify as being “indexed to the entities own stock.”

It is worth noting that there are a few provisions that would seem to alter the number of shares but, in fact, do not preclude an embedded feature from being indexed to the entity’s own stock. The first provision allows for the use of an offsetting position in the underlying shares, to hedge the inherent risk of stock price changes. In other words, inputs that would offset the effects of stock price fluctuation through a change in the number of shares held, are permitted.

The second provision allows for a single party to change the terms of the agreement so long as such modifications are beneficial to the other party. Again, an instrument containing this type of provision would not be precluded from being indexed to the entity’s own stock.

Criteria for an embedded feature to be classified as equity

Criteria for an embedded feature to be classified as equity

Within ASC 815-40 the codification gives several criteria for when an embedded feature qualifies to be classified as equity. The foundation for these criteria is the fact that “contracts that require settlement in shares are equity instruments,” per ASC 815-40-25-1.

Due to the complexity of contracts with embedded features, the codification includes greater detail regarding situations that would require equity classification. The codification clarifies that equity classification is necessary for contracts that “require physical settlement or net share settlement,” per ASC 815-40-25, or, those that “give the entity a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement)” and meet some additional qualifications in ASC 815-40-25 and 815-40-55.

The additional qualifications mentioned above are found in ASC 815-40-25-7 through 25-35 and 815-40-55-2 through 55-6. The qualifications in 25-7 through 25-35 are as follows:

  1. The contract cannot require net cash settlement unless the holders of the underlying shares would receive cash as well. This also excludes the circumstances in which payment of cash is required due to the final liquidation of the entity.
  2. The arrangement must allow for the entity to settle in unregistered shares.
  3. The entity will not have an issue with the number of authorized and unissued shares required to settle the contract.
  4. The arrangement provides for a specific limit of shares to be delivered in the case of a settlement.
  5. In the case that the entity fails to file with the SEC according to the required schedule, no cash payments will be required.
  6. Top-off and make whole provisions requiring cash settlement are not part of the terms of the arrangement.
  7. The arrangement does not provide for a counterparty to have higher ranking rights than the shareholders.
  8. No collateral is required for any reason at any time as a part of the contracts.

The qualifications in 815-40-55-2 through 55-6 pertain to circumstances in which a change of control outside of the entity’s control requires net cash settlement. It states that if in this scenario there is a provision that would require the counterparty to receive—or permits them to deliver upon settlement—the same type of consideration as the shareholders of the contract, equity classification would not be prohibited.

Beneficial conversion feature

Beneficial conversion feature

Before discussing the accounting for beneficial conversion features, it is important to note that this guidance is only applicable after having determined that the feature will not be bifurcated and does not fall under the cash conversion guidance.

When the conversion price of a convertible instrument is below the fair value of the shares of the underlying stock, a beneficial conversion feature (BCF) exists. At this price, the feature is said to be “in the money.” The intrinsic value of a BCF can normally be calculated by multiplying the number of shares received upon conversion by the positive difference between the fair value of the stock at commitment date and the contractual conversion price.

However, such a calculation is only allowable if there are not any complications present, such as instruments that are not immediately convertible, discounts present due to issuing the debt at a discount, basket transactions with partial allocation of proceeds to the debt, and so on. After performing the simple calculation to find the BCF, the accounting is relatively straightforward. The intrinsic value of the BCF is allocated to additional paid-in-capital (APIC) and the balance of the instrument’s proceeds are allocated to the debt host. The difficulty of working with BCF’s arises with the complications listed previously.

BCF Complications

The complications mentioned above present a challenge because they can result in BCF’s with values different from what would be seen when using the contractual conversion price as the appropriate measure. Consequently, the guidance states that the effective conversion price, rather than the contractual conversion price, should be used to test for a BCF.

