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Accounting for Convertible Debt

Posted
Updated
ByKatie Yazbeck

 

Convertible debt instruments have features that permit or require the holder to convert the instrument into the issuer’s equity securities. Companies may prefer to issue convertible debt because the interest rate is typically lower compared to traditional non-convertible debt. Investors like convertible debt for the potential equity upside.  The convertible debt instrument may have automatic or optional conversion features.

Accounting Models

The terms of the convertible debt instrument and settlement provisions will dictate the accounting treatment. The FASB simplified the accounting for convertible debt with the issuance of ASU 2020-06. There are now only three different accounting models for convertible debt:

 

Accounting Model

Recognition and Measurement

Straight debt

  • Recognize a liability equal to the proceeds received
  • Recognize a discount or premium similar to nonconvertible debt
  • Amortize the discount or premium over the term to interest expense
  • Upon conversion, no gain or loss is recognized, and the carrying amount of the liability will be transferred to equity to reflect the shares issued

Derivative separation

  • Bifurcate the embedded derivative (conversion option) based on fair value
  • Recognize the derivative at fair value as a discount to the liability
  • Record changes in the fair value of the derivative in earnings
  • Recognize a discount or premium similar to nonconvertible debt
  • Amortize the discount or premium over the term to interest expense
  • Upon conversion, the debt and the derivative liability is subject to extinguishment accounting and a gain or loss is recognized. The derivative is remeasured to the fair value at conversion date. The gain or loss is calculated as the difference between the fair value of the consideration issued upon conversion to the carrying value as of the conversion date.

 

Substantial premium separation

  • Recognize a liability equal to the principal amount
  • Record the difference between the proceeds received and the principal amount in additional paid-in capital
  • Upon conversion, no gain or loss is recognized, and the carrying amount of the liability will be transferred to equity to reflect the shares issued

 

The recognition and measurement provisions under each model are different; therefore, it is critical to first determine the appropriate model to use. The following steps should be followed to determine the appropriate model:

  1. Is the convertible debt instrument required to be fair valued under ASC 480, or was the fair value option elected?

The first step is to determine if the convertible debt instrument is within the scope of ASC 480, which applies to freestanding financial instruments with characteristics of both liabilities and equity. To be within the scope of ASC 480, the instrument must embody either:

  • An obligation to buy back the issuer’s shares by transferring assets or
  • Issue a variable number of shares for which the monetary value is predominantly fixed, varies with something other than the fair value of the issuer’s equity shares, or varies inversely in relation to the issuer’s equity shares.

If either criteria is met, the convertible debt instrument is within the scope of ASC 480, and the Company should it as a liability at fair value, with changes in fair value recorded in earnings each reporting period. If the convertible debt instrument does not meet the criteria under ASC 480, the Company should proceed to the next step to determine the balance sheet classification under ASC 815.

  1. Is the conversion option an embedded derivative that should be bifurcated?

If the conversion option (and other embedded components) meets all the following criteria, it should be bifurcated from the debt host and accounted for separately as a derivative:

  • The embedded derivative is not clearly and closely related to those of the host contract.
  • The convertible debt instrument is not remeasured at fair value under other GAAP with changes in fair value reported in earnings.
  • The embedded derivative would be a derivative instrument on a standalone basis subject to the requirements of ASC 815 (one or more underlying, net investment, net settlement)

In determining whether the embedded derivative is clearly and closely related to the host contract, the Company should first determine whether the host is a debt or equity host.

If all the criteria above are met, the embedded derivative should be bifurcated and accounted for as a derivative at fair value, with the changes in fair value recognized in earnings.

  1. Was the convertible debt issued with a substantial premium?

There is no brightline in determining what is considered “substantial.” However, 10% is often used as a starting point. Other factors, such as whether the amortization premium would result in negative interest expense, should also be considered.

If it is determined that the convertible debt instrument is issued at a substantial premium, the presumption is that the premium represents paid-in capital. Therefore, the convertible debt instrument is separated into a liability for the principal amount and additional paid-in capital for the excess proceeds. The amounts recorded in additional paid-in capital would not be subsequently remeasured.

EPS Considerations

Convertible debt will impact a company’s diluted EPS calculation. Companies will need to apply the if-converted method, which assumes the conversion of the entire convertible instrument into shares that will be added to the denominator of the diluted EPS calculation.

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