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.
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.
B. 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 as a "hybrid instrument," which the FASB Accounting Standards Codification® (ASC) Master Glossary defines as "[a] contract that embodies both an embedded derivative and a host contract." To determine whether an embedded conversion option must be bifurcated from a hybrid instrument, it is first necessary to determine the nature of the host contract (that is, whether it is more akin to debt or equity).
Although the Master Glossary does not define a "host contract," over time practitioners have developed two methods that preparers currently use to evaluate whether a host contract is more akin to debt or equity:
1. The "whole instrument" approach
2. The "chameleon" approach
Under the "whole instrument" approach, an entity considers all of the terms and features of the hybrid instrument, including the feature that is being evaluated for bifurcation, to determine the nature of the host contract.
Under the "chameleon" approach, an entity considers all of the terms and features of the hybrid instrument, except for the embedded feature the entity is evaluating for bifurcation, to determine the nature of the host contract. Therefore, the nature of the host contract could change, depending on the feature the entity is evaluating. For example, if a hybrid instrument contains an embedded conversion feature and an embedded put option, the host contract could be considered more debt-like when evaluating the conversion feature and more equity-like when evaluating the put option.
The FASB has issued limited guidance on determining the nature of a host contract, as explained in the following paragraphs.
The guidance in ASC 815-15-25-16, Derivatives and Hedging: Embedded Derivatives, states that
If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract. However, most commonly, a financial instrument host contract will not embody a claim to the residual interest in an entity and, thus, the economic characteristics and risks of the host contract shall be considered that of a debt instrument.
ASC 815-15-25-17 goes on to state that
Because the changes in fair value of an equity interest and interest rates on a debt instrument are not clearly and closely related, the terms of convertible preferred stock (other than the conversion option) shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument. A typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument.
The preceding guidance describes the "chameleon" approach, because the host contract includes the terms of convertible preferred stock other than the conversion option, which is the feature being analyzed. The SEC staff, however, has indicated that either the "chameleon" or the "whole instrument" approach is acceptable, as explained in "SEC staff's guidance on determining the nature of a host contract" below.
SEC staff's guidance on determining the nature of a host contract
There is a third approach that is no longer being used to determine whether a host contract is more akin to debt or equity. Under the "clean" approach, an entity excludes all of the features embedded in the hybrid instrument to determine the nature of the host contract. With this approach, the nature of a host contract in a hybrid instrument that contains both an embedded conversion feature and an embedded put option depends primarily on whether the instrument is structured as equity or debt. If the instrument is preferred stock, it would likely be considered an equity host regardless of the embedded features. Although some entities used this approach after the FASB issued Statement 133, Accounting for Derivative Instruments and Hedging Activities, the SEC staff has since issued guidance that we believe effectively forbids the "clean" approach.
As documented in EITF Topic D-109, Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133, which is now codified in ASC 815-10-S99-3, Derivatives and Hedging, the SEC staff announced that it believes
... in performing an evaluation of an embedded derivative feature under [ASC] paragraph 815-15-25-1(a), the consideration of the economic characteristics and risks of the host contract should be based on all of the stated or implied substantive terms and features of the hybrid financial instrument ... In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature is not necessarily determinative of the economic characteristics and risks of the host contract (that is, whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument). Although the consideration of an individual term or feature may be weighted more heavily in the evaluation, judgment is required based upon an evaluation of all the relevant terms and features. For example, ... the fact that a preferred stock contract without a mandatory redemption feature would be classified as temporary equity under [ASC] paragraph 480-10-S99-3A is not in and of itself determinative of the nature of the host contract (that is, whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument). Rather, ... the nature of the host contract depends upon the economic characteristics and risks of the preferred stock contract.
Following the March 2007 publication of Topic D-109, both financial statement preparers and standard setters questioned the SEC staff's intent in issuing this guidance. Although the Commission has provided no formal clarification, it is our view that the SEC staff's intent in issuing the guidance in Topic D-109 was to express that the "clean" approach to evaluating the nature of a host contract is not acceptable, rather than to require use of the "whole instrument" approach when evaluating a conversion feature embedded in a hybrid instrument issued in the form of a share, such as convertible preferred stock.
In our view, the key language in the SEC staff announcement is that "...the consideration of the economic characteristics and risks of the host contract should be based on all of the stated or implied substantive terms and features of the hybrid financial instrument [emphasis added]." On the surface, this language appears to require the use of the whole instrument approach. However, the SEC staff announcement includes the following footnote:
The "hybrid financial instrument" includes the terms and features pertaining to other embedded derivatives that are separately evaluated under [ASC] paragraph 815-15-25-1. However, the SEC staff understands that as an accounting policy some registrants exclude the terms and features pertaining to the individual embedded derivative being evaluated under paragraph 815-15-25-1 in determining the nature of the host contract for that particular embedded derivative.