The effective conversion price is determined by the proceeds which will be allocated to the convertible debt—embedded derivatives included—measured as of the commitment date. The codification defines a commitment date in ASC 470-20-30-10 to be “the date when an agreement has been reached that meets the definition of a firm commitment.” The determination of the commitment date is very important and should be done with great care, as some agreement’s terms make it difficult to establish a definite commitment date. For example, agreements that allow for a party to back out of the transaction for any reason cannot establish a valid commitment date until the earlier of the issuance of the convertible security or the expiration of the provision allowing for such an action.

Calculating the effective conversion price can be complicated. Two categories of impact areas to consider are listed below. The first is a list of items or events that will affect the calculation of the price and should be included, and the second is a list of items or events that you should not include in the calculation.

Items/Events to include in the effective conversion price:

  1. Issuance costs paid to investors, as these in effect reduce the proceeds received by the issuer.
  2. Embedded derivatives requiring bifurcation that can be settled separately from the conversion of the instrument at the same time or at a prior time.

Items/Events not to include in the effective conversion price:

  1. Third party issuance costs. These are costs paid to third parties for the issuance of the convertible instruments.
  2. All embedded derivatives requiring bifurcation other than those listed in item number two above.

Once the effective conversion price has been determined, you can use it to evaluate if a BCF exists. If there is a BCF, the intrinsic value of the conversion option (the portion that is “in the money”) must be recognized in equity and an equal reduction must be made to the carrying value of the instrument. ASC 470-20-35-7 explains that this reduction or discount will then be amortized as interest expense from the date of issuance until the date of redemption (if there is a stated date of redemption). ASC 470 further explains that if there is no stated date of redemption and the instrument has a multi-step discount, cumulative amortization must occur equal to the greater of either the amount that the investor can realize at the interim date, or the amount that is calculated using the effective yield method, using the conversion terms that would provide the greatest benefit to the investor. Lastly, the guidance states that if there is no stated redemption date and there is no multi-step discount, the discount must then be amortized using the effective yield method from the date of issuance to the earliest date of conversion.

The following example from EY’s Issuer’s accounting for debt and equity financings FRD illustrates how the effective conversion price should be used to compute the intrinsic value:

Your debt may contain conversion features that change with the occurrence of one or more contingent events. It is possible that those events can create beneficial conversion features. If you find yourself in this situation, those contingent beneficial conversions should be measured at their intrinsic value at the commitment date and be recognized if and when the contingent event occurs, following the same guidance explained above.

BCF’s and conversion features should be evaluated at each balance sheet date to determine if conversion terms have changed that would in turn create or modify a BCF, and to determine if the current classification is still appropriate.

Additionally, when an instrument that contains a BCF is converted, any discounts that have not been fully amortized must be recognized immediately as interest expense.

Cash conversion guidance

Cash conversion guidance

In the case that a conversion feature within a hybrid debt instrument can be settled in cash, the guidance found in the Cash Conversion subsections of ASC 470-20 must be used. ASC 815-15-55-76A gives four steps explaining how the guidance on accounting for embedded derivatives within the scope of ASC 470-20 should be applied:

  1. The instrument must be evaluated for any embedded features in addition to the cash conversion feature that need to be evaluated for bifurcation.
  2. Evaluate whether any of the identified features need to be accounted for separately as derivative instruments.
  3. Separate the liability portion of the instrument from the equity portion. The liability portion will include all embedded features except the conversion option. To determine the carrying value of the liability, measure the fair value of a debt instrument that is the same in every way except for the cash conversion feature and having an equity component. To measure the carrying value of the equity portion simply subtract the calculated value of the liability portion from the proceeds attributed to the debt initially. The equity portion of the proceeds will be recognized in additional paid-in capital.
  4. Any embedded features that require bifurcation would be separated from the liability portion as a single derivative instrument after the allocation of the proceeds to the two separate portions, avoiding impacting the accounting for the equity portion.

After the liability and equity portions have been separated, the discount attributed to the liability portion should be amortized such that the interest expense is equal to the debt borrowing rate given for the issuance of nonconvertible debt. This is necessary because the purpose of separating the liability and equity portion is to require an issuer of convertible debt with permitted or required cash settlement to recognize interest costs as if they had issued a similar debt instrument, but without an embedded conversion option. The intent of the resulting accounting is to accurately represent the cost of interest paid for debt with a conversion option.

