On December 19, 2023, FASB issued an exposure draft that would clarify issues related to the settlement of convertible debt securities:
- Requirements for determining whether certain settlements of convertible debt should be accounted for as an induced conversion
- When induced conversion guidance can be applied to a convertible debt instrument that is not currently convertible
While FASB was asked to consider guidance on specific issues related to identifying induced conversions, including how to consider additions, deletions, or modifications to settlement terms involving volume-weighted-average-price (VWAP) terms, the proposed update addresses the issues more broadly.
The proposal adds three new examples to illustrate these points. Comments are due by March 18, 2024.
An induced conversion of convertible debt is when a company offers sweeteners—such as additional shares or other consideration—to entice investors to convert the instrument. When an instrument’s terms are changed for a limited period to induce conversion, current GAAP provides guidance for determining if the transaction should be accounted for as an induced conversion or a debt extinguishment. For an induced conversion, an entity recognizes an expense only for the consideration in excess of what was issuable under the original conversion privileges. For an extinguishment, an entity recognizes an extinguishment gain or loss for the difference between the reacquisition price, i.e., the total consideration issued, and the net carrying amount of the extinguished debt instrument.
Convertible debt instrument features have evolved since FASB’s predecessor—the Accounting Principles Board (APB)—issued ABP Opinion 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, in 1969 and FASB issued the current guidance on induced conversion in Statement of Financial Accounting Standards No. 84, Induced Conversions of Convertible Debt, in 1985. Because the overall accounting can be complicated for financial instruments that have characteristics of both debt and equity, i.e., convertible debt, in 2020, FASB issued Accounting Standards Update (ASU) 2020-06, Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity,1 which made targeted changes to the guidance on convertible instruments and reduced the number of accounting models for separate accounting of conversion options in convertible debt from four to two, including eliminating the cash conversion model established in FASB Staff Position APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). The removal of this cash conversion model had some unforeseen consequences on the identification of and accounting for induced conversions of convertible debt with cash conversion features that are being addressed by this proposal.
Qualification as an Induced Conversion
Under existing GAAP, one qualification for induced conversion accounting is that the settlement results in the holder receiving, in addition to any inducements, all of the equity securities issuable under the conversion terms in the debt at issuance. With the elimination of the cash conversion models, which addressed all settlements for those instruments, the historic induced conversion guidance needs to be considered. However, practitioners observed to FASB that determining what it means to issue “all of the equity securities” is not clear for these cash convertible instruments.
Under the proposal, to account for a settlement of a convertible debt instrument as an induced conversion, an inducement offer must provide the debt holder with—at a minimum—the consideration (in form2 and amount) issuable under the conversion privileges provided in the instrument’s terms. An entity would assess whether this criterion is satisfied as of the date the inducement offer is accepted by the holder.
If, when applying the clarified criterion, the convertible debt instrument had been modified (without being deemed extinguished as being substantially different) within a one-year period leading up to the offer acceptance date, then an entity would compare the terms provided in the inducement offer with the terms that existed one year before the offer acceptance date.
The proposal would not change the other existing criteria that must be satisfied to account for a settlement transaction as an induced conversion.
Application to VWAP Formulas
VWAP formulas in convertible debt instruments are primarily used to ensure that the settlement of the convertible debt instrument is based on the average price of the underlying shares over a specified trading period to avoid the potential to settle based on a share price from a particularly volatile day. In some induced conversions, a VWAP formula may be added, deleted, or modified, giving rise to the question under the old guidance as to whether, once again, “all the equity securities” under the existing terms were being issued.
The proposal’s broader guidance serves to address the incorporation, elimination, or modification of a VWAP formula by requiring the issuer to assess whether the form and amount of conversion consideration are preserved using the singular fair value of an entity’s shares as of the offer acceptance date in lieu of a calculated average from the future.
If the form and amount of consideration issuable under the original conversion privileges are not preserved in the inducement offer, measured using the fair value of the shares on the offer acceptance date, then the transaction cannot be accounted for as an induced conversion and will instead be accounted for as an extinguishment.
Application of Induced Conversion Accounting to Instruments Not Currently Convertible
Based on the current codification and exacerbated by the amendments to the convertible debt models through ASU 2020-06, it was not clear how or when the induced conversion model would be applied to instruments that were not currently convertible. That would include instruments that could become convertible on the occurrence of a future contingent event.
The proposal would clarify that the induced conversion guidance can be applied to a convertible debt instrument that is not currently convertible so long as it had a substantive conversion feature as of its issuance date and is within the scope of ASC 470-20. A substantive conversion feature is already defined in the literature and is a conversion feature that is at least reasonably possible of being exercisable in the future absent the issuer’s exercise of a call option.
Transition & Effective Date
If approved, an entity would be able to apply this guidance on either a prospective or a retrospective basis. Under a prospective transition, an entity would apply the changes to any settlements of convertible debt instruments that occur after the final ASU’s effective date. Under a retrospective transition, an entity would recast prior periods and recognize a cumulative-effect adjustment to equity as of the later of the following dates: (1) the beginning of the earliest period presented and (2) the date the entity adopted the amendments in ASU 2020-06. An entity could not apply these changes to settlements that occurred before to the adoption of ASU 2020-06 (including settlements occurring within periods that were recast retrospectively under the full retrospective transition approach permitted by ASU 2020-06). Certain transition disclosures would be required for retrospective application.
The effective date and early application will be determined after a review of comment letter feedback.
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- 1See “Accounting for Convertible Instruments – Refresher for Private Companies” for additional details.
- 2Changes that result in the amount of cash (or other assets) and number of shares being indexed to something other than the future price of the issuer’s shares, e.g., the fair value of a commodity, would be considered a change in the form of settlement.