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Accounting for Convertible Debt Instruments that May Be Settled in Cash Upon Conversion

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November 2009

Table of Contents

Executive Summary

Instruments in the Scope of the FSP

The Fair Value of the Liability Component of Convertible Debt

The Nonconvertible Borrowing Rate

The Expected Life of the Debt

Allocation of Transaction Costs

Income Taxes

Earnings per Share

Disclosures

Modification and Exchange

Derecognition

EITF Topic D-98 (ASC 480-10) and the FSP

Interplay between Issue 07-5 (ASC 815-40) and the FSP

Retrospective Adoption of the FSP for SEC Registrants

Example I – Accounting at Issuance and at Subsequent Conversion under the FSP

 

Executive Summary

FASB Staff Position APB 14-1 (ASC 470-20), Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (the FSP), changed the accounting and disclosure for convertible debt instruments that permit or require the issuer to pay cash upon conversion. The FSP eliminated the perceived accounting benefits these convertible instruments have enjoyed. Before the FSP became effective, the conversion options on these instruments were not separated and the treasury stock method of EPS calculation was allowed for the conversion spread. Consequently, prior accounting for these instruments resulted in a lower amount of interest expense and a less dilutive effect on EPS compared with other similar instruments. Both the number of instruments affected and the effect of the FSP are significant.

Instruments in the scope of the FSP include convertible debt instruments that may be settled, either partially or entirely in cash or other assets upon conversion, and in which the conversion option is not required to be bifurcated from the debt host. For these instruments, the liability component is measured first at the fair value of the liability without the conversion option, and the difference between the proceeds from the instrument and the fair value of the liability without the conversion option represents the residual equity component. An example of such an instrument follows:

Company A issues convertible debt and the conversion feature does not require bifurcation. When a convertible debt holder decides to convert, the Company can settle in stock, cash, or a combination of the two, as it chooses. At issuance, the Company measures the fair value of the liability component first, and the difference between the proceeds from the instrument and the fair value of the liability without the conversion option represents the residual equity component. Company A’s debt was issued with the following features in thousands of dollars:

  • The Company issued $1,500 of 2% convertible debt on November 22, 2009 with a due date of November 22, 2014.
  • Without the conversion feature, the Company would have paid a coupon rate of 8% on the debt.
  • Interest on the $1,500 will be 2%, $30, payable annually. The principal is due November 22, 2014.
  • The entire $1,500 note will be convertible at $15/share.

Company A selected the income method to value the liability component. The Company estimated the fair value of the liability component without the conversion option by calculating the present value of its cash flows using a discount rate of 8%, the market rate for similar notes with no conversion features, as follows in thousands of dollars:

The present value of the principal and interest payments over the 5 year life at 8%

= $1,140

The residual allocated to equity

= $360


Total

$1,500


During the 5-year life of the note, Company A recognizes $510 in interest expense, consisting of $150 of cash interest payments ($30*5=$150) and $360 of discount amortization. The present value of the annual interest payments of $30 for 5 years and the principal payment of $1,500 at the end of the 5th year at the company’s nonconvertible borrowing rate of 8%=$1,140. The residual allocated to equity is $1,500-$1,140=$360; this $360 represents the discount resulting from the application of the FSP that is amortized over the 5-year life.

The FSP is effective for fiscal years beginning after December 15, 2008. The transition guidance requires retrospective application to all periods presented. It therefore applies to instruments that were outstanding during any of the periods presented in a company’s financial statements, including instruments that have been paid off or converted prior to the effective date of the FSP.

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Instruments in the Scope of the FSP

The FSP is a complex set of guidance that significantly affects debt instruments (commonly referred to as Instruments B, C, and X (1)) that have the following features:

  • Instrument B – Upon conversion, the issuer may satisfy the entire obligation in either stock or cash equivalent to the conversion value; (2)
  • Instrument C – Upon conversion, the issuer must satisfy the accreted value (3) of the obligation in cash and may satisfy the conversion spread in either cash or stock; and
  • Instrument X – Upon conversion, the issuer may satisfy the entire obligation in any combination of cash and shares at the issuer’s option.

Also, the FSP significantly affects accounting for beneficial conversion features. EITF Issues 98-5 (ASC 470-20), Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and 00-27 (ASC 470-20), Application of Issue No. 98-5 to Certain Convertible Instruments, will no longer apply to instruments within the scope of the FSP because the conversion feature will be accounted for separately from the liability component.