In this footnote, the SEC staff acknowledges that the hybrid instrument includes the terms and features pertaining to other derivatives embedded in the hybrid instrument. Further, the footnote indicates that some registrants have adopted the "chameleon" approach as an accounting policy, and the SEC staff does not explicitly offer a view on its acceptability.
It is our view that an entity can choose, as an accounting policy, to evaluate hybrid instruments using either the "whole instrument" or the "chameleon" approach. We believe that entities should consistently apply a single approach to all hybrid instruments from period to period.
Although ASC 815-15-25-17 provides two examples of host contracts that are clearly debt-like or clearly equity-like, it does not address the gray area in between these two extremes, where most hybrid equity instruments fall.
There are no bright-lines for evaluating the nature of a host contract in a convertible instrument. There are, however, certain indicators that entities should be aware of when assessing the nature of a host contract. Common indicators that a host contract is more debt-like include the following:
- The instrument is redeemable for a fixed amount at the option of the holder.
- The instrument has a cumulative fixed dividend rate.
- The issuer is required to post collateral.
- The holder can force the issuer into bankruptcy.
- The instrument is subject to covenants similar to those typically found in debt arrangements.
- The holder receives preference over other shareholders in liquidation.
Common indicators that a host contract is more equity-like include the following:
- The instrument is perpetual.
- The instrument does not have a fixed dividend rate but participates in dividends with other classes of equity.
- The instrument carries voting rights.
- The instrument is convertible into common shares.
None of these indicators alone should be viewed as determinative of the nature of a host contract. Rather, host contracts must be evaluated in their entirety, and judgment is necessary to properly determine their nature.
Although the authoritative accounting guidance does not prescribe a method for determining the nature of a host contract, we have developed the following flowchart to aid preparers and auditors in making this determination for common types of hybrid preferred shares, which is discussed in greater detail below.
The process of assessing whether a host contract is more akin to debt or equity, as depicted in the flowchart, places greater weight on redemption and return features. Therefore, the first question is, "Are the shares redeemable," either mandatorily or at the option of the holder? If the shares are not redeemable, then the host contract is likely more akin to equity, depending on the evaluation of other terms and conditions.
If the shares are redeemable, then the next question is, "Does the redemption feature provide a debt-like return?" A redemption feature that provides a debt-like return to the holder is an indicator that the host contract is more akin to debt.
An entity then must answer the question, "Is the redemption feature contingent?" A "no" response strongly indicates that the host contract is more akin to debt. However, if an event outside the entity's or the holder's control must occur for the shares to be redeemed, then other terms and conditions of the hybrid instrument, including the contingency that would give rise to redemption, would need to be considered to determine whether the host contract is more akin to debt or more akin to equity.
As noted in the flowchart, it is important to consider the terms and features of the hybrid instrument other than redemption and return provisions in determining the nature of the host contract.
Step 2: Is the conversion feature clearly and closely related to the host instrument?
Step 2 summary
If the host contract is more akin to debt, an embedded conversion feature is not clearly and closely related and requires further analysis.
If the host contract is more akin to equity, an embedded conversion feature is clearly and closely related and does not require bifurcation.
Once an entity has determined the nature of the host contract, it must evaluate whether the conversion option is "clearly and closely related" to the host contract, as stipulated in ASC 815-15-25-1. To do this, an entity must determine whether the values of the host contract and the conversion option are primarily dependent on the same economic characteristics and risks.
The value of a conversion option is primarily dependent on the issuer's share price. If there is an increase in the value of the shares underlying the conversion option that will be transferred to the holder upon exercise, then the value of the conversion option will increase as it becomes more "in the money" (or less "out of the money"). Likewise, the value of an equity-like host contract would primarily be dependent on the same economic characteristics and risks as those that impact the value of the shares underlying the conversion option. Accordingly, if a host contract is deemed to be more equity-like, then it is clearly and closely related to an embedded conversion feature.
The value of a debt instrument, on the other hand, is not primarily dependent on the same economic characteristics and risks as those that impact the issuer's share price. Rather, it primarily fluctuates due to changes in the issuer's credit standing and market interest rates. If an issuer's credit rating decreases, or if market interest rates for similar borrowers increase, then the issuer's debt will become less valuable. The value of a debt-like host contract, therefore, is deemed to be primarily dependent on these economic characteristics and risks. Accordingly, if a host contract is more debt-like, then it is not clearly and closely related to an embedded conversion feature.
If the economic characteristics and risks of the embedded conversion feature are clearly and closely related to those of the host contract, then the embedded feature would not be bifurcated from the host contract. Conceptually, bifurcation is not required if the conversion feature bears a close economic relationship to the host contract.
