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By: Linda Cavanaugh, CPA
Paragraph 12 of APB 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, states that the conversion feature of the debt should not be accounted for separately and that all of the proceeds from the issuance of the debt should be allocated to the liability. This FSP clarifies that convertible debt instruments that can be settled in cash are not covered by Paragraph 12 of APB 14. The important variable is whether the holder of the debt can upon conversion receive stock or cash or a combination of both.
The FSP is effective for fiscal years beginning after December 15, 2008 and is to be applied retrospectively. Any offsetting adjustment is to be recorded in the opening balance of retained earnings. Only debt instruments outstanding during any period presented are to be retrospectively adjusted. Any asset impairment tests do not have to be re-performed for earlier periods and any asset impairment test should not be performed for transitional purposes.
1. What is the scope of the FSP?
This FSP applies to:
•Convertible debt that, by its stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement, unless the embedded conversion option is required to be separately accounted for as a derivative
•Preferred shares classified as redeemable financial instruments in the liability section.
This FSP does not apply to:
•Convertible preferred shares that are classified as equity
•Convertible debt instruments that require or permit settlement in cash upon conversion only in specific circumstances in which the holders of the underlying share also would receive the same form of consideration
•Convertible debt instruments that require fractional shares to be settled in cash (unless they meet either of the two criteria above).
2. How are the instruments included within the scope of this FSP to be accounted for?(/b>
Allocation of initial proceeds
The liability and equity components of the convertible debt instrument need to be separately accounted for so that they reflect the entity’s non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. To accomplish this, the carrying amount of the liability component is measured based on the fair value of a similar liability that does not have an associated equity component. This amount is then deducted from the initial proceeds to arrive at the carrying value for the equity component.
If the initial transaction includes other rights or privileges in addition to the convertible debt instrument, a portion of the initial proceeds are allocated to these rights and privileges. Transaction costs incurred with third parties are to be allocated between the liability and equity components of the debt instrument.
If an entity concludes that an embedded feature will not be exercised, the embedded feature is considered non-substantive and does not affect the initial measurement of the liability component. However, an embedded feature that is considered substantive must be evaluated in light of FAS 133 to determine if it should be separately accounted for. If the embedded feature is to be separately accounted for, it must be separated from the liability component when allocating the proceeds to the liability and equity components.
There may be a basis differential when applying this method that will need to be evaluated under FAS 109 for any deferred tax effects and the debt instruments within the scope of this FSP are not eligible for the fair value option under FAS 159.
Once the allocation of the initial proceeds has been completed, the excess of the principal amount of the liability component over its carrying amount is to be amortized to interest expense using the interest method in APB 21. Debt discounts and issuance costs are to be amortized over the expected life of a similar liability that does not have an equity component. The expected life of the liability component is not to be reassessed unless the terms of the instrument are modified.
If the equity component is later reclassified to the liability section, it is to be measured at fair value and the difference is to be accounted for as an adjusted to stockholder’s equity. If this component is subsequently reclassified back to the equity section, the gain or loss is not reversed.
If the debt instrument is derecognized, the consideration transferred and any related transaction costs incurred are allocated to the extinguishment of the liability and the reacquisition of the equity components.
If the debt instrument is modified and is not required to be derecognized, the expected life of the liability is to be reassessed and a new effective interest rate determined.
If the debt instrument is modified such that it no longer requires or permits cash settlement, the components continue to be accounted for separately unless the original debt instrument is to be derecognized.
If a debt instrument that does not fall within the scope of this FSP is modified such that it does fall within the scope, the provisions of this FSP are to be applied prospectively.
3. What are the new disclosures?
The following disclosures are required in annual financial statements for convertible debt instruments within the scope of this FSP if the debt instruments were outstanding during any of the periods presented.
1.For each date that a balance sheet is presented:
a.The carrying amount of the equity component
b.The principal amount of the liability component
c.The unamortized discount
d.The net carrying amount of the liability component.
2.As of the date of the most recent balance sheet presented:
a.The remaining period over with the discount will be amortized
b.The conversion price and number of shares that can be converted
c.The amount by which the instrument’s if-converted amount exceeds it principal amount
d.Information about derivative transactions entered into in connection with the issuance of the debt instruments
1.Term of derivatives
2.How they relate to the debt instruments
3.Number of shares underlying the derivatives
4.Reasons for entering into the derivatives.
3.For each period an income statement is presented:
a.the effective interest rate on the liability component
b.The amount of interest expense recognized for the period relating to both the contractual interest payable and the amortization of the discount.
4.The transition disclosures in paragraphs 17 and 18 of FAS 154 are to be included.
Good Luck. This appears to be a complicated topic.