Convertible preferred shares that are mandatorily redeemable financial instruments are classified as liabilities under FASB Statement 150 (ASC 480-10), Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, because they require a cash settlement at maturity. If these instruments may be converted for cash (in whole or in part), they are also within the scope of the FSP. For example, an Instrument C in the form a mandatorily redeemable preferred share would be within the scope of the FSP. Instruments outside the scope of the FSP include:

  • Convertible debt instruments with embedded conversion options that are accounted for separately as a derivatives under FASB Statement 133 (ASC 815-10), Accounting for Derivative Instruments and Hedging Activities;
  • Convertible preferred shares that are accounted for in equity or in temporary equity
  • Convertible debt that requires settlement only in the issuer’s own stock;
  • Convertible debt that requires or allows settlement of fractional shares in cash;
  • Convertible debt that allows for settlement in cash or shares in circumstances in which holders of the underlying shares also would receive the same form of consideration, for example, in a change-of-control transaction; and
  • Convertible debt that settles in cash at maturity at its principal amount.

The Fair Value of the Liability Component of Convertible Debt

For instruments within the scope of the FSP, companies are required to determine the carrying amount of the liability component of convertible debt at issuance by measuring the fair value of a similar liability, without the conversion option, but including any other embedded features that may be present in the instrument. This represents the measurement of the nonconvertible liability at fair value using information available at the issuance date. Once determined, this fair value is not subject to revaluation at a later date. Only embedded features that are substantive should be included in the initial measurement of the liability component. Embedded features are considered non substantive if, at issuance, the company concludes that it is probable that the embedded feature will not be exercised.

MFA Insight: As a reminder on fair value measurement, companies that issued financial instruments on or after the effective date of FASB Statement 157 (ASC 820-10), Fair Value Measurement, should measure the fair value of the liability component using Statement 157 (4). Determining this fair value is not necessarily straight forward especially since embedded put and call options are very common in these instruments. Companies may therefore have trouble determining which options are substantive, calculating the fair value of a loan with these features, and determining the effect of the options on the expected life of the liability component. Information such as the price of a similar liability, or inputs to valuation techniques, are not always readily available and may be particularly challenging to obtain if the company’s credit rating is below investment grade. A best practice is to begin the valuation process early and to consider using a valuation specialist.

The company may use the following approaches, available under both Statement 157 (ASC 820-10) and preexisting GAAP, to determine the fair value of a nonconvertible liability.

Market approach – Identify the fair value of comparable liabilities

In practice, companies may find it difficult to use a market approach to determine the fair value of a similar liability because debt with the same rights and obligations (e.g., call/put rights, other embedded features, maturity date, specific covenants, etc.) might not exist at date of issuance of those instruments. Under this approach, companies should consider the differences in the nature of the nonconvertible debt being fair valued when compared with the debt being used to determine the fair value. These can include features such as seniority, issuance date, put or call options, and collateral provisions. The rate differences associated with the differences in features should be determined using independent market data.

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Income approach – Discount cash flows at the nonconvertible interest rate of comparable liabilities to determine the fair value

Companies can use an income approach and also can derive information for inputs to a valuation technique using a lattice model. As a result, it is possible for a company to determine the fair value of their convertible debt based on the fair value of a hypothetical instrument with similar features.

If the convertible debt includes embedded put and or call options that require bifurcation, after the company has valued the liability component with these features, it must bifurcate the options. The bifurcated put and or call options should then be recorded at fair value as a single compound derivative.The valuation of the liability component and the embedded put and call features may be complicated and may require a valuation specialist. Bifurcation of an embedded put and or call option from the liability component does not affect the accounting for the equity component.

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The Nonconvertible Borrowing Rate

One key factor for determining the fair value of the liability at the date of issuance is the nonconvertible debt borrowing rate. The rate may be estimated by one or a combination of the following methods:

  • Determining the borrowing rate of the company’s other financing arrangements on existing nonconvertible debt. These rates would only be appropriate if the borrowings and the convertible debt had comparable attributes such as issuance date, term, seniority of the debt, and substantive embedded features such as put or call options;
  • Considering the borrowing rate for nonconvertible debt with comparable attributes such as those listed above issued by peer companies. Peer companies should be similar in size, nature and financial profile (e.g., creditworthiness). A company could obtain this information from the market based on trading prices, investment bank data, and possibly from other unrelated parties; and/or
  • Generating the rate using a model such as a lattice model. Companies that use models to derive the nonconvertible borrowing market rate should consider factors similar to those mentioned in the preceding paragraphs.

