A Roadmap to the Issuer’s Accounting for Convertible Debt April 2020 The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, and is reproduced with permission. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication. 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Publications in Deloitte’s Roadmap Series Business Combinations Business Combinations — SEC Reporting Considerations Carve-Out Transactions Comparing IFRS Standards and U.S. GAAP Consolidation — Identifying a Controlling Financial Interest Contingencies and Loss Recoveries Contracts on an Entity’s Own Equity Convertible Debt Current Expected Credit Losses Disposal of Long-Lived Assets and Discontinued Operations Distinguishing Liabilities From Equity Earnings per Share Environmental Obligations and Asset Retirement Obligations Equity Method Investments and Joint Ventures Equity Method Investees — SEC Reporting Considerations Fair Value Measurements and Disclosures Foreign Currency Transactions and Translations Income Taxes Initial Public Offerings Leases Noncontrolling Interests Non-GAAP Financial Measures Revenue Recognition SEC Comment Letter Considerations, Including Industry Insights Segment Reporting Share-Based Payment Awards Statement of Cash Flows iii Acknowledgments This Roadmap reflects the thoughts, contributions, and accumulated experience of members of the financial instruments team in Deloitte’s National Office. We are grateful for the contributions of Magnus Orrell, who led the preparation of the Roadmap, and Ashley Carpenter, who provided advice and direction. In addition, we acknowledge the contributions of members of our Production group — Lynne Campbell, Adrienne Julier, Jeanine Pagliaro, and Yvonne Rudek. iv Contents Preface xii Contacts xiii Chapter 1 — Overview 1 Chapter 2 — Scope 6 2.1 Overview 6 2.2 General Considerations 6 2.3 Embedded Derivatives 8 2.3.1 Interaction Between ASC 470-20 and ASC 815-15 8 2.3.2 Bifurcation 8 2.3.2.1 Overall Framework 8 2.3.2.2 Condition 1 — Not Clearly and Closely Related 10 2.3.2.3 Condition 2 — Hybrid-Instrument Accounting 11 2.3.2.4 Condition 3 — Derivative Instrument 12 2.3.3 Bifurcation Analysis for Embedded Conversion Features 14 2.4 Share-Settled Redemption or Indexation Features 15 2.5 Fair Value Option 16 2.6 The SEC’s Guidance on Temporary Equity 17 2.7 Debt Exchangeable Into the Stock of Another Entity 20 2.8 Convertible Debt Instrument Issued to Nonemployees in Share-Based Payment Transactions 21 Chapter 3 — Contract Analysis 24 3.1 Overview 24 3.2 Framework for the Issuer’s Accounting Analysis 24 3.3 Identifying and Evaluating Contractual Terms 26 3.4 Unit of Account 27 3.4.1 Overview 27 3.4.2 Freestanding Financial Instruments 27 3.4.2.1 Overview 27 3.4.2.2 Convertible Debt Instruments 28 3.4.2.3 Debt Instruments Issued With Warrants 29 3.4.3 Registration Payment Arrangements 30 v Deloitte | A Roadmap to the Issuer’s Accounting for Convertible Debt (2020) 3.5 Allocation of Proceeds and Issuance Costs 32 3.5.1 Overview 32 3.5.2 Allocation of Proceeds 32 3.5.2.1 Overview 32 3.5.2.2 With-and-Without Method 33 3.5.2.3 Relative Fair Value Method 35 3.5.2.4 Other Transaction Components 38 3.5.3 Allocation of Issuance Costs 38 3.5.3.1 Concept of Issuance Costs 38 3.5.3.2 Allocation Methods 39 3.5.3.3 Transactions That Involve the Receipt of Noncash Financial Assets 39 3.5.4 Allocation to Components or Features Contained in a Freestanding Convertible Debt Instrument 43 Chapter 4 — Traditional Convertible Debt 44 4.1 Overview 44 4.2 Scope 44 4.3 Initial Accounting 46 4.4 Subsequent Accounting 47 4.5 Derecognition 47 4.5.1 Overview 47 4.5.2 Conversion in Accordance With the Instrument’s Original Terms 48 4.5.2.1 Interest Forfeiture 49 4.5.2.2 Conversion of Debt With a Separately Recognized Equity Component for Reasons Other Than a BCF or CCF 50 4.5.2.3 Debt Tendered Upon Exercise of Detachable Warrants 50 4.5.3 Conversion Upon Issuer’s Exercise of a Call Option 51 4.5.3.1 General Considerations 51 4.5.3.2 Determining Whether a Conversion Feature Is Substantive 52 4.5.3.3 Illustrations 54 4.5.4 Induced Conversions 58 4.5.4.1 Scope 58 4.5.4.2 Recognition and Measurement 62 4.5.4.3 Illustrations 64 4.5.5 Extinguishments 66 4.5.5.1 Scope 67 4.5.5.2 Recognition