Evaluating Embedded Conversion Features: How To Determine Whether Conversion Options Require Derivative Accounting - May 2013

Summary

Entities often obtain financing or raise capital by issuing convertible debt or equity instruments. These instruments offer flexibility by providing the holder with the option to either (a) continue collecting a yield or dividends, or (b) participate in changes in the entity's share price. Including a conversion feature in a debt or equity instrument also allows an issuer to incur a lower cost of borrowing or raising capital, at least in terms of stated yield or dividends. Yet, despite the prevalence of these forms of financing, entities frequently struggle with the accounting implications of embedded conversion features.

This bulletin explores, step by step, the process for evaluating a conversion feature embedded in a debt or equity instrument to determine the appropriate accounting. The central question in this evaluation is whether the holder's option to convert must be accounted for like a derivative, separately from the debt or equity instrument itself. In certain circumstances, if the economic characteristics of the conversion option are sufficiently distinct from those of the "host" debt or equity instrument, the conversion feature must be accounted for as an embedded derivative, meaning it is classified as a liability and marked to fair value each reporting period through net income. Given the complexity of the accounting guidance in this area and the potential impact that errors in its application could have on earnings, it is important that entities properly evaluate these features.

Although this bulletin addresses many critical items for issuers to consider when evaluating a convertible instrument, it is not intended to be a complete guide for evaluating convertible instruments or financial instruments with other embedded features, such as put or call options. In particular, a debt instrument with a conversion option that does not require separation as an embedded derivative might include terms allowing settlement upon conversion either wholly or partially in cash, in which case an entity would separately account for a portion of the proceeds as an equity component. Other financial instruments with conversion options that do not require separation as an embedded derivative might contain a beneficial conversion feature that must be separated and accounted for as a component of equity. Convertible instruments that contain these features are beyond the scope of this bulletin. In addition, this bulletin does not address the financial statement classification of the host contract.

1. Introduction

   Conversion features allow the holder to convert a debt or equity instrument, such as preferred stock, into another instrument, such as common stock. Conversion terms typically indicate a set conversion price or ratio that determines how many common shares to exchange for the outstanding debt or shares upon conversion.

   To illustrate, a convertible debt instrument might specify a conversion price of $1.00 per common share, which means that dividing the principal amount of debt outstanding at the conversion date by the conversion price of $1.00 would yield the number of common shares transferred upon conversion. Or, convertible preferred stock might specify a conversion ratio of 1:1, indicating that for each preferred share converted, the holder would receive one common share.

   Obviously these are simple examples; conversion terms are sometimes much more complicated. For example, some conversion terms involve a contingency that triggers the holder's ability to exercise the conversion option, while others include a feature that automatically adjusts the conversion price if a certain event occurs, such as the issuance of common shares or equity-linked instruments, including other convertible instruments or warrants.

   Our discussion in this bulletin is limited to the process for determining whether conversion features embedded in either a debt or equity instrument require bifurcation (separate derivative-like accounting).

   This bulletin does not address the following characteristics an entity must consider if it determines that an embedded conversion feature does not require bifurcation:

   Beneficial conversion features Convertible debt when the conversion can be settled wholly either in cash or shares, or in some combination of the two Additionally, instruments might include embedded features other than conversion options that require evaluation for potential bifurcation. Frequently, these include embedded put and call features, which, though subject to the same evaluation framework described in this bulletin, are not specifically addressed herein.

2. Process for evaluating embedded conversion features

   The process for determining whether a conversion feature embedded in a debt or equity instrument requires bifurcation is described below in five steps, which correspond to the flowchart in Appendix A.

   Evaluating convertible debt instruments

   For applying this process to convertible debt instruments, preparers will generally begin the analysis with Step 3. The host contract in a convertible debt instrument is nearly always deemed more akin to debt.

   Step 1: Is the host contract more akin to debt or equity?

   Step 1 summary

   Apply either the "whole instrument" (consider all embedded features) or the "chameleon" (exclude the feature being analyzed) approach to gauge whether the host contract is more debt-like or equity-like, focusing on redemption and return provisions.

   A debt or equity instrument that contains a conversion feature is referred to...