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The Expected Life of the Debt

Determining the expected life of the debt is important for the following reasons:

  • The debt discount and debt issuance costs are amortized over the expected life. The debt discount includes the amount allocated to the equity component (the residual of the proceeds at issuance after fair valuing the debt component) plus the fair value of any bifurcated embedded derivatives.
  • If the income approach is used to measure the fair value of the liability component at initial recognition, the expected life is a necessary input.

The FSP requires companies to match the amortization period for the debt discounts and debt issuance costs to the expected life of similar debt that does not have a conversion right. The FSP further notes that if the income approach was used, this expected life should be consistent with the period over which the discounted cash flow was measured.

The company should identify all substantive embedded features in the debt at issuance, other than the conversion option, to determine if they affect the expected life in addition to determining whether the feature requires bifurcation under Statement 133 (ASC 815-10), Issue 07-5 (ASC 815-40), and Issue 00-19 (ASC 815-40).

The company may determine that the expected life of the debt is shorter than the contractual life if the debt includes a substantive put option. Generally, companies conclude that the expected life is through the first put date unless interest rates are expected to drop significantly such that it would be beneficial for holders to continue to hold onto the debt. Companies generally do not shorten the debt’s expected life for a call option because there is a low coupon rate associated with these instruments. In accordance with the FSP, companies do not reassess the expected life of the liability in periods subsequent to issuance unless the terms of the instrument are modified. Therefore, the reported interest expense for an instrument should be determined based on the stated interest rate (i.e., coupon payments) once the debt discount is fully amortized (e.g., when the debt remains outstanding after the first put date).

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Allocation of Transaction Costs

The FSP requires direct transaction costs incurred with third parties other than investors, such as attorney fees, to be allocated between the liability and equity components. The allocation should be based on the proportion that each component represents of total proceeds at issuance

MFA Insight: In the example above, the company issued $1,500 of convertible debt; $1,140 (76%) was allocated to liability, and $360 (24%) was allocated to equity. If transaction costs were $100, the company would capitalize $76 as debt issuance costs and would treat $24 as equity issuance costs that reduce equity at the time of the transaction.

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Income Taxes

When companies recognize both a debt and an equity component, there is generally a basis difference associated with the liability component that represents a temporary difference for purposes of applying FASB Statement 109 (ASC 740-10), Accounting for Income Taxes. The FSP directs companies to recognize the initial deferred taxes for the tax effect of that temporary difference as a charge to additional paid-in capital and a credit to deferred tax liability. This accounting only applies if the company does not have a full valuation allowance under Statement 109 (ASC 740-10). The FSP, like EITF Issue 05-8 (ASC 740-10), Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature, directs companies to recognize a deferred tax liability on the difference between the tax and accounting basis of debt.

Over the life of convertible debt, the company’s deferred tax liability is reduced, and a deferred tax benefit is recognized as the debt discount is amortized. The company’s total income tax benefit includes not only the deferred tax benefit from the reversal of the deferred tax liability, but also the current tax benefit of deducting the contractual interest.

If a company settles convertible debt, a book gain or loss is recognized upon extinguishment. At the same time, the company should record a deferred tax benefit and reverse any residual deferred tax liability that had been recorded.

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Earnings per Share

The FSP does not change the basis on which a company assumes share settlement or cash settlement of the debt for EPS purposes (5). Companies should continue to use the if converted method for instruments that have full share settlement and the treasury stock method for instruments with partial share settlement. As such, the EPS methods should be applied as follows:

  • If converted method – Interest expense added back to the numerator would be higher since the interest expense increases under the FSP due to amortization of debt discount. This method would be used for (Instruments are defined on page 2):
    • Instrument B – Assumes share settlement; and
    • Instrument X – Assumes that the company claims full share settlement.
    • Treasury stock method – Companies should continue to use the treasury stock method for those instruments that allow only the conversion spread to be settled in shares of stock. Interest expense would remain in the numerator and would be higher since the interest expense increases under the FSP. Incremental shares would be included in the denominator if the conversion option is in the money. The treasury stock method would be used for:
      • Instrument C – Assumes that the company claims net share settlement of the conversion spread.

