The Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) to provide clarity on when to apply induced conversion accounting versus extinguishment accounting.
Key considerations of the proposed guidance include:
- Expanded criteria for induced conversions
- Required preservation of consideration form and amount
- Clarified impact of a Volume Weighted Average Price (VWAP) formula
- Required one-year look back
Comments on the proposed ASU were due March 18, 2024. Further updates will be provided as the proposal progresses.
Who Is Affected
The proposed amendments would apply to all entities that settle convertible debt instruments for which the conversion terms were changed to induce conversion.
Background
When the terms of a convertible debt instrument are changed to induce conversion of the instrument, an entity needs to determine whether the transaction should be accounted for as an induced conversion or a debt extinguishment.
Under current generally accepted accounting principles (GAAP), the guidance on induced conversions is contained in Topic 470-20, Debt with Conversion and Other Options. As this section of the guidance was written before cash convertible instruments became prevalent in the marketplace, this guidance as currently written only applies to debt that’s convertible wholly into equity securities pursuant to the conversion terms of the debt at issuance.
Among other changes, the amendments in ASU 2020-06, Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, removed the cash conversion accounting model under Topic 470-20.
As a result of ASU 2020-06, convertible debt with cash conversion features became subject to the same conversion guidance as traditional convertible debt instruments, however the induced conversion guidance wasn’t amended, resulting in confusion around whether conversions of debt instruments with cash conversion features should be accounted for as induced conversions or as extinguishments.
What Would Change with the Proposed ASU?
In response to stakeholder feedback, the proposed ASU would amend the guidance for applying induced conversion accounting.
The following is a summary of the proposed updates.
Settlements of Convertible Debt Instruments with Cash Conversion Features
The proposed ASU would amend the induced conversion guidance in Topic 470-20 to expand the criteria to include certain debt instruments other than those only convertible to equity securities.
In addition, the proposed amendments would clarify that for a settlement of a convertible debt instrument to be accounted for as an induced conversion, the inducement offer would need to include, at a minimum, the consideration—in form and amount—as provided for in the terms of the existing debt instrument.
An entity would assess whether a settlement of convertible debt would be accounted for as an induced conversion as of the date the inducement offer is accepted by the holder.
Preservation of the Form and Amount
To meet the criteria to be accounted for as an induced conversion under the proposed amendments, the inducement offer is required to preserve the form and amount of consideration issuable upon conversion in accordance with the terms of the existing instrument.
As demonstrated in Case E in the implementation guidance under the proposed amendments, if the terms of the existing instrument provided for settlement of the principal amount in cash and permitted the settlement of the conversion premium in any combination of cash and shares, but the inducement offer provided for settlement in only shares, the criterion to require preservation of the form of the existing debt instrument wouldn’t be met as the inducement offer doesn’t offer cash consideration.
If an inducement offer provides for an amount less than the amount issuable under the existing conversion privileges, the criterion to require the preservation of the amount of the terms of the existing debt instrument wouldn’t be met.
Incorporation, Elimination, or Modification of a VWAP
The proposed amendments would clarify that the incorporation, elimination, or modification of a VWAP formula wouldn’t automatically cause a settlement to be accounted for as an extinguishment.
The incorporation, elimination, or modification of a VWAP formula that’s based on future share prices wouldn’t affect the determination of the amount of cash or number of shares issuable for the induced conversion assessment because the fair value of the shares as of the date the inducement offer is accepted would be used to determine whether the form and amount of the settlement have been preserved, instead of the future VWAP.
In the event the amount of cash and number shares are indexed to something other than the future price of the issuer’s shares—for example, the fair value of a commodity—this would be considered a change in the form of the settlement.
One-Year Look-Back
When assessing whether a settlement of convertible debt should be accounted for as an induced conversion, the proposed ASU would require entities to look back one year from the date of offer acceptance.
If the convertible debt instrument had been exchanged or modified without being deemed to be substantially different during the one-year look-back period, the entity would be required to compare the terms provided in the inducement offer with the terms in place one year prior to offer acceptance.
This proposed amendment is intended to prevent the modification of instruments for the purpose of achieving a specific accounting outcome.
Debt Instruments Not Currently Convertible
The proposed ASU would clarify that the induced conversion guidance would apply to a convertible debt instrument that isn’t currently convertible as long as it contained a substantive conversion feature as of the issuance date.
To be considered a substantive conversion feature, the conversion feature must be at least reasonably possible of being exercised in the future absent the issuer’s exercise of a call option.
Proposed Transition Method
The amendments would permit an entity to apply the guidance on either a prospective or a retrospective basis.
Under the prospective transition approach, an entity would apply the amendments to any settlements of convertible debt instruments that occur after the effective date.
Under the retrospective transition approach, an entity wouldn’t be permitted to apply the amended guidance to settlements that occurred prior to the entity’s adoption of ASU 2020-06.
We’re Here to Help
For more information on how the proposed amendments may affect your business, contact your Moss Adams professional.