and Measurement 70 4.5.5.3 Extinguishments Between Related Parties 71 4.5.6 Modifications and Exchanges 72 4.5.7 Troubled Debt Restructurings 74 4.6 Presentation and Disclosure 75 4.6.1 Presentation on a Classified Balance Sheet 75 4.6.2 Presentation of Issuance Costs 76 vi Contents 4.6.3 EPS Calculation 76 4.6.3.1 Basic EPS 76 4.6.3.2 Diluted EPS 77 4.6.3.3 Induced Conversions 77 4.6.3.4 Nonsubstantive Conversion Options 78 4.6.4 Disclosure 78 Chapter 5 — Convertible Debt Issued at a Substantial Premium 83 5.1 Overview 83 5.2 Scope 83 5.3 Initial Recognition 84 5.4 Subsequent Accounting 85 Chapter 6 — Cash Conversion Features 86 6.1 Overview 86 6.1.1 General Considerations 86 6.1.2 Objective of the CCF Guidance 86 6.1.3 Common Variants 87 6.2 Scope 89 6.2.1 Convertible Debt 89 6.2.2 Liability-Classified Convertible Preferred Stock 89 6.2.3 Exceptions 91 6.2.3.1 Equity-Classified Convertible Stock 91 6.2.3.2 Holders of Underlying Shares Receive Same Form of Consideration 91 6.2.3.3 Cash Settlement of Fractional Shares 91 6.2.4 Other Considerations 92 6.2.4.1 Embedded Derivatives 92 6.2.4.2 Share-Settled Redemption or Indexation Features 93 6.2.4.3 Fair Value Option 93 6.2.4.4 The SEC’s Requirements Related to Temporary Equity 93 6.2.4.5 Beneficial Conversion Features 94 6.3 Initial Accounting 94 6.3.1 Separation of Liability and Equity Components 94 6.3.2 Initial Measurement of the Liability Component 95 6.3.2.1 Hypothetical Nonconvertible Debt 95 6.3.2.2 Nonsubstantive Features 96 6.3.2.3 Fair Value Measurement 97 6.3.2.4 Application of an Income Approach 97 6.3.3 Initial Measurement of the Equity Component 99 6.3.4 Transaction Costs 100 6.3.5 Multiple-Element Transactions 100 6.3.6 Embedded Derivatives 101 6.3.7 Deferred Taxes 102 vii Deloitte | A Roadmap to the Issuer’s Accounting for Convertible Debt (2020) 6.4 Subsequent Accounting 103 6.4.1 Liability Component 103 6.4.2 Equity Component 104 6.5 Derecognition 105 6.5.1 General Approach 105 6.5.2 Induced Conversions 107 6.5.3 Modifications and Exchanges 109 6.5.3.1 Extinguishment Accounting 110 6.5.3.2 Modification Accounting 111 6.5.3.3 Convertible Debt Modified to Remove CCF 111 6.5.3.4 Convertible Debt Modified to Add CCF 112 6.6 Presentation and Disclosure 112 6.6.1 Presentation on a Classified Balance Sheet 112 6.6.2 EPS Requirements 113 6.6.2.1 Basic EPS 113 6.6.2.2 Diluted EPS 114 6.6.2.3 Out-of-the-Money Conversion Options 117 6.6.2.4 Consideration of Extinguishment Gains and Losses 118 6.6.3 Disclosure 119 6.7 Comprehensive Example 121 6.7.1 Overview 121 6.7.1.1 Assumptions 121 6.7.2 Recognition and Initial Measurement 122 6.7.3 Subsequent Accounting 122 6.7.4 Derecognition 123 6.7.4.1 General Considerations 123 6.7.4.2 Settlement in a Combination of Cash and Shares 125 6.7.4.3 Cash Settlement 126 6.7.4.4 Share Settlement 126 Chapter 7 — Beneficial Conversion Features 127 7.1 Overview 127 7.2 Scope 127 7.2.1 General Considerations 127 7.2.2 Embedded Derivatives 128 7.2.3 Share-Settled Redemption Features 128 7.2.4 Fair Value Option 130 7.2.5 Cash Conversion Features 131 7.2.6 The SEC’s Requirements Related to Temporary Equity 131 7.2.7 Liability-Classified Convertible Shares 131 7.2.8 Grandfathered Guidance 132 viii Contents 7.3 Initial Accounting 132 7.3.1 Recognition 132 7.3.2 Measurement 134 7.3.2.1 Intrinsic Value 134 7.3.2.2 Conversion Price 137 7.3.2.3 Stock Price 146 7.3.3 Paid-in-Kind Features 148 7.3.4 Warrants Exercisable Into Convertible Debt Instruments 156 7.3.4.1 Equity-Classified Warrants 156 7.3.4.2 Liability-Classified Warrant 159 7.3.5 Convertible Debt Instruments Issued to Nonemployees fi n Share-Based Payment Transactions 160 7.3.5.1 Step 1 — Determine the Instrument’s Effective Conversion Price on the Basis of the Proceeds Allocated 162 7.3.5.2 Step 2 — Compute a BCF’s Intrinsic Value by Comparing the Convertible Debt Instrument’s Effective Conversion Price to the Fair Value of the Equity Instrument the Holder Would Receive Upon Exercising the Option 163 7.3.6 Deferred Taxes 164 7.4 Subsequent Accounting 165 7.4.1 Overview 165 7.4.2 Instruments With a Stated Redemption Date 165 7.4.2.1 Illustrations — Amortization From the Date of Issuance to the Stated Redemption Date 166 7.4.2.2 Illustration — BCF That