Accounting for Extinguishment of Debt with an Embedded Conversion Feature

Companies issue convertible debt that may come with embedded conversion features. These debt instruments are useful for issuing entities to raise capital.

Investors can enjoy additional benefits of embedded conversion features as well as convertible debt features.

Let us discuss the extinguishment of debt with an embedded conversion feature and its accounting treatment.

Debt with an Embedded Conversion Feature

Convertible debt offers flexible options to issuers to raise finance. Investors can also receive flexible terms and benefits through convertible debt investments.

Commonly, convertible debt is issued in the form of bonds or preferred shares. The debt can be converted to common stocks of the issuer (or a company in the same group) upon conversion.

In certain cases, debt comes with an embedded conversion feature that allows cash conversion. These debt instruments can be converted to cash for the difference in the conversion value and the accredited value (conversion spread).

Debt conversion can also come in the form of both stock and cash payments. Either way, the issuer must settle the obligation through cash or stock issuance.

Accounting for Convertible Debt Extinguishment

A reporting entity should first assess the debt conversion feature. The accounting treatment of the convertible debt extinguishment would depend on the conversion feature. Whether the conversion is in the form of cash, stock, or whether it is beneficial or contingent conversion.

ASC 470-50 guides on the accounting treatment of convertible debt extinguishment that is settled fully or partially in cash. The accounting treatment would basically be the same whether the convertible debt is extinguished or converted.

In both cases, the reporting entity would record the fair value of the consideration transferred and any transaction costs incurred between the debt component that reflects the extinguishment of debt, and the equity component that reflects the reacquisition of the embedded conversion feature.

The issuer would first calculate the fair value of the debt immediately before the extinguishment. The issuer can take the carrying value of the debt by using an updated expected remaining life of the debt instrument as well as an updated nonconvertible debt instrument rate.

The difference between the fair value of the debt instrument immediately before its extinguishment and the carrying value of the debt amount is recorded as a gain or loss in the income statement of the entity. The carrying amount would include the debt issuance costs and unamortized debt costs.

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A convertible debt instrument may not come with an embedded conversion feature for cash from the beginning. In some cases, a debt instrument may embed a conversion feature later as well when it is modified. Either way, when the convertible debt with a conversion feature fulfills the recognition criteria, it should be accounted for using the same ASC 470-50 guidance as stated above.

In these cases, the liability component of the debt should be recorded at fair value as of the modification date. The carrying amount of the equity component should be recorded as the difference between the total carrying value of the debt instrument and the fair value of the liability component.

Example

Suppose a company ABC issues convertible debt with embedded conversion features. The stock price of ABC was $ 85 and par value of $1 at the time of debt issuance. The conversion will be:

(1). in cash up to the principal repayment of the debt; and

(2). net shares equal to any value due to the conversion option being in the money.

The following data is available:

Principal Amount$ 1,000
Coupon Rate2%
Years to Maturity7
Investor’s put option5 years and beyond
Issuer’s call option2 years and beyond

Conversion Terms:

The investors can consider converting in any quarter following a quarter in which ABC company’s share price traded at or above $110 for at least 60 days.

Upon conversion, the investor will basically receive $1,000 in cash and net shares which is equal to any value due to the conversion option being in the money

ABC Company uses benchmarking analysis to determine the coupon rate of a similar debt instrument at 8.02%.

Using PV calculation, the initial value of the debt ($ 1,000) would be $ 760. Therefore, the proceeds recorded for the equity section will be ($1,000 – $760) $ 240.

ABC has the following amortization table for the convertible debt instrument.

 Y1Y2Y3Y4Y5
Beginning Balance760801845893944
Amortization of Discount4144485156
Ending Balance8018458939441,000

Suppose after 3 years the share price is at $ 125. The company uses its call option.

The investors can:

(1). The company can convert the debt instrument and then receive cash and shares with a value equal to $1,250. This is the conversion value of the instrument, or

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(2). The company may choose not to convert and receive $1,000 upon settlement of the call option. Investors choose to convert their debt instruments. ABC company delivers $1,000 in cash and 2 shares (worth $125 each) for total consideration of $1,250.