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      Disclosures

      Under the FSP, companies should disclose the following:

      At each balance sheet date:

      • The carrying amount of the equity component; and
      • The principal amount of the note, its unamortized discount, and its net carrying value.

      For the most recent balance sheet date:

      • The remaining amortization period for the debt discount on the liability component;
      • The conversion price and number of shares used to determine the aggregate consideration to be delivered upon conversion;
      • The excess of the instrument’s if converted value over the principal amount, regardless of whether the instrument is currently convertible (NOTE: this disclosure is required only for public entities);
      • Information about derivative transactions entered into in connection with the issuance of instruments in the scope of the FSP, including:
        • The terms of those derivative transactions;
        • How those derivative transactions relate to the instruments;
        • The number of shares underlying those transactions; and
        • The reasons for entering into those transactions.

        For each income statement period presented, the company should disclose the following:

        • The effective interest rate on the liability component for the period; and
        • The amount of interest expense recognized for the period relating to both the contractual coupon rate and the amortization of the discount on the liability component disclosed on a disaggregated basis.

        If the company is a public company, it should consider whether the accounting for the convertible debt represents a critical accounting estimate and, if it does, include a discussion of the estimate in the critical accounting policies section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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        Modification and Exchange

        The FSP does not change the guidance on debt restructuring, extinguishment, or modification accounting in FASB Statement 15 (ASC 470-60), Accounting by Debtors and Creditors for Troubled Debt Restructurings, and EITF Issue 96-19 (ASC 470-50), Debtor’s Accounting for a Modification or Exchange of Debt Instruments as amended by EITF Issue 06-6 (ASC 470-50), Debtor’s Accounting for a Modification (or Exchange) of Convertible Debt Instruments. If a company modifies its convertible debt, it must analyze the change, first considering whether it is a troubled debt, and if not, concluding whether it is an extinguishment or modification. If the company concludes that the change is to be accounted for as an extinguishment, then the company derecognizes the original convertible debt instrument (see the Derecognition section below).

        If a company concludes that a change to convertible debt is a modification (i.e., the modified debt is not substantially different (6)), and the modification is an addition or elimination of a cash settlement feature, then the company should perform the following accounting:

        • Addition of a cash settlement feature – A company adds a cash settlement feature to convertible debt that was not within the scope of the FSP. For example, a company modifies a convertible debt instrument to change the stock settleable conversion option to a conversion option that can be settled either in stock or cash at the company’s option. In this situation, the liability and equity allocation guidance of the FSP should be applied prospectively from the date of the modification.

        The company determines the fair value of the liability component as of the modification date. The amount of the equity component is then determined by deducting the fair value of the liability component from the overall carrying amount of the convertible debt instrument as of the date of modification. At that date, a portion of any unamortized debt issuance costs should be reclassified and accounted for as equity issuance costs based on the proportion of the overall carrying amount of the convertible debt instrument that is allocated to the equity component.

        • Removal of a cash settlement feature – A company changes a convertible debt instrument to remove a cash settlement feature, and because the instrument is no longer settled either partially or entirely in cash upon conversion, the instrument is no longer within the scope of the FSP. In this situation, the company should continue to account for the components of the instrument separately and continue to amortize the recorded debt discount. For example, a company modifies the conversion option on convertible debt within the scope of the FSP to remove the cash settlement feature and replace it with share settlement. The company should continue to separately account for the debt and equity components, should reassess the expected life of the liability, and continue to amortize the debt discount. If the company determines that the life of the liability should change, the company should modify the effective interest rate accordingly.

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        Derecognition

        Companies with convertible debt instruments within the scope of the FSP should account for conversions into common stock or extinguishments as settlements in which the liability component is extinguished and the equity component is reacquired. Consequently, regardless of the form of the consideration transferred in the settlement (e.g., conversion to equity shares, repayment in cash, etc.), the fair value of that consideration is attributed to the liability and equity components in the same manner as the initial proceeds were allocated. In other words, the consideration is measured at fair value and allocated to the liability component based on the liability’s fair value at the settlement date. Any remaining consideration is attributed to the reacquisition of the equity component and recognized as a reduction of stockholders’ equity. The result is that a gain or loss is recognized upon conversion, or upon any other settlement, equal to the difference between the fair value and the carrying amount of the liability component at the conversion/settlement date.