If the embedded conversion feature is not clearly and closely related to the host contract, then further evaluation is necessary, as described in the subsequent steps.
Step 3: Is the hybrid instrument marked to fair value in its entirety each period?
Step 3 summary
If the hybrid instrument is not remeasured at fair value, further analysis is required.
If the hybrid instrument is remeasured at fair value, the embedded conversion option does not require bifurcation.
When the hybrid instrument is marked to its fair value through earnings each period, separate accounting for the conversion option is unnecessary. Accounting for the host contract and the embedded feature (assuming that it is not clearly and closely related to the host contract) would be identical, so that accounting for them as a single instrument would not be misleading to financial statement users. In practice, this criterion applies only to certain hybrid convertible debt instruments for which the issuer elects the fair value option under ASC 815-15-25-4 through 25-6. The fair value option is not available for hybrid instruments that are not required to be classified as liabilities or for convertible debt with a component classified in shareholders' equity. Therefore, an entity cannot apply the fair value option to convertible preferred stock.
Step 4: Does the embedded conversion feature meet the definition of a derivative?
Step 4 summary
If an embedded conversion feature meets the definition of a derivative, further analysis is required. The key characteristic of a derivative in this analysis is whether it provides for net settlement. Conversion features would generally provide for net settlement if the underlying shares are actively traded or if the hybrid instrument is redeemable at fair value or the "if-converted" value.
If an embedded conversion feature does not meet the definition of a derivative, then it does not require bifurcation.
If the economic characteristics and risks of the embedded feature are not clearly and closely related to those of the host contract, and if the hybrid instrument is not marked to fair value through earnings each period, then an entity must consider whether the embedded feature meets the definition of a "derivative." According to the guidance in ASC 815-10-15-83, an embedded feature must exhibit all of the following characteristics to qualify as a derivative:
1. Has an underlying and notional amount
2. Requires little or no initial net investment
3. Provides for net settlement
An embedded conversion feature generally meets the first two criteria. First, the underlying is the issuer's stock price and the notional amount is the number of shares into which the hybrid instrument is converted. Second, the initial net investment, which equals the fair value of the conversion feature, is generally less than the fair value of the underlying shares and therefore complies with the second criterion.
But the third criterion might not be met if, for instance, the entity's shares are not publicly traded. Generally, if an entity's shares are publicly traded, then a conversion feature is considered to provide for net settlement, because the holder can readily sell the shares received upon conversion for cash. It is important to note, however, whether a public entity's shares are actively traded. The key to meeting the net settlement criterion for a derivative instrument is that the shares must be readily convertible to cash; if a public entity's shares are thinly traded, then it is necessary to determine whether a holder can readily sell shares received upon conversion into the market without significantly affecting the share price. To determine whether the market would rapidly absorb the conversion shares without significantly impacting the share price, an entity must consider the smallest increment in which a holder can convert a hybrid instrument into shares. If a hybrid instrument must be converted in its entirety or in large blocks rather than in smaller increments, the market for the issuer's shares may be unable to absorb the shares issued in a conversion without significantly affecting the price.
Holders that obtain shares of a private entity upon conversion are probably unable to readily sell those shares; therefore, a conversion feature embedded in private company shares, barring a contractual net settlement feature, would generally not allow for net settlement.
Similarly to the evaluation of the nature of a host contract described in Step 1, all of the features in a hybrid instrument, as well as the features of the underlying shares, must be considered in determining whether a conversion feature meets the net settlement criterion for a derivative instrument. For example, a private company issues preferred shares that can be converted into common shares that are, in turn, redeemable at fair value. Although the issuer is private, the holder would be able, upon conversion, to redeem its common shares directly with the company for cash. In that case, the net settlement criterion is met, and the conversion feature meets the definition of a derivative.
Alternatively, a private company issues convertible preferred shares that are considered to be debt-like and subject to a put option at an amount that results in the holder realizing the "if converted" value in cash. The "if converted" value is equal to the fair value of the conversion shares, and provides the holder with the same economic benefit as though it had converted the hybrid instrument and then immediately redeemed the conversion shares for cash at fair value. It is important to note that if a convertible hybrid instrument is redeemable at fair value, the consideration transferred upon redemption would encompass the "if converted" value, because the fair value of a convertible hybrid instrument includes the fair value of the conversion option. In that scenario, the net settlement criterion is also met, and the conversion feature meets the definition of a derivative.
If an embedded conversion feature taken as a stand-alone instrument does not meet the definition of a derivative, then the feature would not be bifurcated from the host contract. If the conversion feature meets the definition of a derivative, however, it may be necessary to separately account for it, unless it meets the criteria for a scope exception from derivative accounting, which is discussed in Step 5.
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