The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2024-04, Debt—Debt with Conversion and Other Options (Subtopic 470-20): Induced Conversions of Convertible Debt Instruments, to clarify the requirements for determining whether certain settlements of convertible debt instruments should be accounted for as an induced conversion.
Background
An issuer may change the original conversion terms in a convertible debt instrument to entice the debt holders to convert their holding to equity shares. The inducements can take many forms. For example, the issuer could reduce the conversion price so that the holder gets more equity shares on conversion, or the issuer could add warrants or other securities or cash payments to the original conversion terms. When the terms of a convertible debt instrument are changed to induce conversion of the instrument, U.S. generally accepted accounting principles (GAAP) provide guidance for determining whether the transaction should be accounted for as an induced conversion, as opposed to a debt extinguishment. If the transaction is accounted for as an induced conversion, an entity recognizes an expense only for the consideration in excess of what was issuable under the original conversion privileges. If the transaction is, instead, accounted for as an extinguishment, an entity is required to recognize an extinguishment gain or loss for the difference between the reacquisition price and the net carrying amount of the extinguished debt instrument.
Main provisions
Under the amendments, to account for a settlement of a convertible debt instrument as an induced conversion:
- An inducement offer is required to preserve the form and amount of consideration issuable upon conversion in accordance with the terms of the existing debt instrument. The form or amount of any additional consideration offered to induce conversion (i.e., consideration greater than that issuable under the original conversion terms) does not affect the accounting for the conversion as an inducement, but it does affect the amount of expense recognized.
The amended guidance replaces the current requirement that states that, to be accounted for as an induced conversion (rather than an extinguishment), an inducement offer should include the issuance of all the equity securities issuable pursuant to conversion privileges provided in the terms of the instrument. As a result, the ASU clarifies that induced conversion accounting also applies to certain settlements of debt instruments with cash conversion features.
- The assessment of the form and amount of consideration in the inducement offer should be performed as of the date the inducement offer is accepted by the holder.
- Issuers that have exchanged or modified a convertible debt instrument within the preceding 12 months (that did not result in extinguishment accounting) should use the terms that existed 12 months before the inducement offer was accepted when determining whether induced conversion accounting should be applied.
To account for the settlement transaction as an induced conversion under the ASU, the conversion is still required to occur pursuant to changed conversion privileges that are exercisable only for a limited period of time.
The amended guidance clarifies that putting in, taking out, or changing a volume-weighted average price formula would not automatically cause a conversion to be accounted for as an extinguishment. Instead, an entity would assess whether the form and amount of conversion consideration are preserved using the fair value of an entity’s shares as of the offer acceptance date.
The ASU also clarifies that the induced conversion guidance can be applied to convertible debt that is not currently convertible if it has a substantive conversion feature and is within the scope of Subtopic 470-20. However, in a change from the initial proposal, the FASB decided that an entity should be required to assess whether a conversion feature is substantive as of both the issuance date and the offer acceptance date (rather than just the issuance date).
Effective date and transition
The ASU is effective for all entities for annual reporting periods beginning after December 15, 2025, and interim reporting periods within those annual reporting periods. Early adoption is permitted for all entities that have adopted ASU 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. An entity may apply the new guidance on either a prospective or a retrospective basis.
Under the prospective transition approach, an entity should apply the amended guidance to any settlements of convertible debt instruments that occur after the effective date of the ASU (e.g., January 1, 2026, for calendar year-end entities).
Under the retrospective transition approach, an entity should recast prior periods and recognize a cumulative-effect adjustment to equity as of the later of (1) the beginning of the earliest period presented and (2) the date the entity adopted the amendments in ASU 2020-06.