        Transaction costs incurred from third parties other than investors that relate directly to the settlement of a convertible debt instrument within the scope of the FSP should be allocated to both the liability and equity components. The costs should be allocated in proportion to the settlement amount allocated to each component. The costs allocated to the debt component should be charged to expense in the period of derecognition and those allocated to the equity component should reduce equity.

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        EITF Topic D-98 (ASC 480-10) and the FSP

        After the FSP was issued, the SEC staff updated EITF Topic D-98 (ASC 480-10), Classification and Measurement of Redeemable Securities. Topic D-98 (ASC 480-10) addresses the classification of the equity component of convertible debt instruments for registrants, and affects instruments within the scope of the FSP. If the issuer can be required to settle convertible debt that is within the scope of the FSP (i.e., the instrument is redeemable at the current balance sheet date for cash), then a portion of the equity component may be required to be classified in temporary equity. This is the case if the redemption or conversion amount is greater than the carrying amount of the liability component at the balance sheet date. The amount reported in temporary equity should generally be the difference between the redemption or conversion amount and the carrying amount of the liability.

        MFA Insight: If at the balance sheet date Company D’s convertible debt is currently redeemable for $117, and the liability component is currently $90, the company should report its temporary equity at $27.

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        Interplay between Issue 07-5 (ASC 815-40) and the FSP

        Both the FSP and Issue 07-5 (ASC 815-40) were effective for fiscal years beginning after December 15, 2008. The FSP applies to convertible debt in which the conversion option is not required to be bifurcated and for which the issuer can settle the converted debt completely or partially in cash. Issue 07-5 (ASC 815-40) provides revised guidance for determining whether a conversion option or warrant is indexed to a company’s own stock. Instruments with certain price reset features are not considered to be indexed to a company’s own stock, and consequently these instruments must be accounted for as derivatives and marked to market each reporting period. Many companies hold financial instruments that are within the scope of both the FSP and Issue 07-5. In this situation, the FSP should be applied first, retrospectively to all periods presented in the financial statements per the transition provisions of the FSP.

        Issue 07-5 (ASC 815-40) should be applied second, and should be applied through a cumulative effect adjustment to the opening balance of retained earnings on the date of adoption. Issue 07-5 (ASC 815-40) also requires application from the original issuance date of the instruments within its scope. However, this is done by way of a cumulative effect adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) on the date of adoption and, unlike the FSP, historical periods are not required to be restated. The cumulative effect adjustment on the date of Issue 07-5 (ASC 815-40) adoption (January 1, 2009 for calendar year companies) would therefore be the difference between:

        • Amounts recognized in the restated statement of financial position, adjusted for retrospective adoption of the FSP; and
        • Amounts that would have been recognized at the date of adoption of Issue 07-5 (ASC 815-40) as if the issue had been applied from the applicable instruments’ original issuance date.

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        Retrospective Adoption of the FSP for SEC Registrants

        The FSP states that it should be applied retrospectively to all periods presented. We are aware that the SEC staff accepts the following approaches regarding the application of the FSP in the selected financial data tables:

        • Financial Statement Approach (7) – Apply the FSP to the convertible debt instruments that were outstanding during any of the periods presented in the audited financial statements included in the registrant’s current year Form 10-K (i.e., 3 years for accelerated filers, 2 years for smaller  reporting companies). For these instruments, the FSP should be applied to the convertible debt from its date of issuance. Companies would correspondingly restate the selected financial data table for these instruments for the 3 or 2 year period (depending on their filing status and, if they are a smaller reporting company, whether they voluntarily provide such a table). They would alert users in a note to the table that these periods in the table are not comparable to the prior periods. The amounts in the table would reflect the cumulative effect of applying the FSP to debt outstanding during the periods presented in the financial statements as an adjustment to the opening retained earnings (8) of the first period presented in the audited financial statements.
        • Selected Financial Data Table Approach (7)
          • Apply the FSP to the convertible debt instruments that were outstanding during any of the periods presented in the selected financial data table in the registrant’s Form 10-K, i.e., the past five years required to be presented or such longer period as the registrant elects to present. Under this approach, the FSP would be applied to the convertible debt from the date of issuance for any instruments outstanding during any period included in the table. The amounts in the table would reflect a cumulative effect adjustment made to the opening retained earnings (8) of the first period presented in the periods covered by the table. It should be noted that if this approach is used and the FSP is applied to convertible debt instruments that were extinguished or converted prior to the period covered by the audited financial statements, the cumulative effect adjustment reflected in the audited financial statements will be different from that under the Financial Statement Approach. Under this approach, the selected financial data table is comparable for the instruments that were outstanding during the period included in the table.