Temporary equity

Temporary equity

ASC 480-10-S99-3A contains SEC staff guidance on the classification and measurement of redeemable securities. Within this guidance there is specific reference to convertible debt instruments that contain a separately classified equity component. According to the guidance, if the convertible debt is redeemable or convertible for cash or other assets at the balance sheet date, a portion should be presented initially in temporary equity. It is important to note that if the debt in question is not redeemable at the balance sheet date but could later be redeemed by the holder of the debt, the debt is not considered to be currently redeemable. Additionally, if the issuer of the debt has the ability to choose to settle in shares rather than cash, temporary equity classification would not be required. This classification is only required if the chance of cash settlement is not within the issuer’s control.

Due to the sometimes unique terms of convertible debt, it is possible that the equity component of the debt may alternate back and forth between temporary and permanent equity from one period to the next. This could happen, for example, if there are specific times that the debt is convertible and times when it is not. It is necessary to reevaluate the classification of your debt at each financial statement date, or quarterly.

The SEC staff guidance clarifies that any portion of the debt that is presented in temporary equity must be measured as the positive difference between the carrying value of the liability portion of the debt at the issuance date, and the amount to be paid to the debt holder as a result of redemption or conversion, also at the issuance date.

The question of how subsequent measurement should occur is less certain than initial measurement, as the SEC staff guidance is not clear on whether any amount subsequently reclassified as temporary equity can exceed the amount that was recognized originally as equity. The following example will illustrate this complexity.

Consider an immediately redeemable debt instrument that is made up of a liability component (L), a derivative liability component (DL), and an equity component that is presented completely in temporary equity (TE). If DL was later reduced, TE would increase, as it is a measure of the amount immediately redeemable, minus L. Thus, although TE was already equal to the full value of the equity component, it would now surpass that component’s actual value. As the guidance is unclear on how to properly treat this kind of scenario, two views are currently held in practice:

  • View A – The original amount allocated to the equity component should not be exceeded by what is presented in temporary equity, even if doing so misrepresents the potential redemption amount faced by the company.
  • View B – The accurate amount that is potentially redeemable should be presented in temporary equity, despite the fact that doing so could result in temporary equity exceeding the original amount allocated to the equity component.

Prevailing industry opinion suggests that if you choose to adopt View A as your accounting practice, it would be advisable to disclose the difference between the full potential redemption amount and the amount shown in temporary equity on your balance sheet.

Conventional convertible debt

Conventional convertible debt

ASC 815-40-25-39 addresses the required analysis for conventional convertible debt instruments. Conventional convertible debt instruments are those that allow the holder to realize the value of the conversion feature only by exercising the conversion option to receive the proceeds as a fixed number of shares or as cash with an equivalent value to the fixed number of shares. The decision between converting into cash or shares must be made by the issuer of the debt, rather than the holder. To be conventional, the debt cannot contain a number of provisions that are often found in debt, including make-whole provisions, anti-dilution provisions that do not meet the qualifications of being “standard,” and any type of provision that allows for the settling of the conversion feature to occur with anything besides a fixed number of shares. The final qualification for convertible debt to be considered conventional is for the conversion feature to be exercisable only upon the passage of time or the occurrence of a contingent event.

Once convertible debt has qualified as conventional, you must determine whether or not the embedded feature should be classified as equity. This analysis is performed while evaluating whether the debt is indexed to the entity’s own stock. To learn more about this analysis, refer to our Accounting for Convertible Debt article.

 


 

 


 

Resources Consulted

 


 

Footnotes

  1. ASC 815-40-15-7D
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Author Caleb Christensen

Caleb grew up in Utah, where he found his passion for the outdoors as well as business. He considers himself a Blockchain enthusiast, and loves spending time enjoying all the beauty Utah has to offer.

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