ABC Company reevaluates the debt instrument using the industry data. It calculates the coupon rate to be 6.10% now that assigns the fair value of $ 925 to the debt instrument.

Now, the $ 1,250 consideration transferred to investors will be recorded as:

  • To extinguish the debt – $ 925
  • To reacquire the embedded conversion $ 325

The difference between the fair value of debt extinguishment ($ 925) and the book value of debt after three years ($ 893) results in a loss of $ 32.

Using the data above, ABC Company can record the following journal entries now.

AccountDebitCredit
Convertible Debt$ 1,000 
Additional Paid-in capital (Conversion option)$ 325 
Loss on Extinguishment$ 32 
Convertible Debt Discount $ 107
Cash $ 1,000
Common Stock (Par value) $ 2
Additional Paid-In Capital (Common Stocks) $ 248

 Beneficial Conversion of Debt

Some companies issue convertible debt with beneficial conversion features that are called “in-the-money” debt instruments. These instruments offer lucrative benefits to investors if converted immediately after issuance of the convertible debt (bonds or preferred shares).

ASC 470-20 guides on the accounting treatment of these debt instruments in a way that the embedded conversion feature of the convertible debt should be accounted for separately.

The conversion feature is recorded at the intrinsic value of the embedded conversion feature. The entity can calculate the intrinsic value of the embedded conversion features as:

  • the difference between the conversion price and the fair value of the common stock (into which the security is convertible)
  • Multiplied by the number of shares into which the security is convertible.

The conversion feature may have more than one option. In such cases, the conversion rate most beneficial to the investor should be used.

A convertible debt instrument with an embedded beneficial conversion feature may extinguish prior to the conversion date as well. In that case, a portion of the reacquisition price of the debt security is allocated to the beneficial conversion feature.

Contingent Conversion of Debt

Some convertible debt instruments can be converted only upon some contingent conditions. These conditions can be set forth by the issuers. For instance, a debt instrument issued with a contingently beneficial conversion feature.

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If the debt instrument is converted with a contingent feature that is outside the control of the investors, it should be recognized at the fair value as of the commitment date. However, it should not be recorded until the contingency clause is satisfied.

ASC 470-20 states that the contingent conversion feature should be recognized but not recorded in the earnings of a reporting entity until the conversion feature is fulfilled.

ASC 815-40-25 also applies to the “conventional contingently convertible debt” instruments. It states that embedded derivatives be bifurcated and accounted for separately under certain conditions, but with an exception for accounting for conversion privileges by issuers of certain convertible securities.

ASC 815-40-25 also states that when a bifurcated debt instrument earlier under the same rule no longer qualifies for the bifurcation, the entity should reclassify the fair value of the liability of the conversion to the shareholders’ equity.

Contingent Conversion of Debt with the Call Feature

A relevant case of contingent convertible debt with a conversion feature arises when the issuer uses the call feature. The issuer may redeem the convertible debt before maturity and even when the contingent conditions do not fulfill.

The investor can be offered cash or stock conversion depending on the conversion feature embedded in the debt instrument at issuance. Similarly, a debt instrument can have a contingent conversion feature at inception. It means the issuer may need refinancing or for other reasons that trigger the conversion feature from the issuer.

ASC 470-20 states that if the debt was issued with a substantive conversion feature originally, the reporting should recognize any gains or losses on such conversion events.

It states that in such cases, when there is a substantive conversion feature, the conversion of debt to equity would result as a book value swap from debt to equity.

Contrarily, if the debt instrument does not have a substantive conversion feature, and the conversion is triggered by the call option by the issuer, it should be accounted for as debt extinguishment.

It would create a gain or loss for the reporting entity. The cost of the debt extinguishment would be recorded as the fair value of the equity. Any resulting differences will be accounted for as a gain or loss for the entity.

ASC 470-20-40 guides on the definition of “substantive conversion” feature as:

“Conversion feature that was, when the debt instrument was first issued, at least reasonably possible of being exercisable in the future, absent the issuer’s exercise of a call option”.

Reference

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