        MFA Insight: In the notes to the financial statements, as part of the transition disclosure required by paragraph 39 of the FSP, a registrant should disclose which approach it selected to implement the FSP, how the transition provisions were applied, and the reasons for electing the approach applied (e.g., if the company had a number of instruments affected by the FSP in all of the past five years, the selected financial data approach affords greater comparability). In a note to the selected financial data table, the registrant should disclose any lack of comparability in the table resulting from using the Financial Statement Approach. Registrants are not required to quantify the effect of any inconsistency resulting from the adoption of the FSP.

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        Example 1 –
        Accounting at Issuance and at Subsequent Conversion under the FSP

        Company B issues 15-year convertible debt at par for proceeds of $2,000 on January 1, 2009. The debt is convertible at any time into shares of Company B’s common stock at a stated conversion price of $10 per share. The quoted market price of Company B’s common stock is $7 per share on the date of issuance. The par value of Company B’s common stock is $1. Upon conversion, Company B can elect to settle the entire if-converted value (the principal amount of the debt plus the conversion spread) in cash, common stock, or any combination thereof. The debt is callable and puttable at par after the tenth year. The Company pays interest annually at the end of each year at a rate of 2 percent on the principal amount or $40 per year. The Company’s nonconvertible borrowing rate is 9 percent which is the rate it would pay for debt with terms similar to the convertible debt that is callable, puttable, and without a conversion feature. The maturity date is December 31, 2023.

        On January 1, 2014, when the quoted market price of Company B’s common stock is $14, all holders of the convertible notes exercise their conversion options. The investors are entitled to aggregate consideration of $2,800. At settlement, the market interest rate for debt with similar terms and features but without a conversion option is 8 percent.

        For purposes of the example, issuance costs and income taxes have been ignored. The only features embedded in the debt are the put, call, and conversion options.

        1. What is the accounting for the liability component and the conversion option component of the convertible debt at issuance by the issuer?

        Step 1 – Company B concludes that the embedded conversion option, the embedded put, and the embedded call do not require bifurcation, and that the convertible debt is within the scope of the FSP.

        Step 2 – Company B applies the FSP and calculates the liability component of the convertible note first, by calculating the expected present value of 10 years of $40 interest payments and the payment of $2,000 at the end of the tenth year at the Company’s nonconvertible interest rate of 9%. The Company uses the expected life of 10 years rather than the contractual life of 15 years. The Company’s nonconvertible debt has terms and features that are similar to the convertible debt, including embedded put and embedded call options, and consequently the Company concludes that 9% is the most appropriate rate to use in the computation. The Company has decided to use an income approach to measure the liability; it could also have chosen to use a market approach. The fair value of the liability component at January 1, 2009 is $1,102. The $898 difference between the proceeds from the issuance of the notes and the fair value of the liability is assigned to the equity component.

        Step 3 – Company B records the following entry at initial recognition:

        Entry at January 1, 2009:

        Cash
        Debt discount

        $ 2,000
        $ 898

         

        Debt
        APIC

         

        $ 2,000
        $ 898

        Company B’s convertible notes contain an embedded call and put that can be exercised at the end of the tenth year. As discussed above, if a company concludes that features embedded in convertible debt are non substantive because it is probable that they will not be exercised, then these features should not be included in the determination of the expected life of the convertible debt. Company B concludes that the put is substantive and consequently that the expected life is the same as the life of the put, ten years. The Company uses the ten-year period to measure the fair value of the liability, and also uses the ten-year period for calculating interest using the effective interest method. During the ten years ending December 31, 2018, the Company recognizes $1,298 of interest expense consisting of $400 of cash interest payments and $898 of discount amortization under the effective interest method.

        In this example, Step 3 will change if the embedded put and call features require bifurcation. After a company identifies the fact that the embedded features require bifurcation, the order of the steps is as follows:

        a. Apply the FSP to separate the liability component, including the put and call features other than the conversion option, from the equity component.

        b. Separate the put and call from the liability component in accordance with Statement 133 and its related interpretations (ASC 815-10).These put and call option derivatives would be allocated their full fair value and bifurcated from the liability component as a single compound derivative. The valuation of the liability component and the embedded put and call features may be complicated and may require a valuation specialist. Separation of an embedded derivative from the liability component does not affect the accounting for the equity component.

        2. What is the accounting for the liability component and the conversion option component by the issuer at conversion on January 1, 2014?
        Company B settles the note on January 1, 2014, and consequently derecognizes the debt component and reacquires the equity component. The Company’s first step is to measure the fair value of the liability component immediately prior to extinguishment by calculating the expected present value of 5 years of $40 interest payments and the payment of $2,000 at the end of the fifth year at the Company’s nonconvertible interest rate of 8% or $1,520. The Company’s nonconvertible debt has terms and features that are similar to the convertible debt, including embedded put and embedded call options, and consequently the Company concludes that 8% is an appropriate rate to use in determining fair value.

        As noted above, the fair value of the aggregate consideration due to the investors is $2,800. The amount attributable to the equity component is $2,800 - $1,520 or $1,280. Whether the consideration is cash, common stock, or a combination of the two, $1,520 will be attributed to the extinguishment of the liability and $1,280 would be attributed to the reacquisition of the equity. Since Company B was carrying the debt at $1,457 on December 31, 2013, the Company would incur a loss of $63 ($1,520 - $1,457) upon settlement of the debt.

        At settlement, Company B would record the following assuming it elects to transfer consideration to the convertible debt holder in the form of $2,000 in cash and 57 shares of common stock with a fair value of $800 (par of $57 and APIC of $743). The $1,280 decrease to APIC for the reacquisition of the conversion option and the $743 increase to APIC from the issuance of common stock at conversion are presented gross in this journal entry for clear presentation.

        Entry at January 1, 2014:

        Debt
        APIC – conversion option
        Loss on extinguishment

        $1,457
        $1,280
        $ 63

         

        Cash
        Common stock at par
        APIC - share insurance

         

        $2,000
        $57
        $743

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        (1) The references are primarily from EITF Issue 90-19 (ASC 815-15), Convertible Bonds with Issuer Option to Settle for Cash upon Conversion. The FSP superseded Issue 90-19 (ASC 815-15).
        (
        2)   Conversion value is defined as the market value of the underlying shares into which convertible debt can be exchanged. Conversion value is calculated by multiplying the number of shares that can be obtained by the market price per share. Debt that can be converted into 50 shares of stock with a market price of $10 each has a conversion value of $500.
        (
        3) Accreted value is defined as the current carrying value of debt with an original-issue discount that takes into account imputed interest that has accumulated since issuance.
        (
        4) For financial instruments that were issued before Statement 157 became effective, companies can use preexisting GAAP to measure fair value that is generally entity-specific and based on entry price.
        (
        5) Also, the FSP does not affect how EITF Topic D-72 (ASC 260-10), Effect of Contracts That May Be Settled in Stock or Cash on the Computation of Diluted Earnings per Share, is applied. Topic D-72 notes that for contracts that provide the company with a choice of settlement methods, the company should assume that the contract will be settled inshares. The company can overcome this presumption if past experience or a stated policy provides a reasonable basis to believe that it is probable that the contract will be paid partially or wholly in cash. For contracts in which the counterparty controls the means of settlement, past experience or a stated policy is not determinative. Accordingly, in those situations, companies should use the more dilutive of cash or share settlement.
        (
        6) Substantially different is defined by the following three tests. See Issue 96-19 (ASC 470-50) for specifics:
              • Ten percent or more difference in cash flows;
              • Value of embedded conversion option difference is ten percent or more; or
              • There is the addition or elimination of a substantive conversion option.
        (
        7) The names of the approaches are names we have designated for convenience. They are not generally recognized and should not be used when describing the approach in a filing.
        (
        8) Or other appropriate components of equity or net assets in the statement of financial position.

        Material Discussed in this Alert is meant to provide general information and should not be acted on without obtaining professional advice tailored to your firm's individual needs. The information is for general guidance only and is not a substitute for professional advice.

        IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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