Induced Conversions of Convertible Debt Instruments – ASU 2024-04 Update

On November 26, 2024, the FASB issued ASU 2024-04,  Debt—Debt with Conversion and Other Options (Subtopic 470-20): Induced Conversions of Convertible Debt Instruments. The intent of this release is to aid in the classification of convertible debt settlements, including identifying situations not previously addressed by ASC 470 where induced conversion accounting can apply.

Background – Convertible Debt Settlement

It helps to think about convertible debt as a combination of a debt security and a stock option. Because stock prices can fluctuate far more than interest rates, the fair value of a convertible bond can vary much more widely than that of a standard non-convertible bond. However, the carrying value follows the traditional bond accounting model as it accretes from issuance to maturity.

Companies may find many reasons to end their convertible borrowing earlier. Perhaps it’s due to an influx of cash, a better interest rate environment, or preparing for a corporate transaction. In addition, if the stock price has increased, it is very likely that the bond will eventually convert. If this is the case, the dilution is already factored in, yet the company continues to pay interest and otherwise service the debt. As a result, it may be beneficial for the company to get the investor to retire the bond early by convincing them to convert, cash settle, or replace it with an alternate security, such as shares with a warrant “kicker.”

As the bond still contains time value, investors would typically demand a higher value than the bond’s current value for the early settlement. When the terms of a convertible debt instrument are changed to encourage investors to settle the notes early, US GAAP provides guidance on determining whether the transaction should be accounted for as an induced conversion instead of a debt extinguishment. The accounting for each of these events is quite different.

• For an induced conversion, expense is recognized based on the inducement or the full settlement amount versus the current as-converted value of the debt.
• For a debt extinguishment, expense is recognized based on the full settlement amount versus the carrying value of the debt.

Because the as-converted value moves based on the stock price while the carrying value doesn’t, the induced conversion is typically preferable if the stock price has increased.

Previously Existing Guidance

After ASU 2020-06 became effective, both of these scenarios existed. However, stakeholders said they had difficulty determining whether to apply induced conversion or extinguishment accounting, particularly when dealing with convertible debt instruments that were cash-settled in accordance with conversion terms that differ from the original contractual conversion terms. One reason for this appears to stem from ASU 470-20, prior to the November 2024 update, which discussed conversion into equity securities. This resulted in transactions that look like inducements not being classified as such due to cash settlement rather than share settlement.

It was also unclear whether induced conversion accounting applied to a convertible debt instrument whose conversion features were not exercisable at the time of settlement.

Significant Changes

While this amendment will generally allow for more settlements to be considered induced conversions, three requirements must be met for an entity to apply this model:

• The inducement must be “pursuant to changed conversion privileges that are exercisable only for a limited period of time.”[1] It cannot be a permanent modification or re-issuance of the debt.

• It must maintain “the consideration (in form and amount) issuable”[2] pursuant to the conversion terms of the existing convertible debt instrument.
• The underlying note must contain “a substantive conversion feature [at both] issuance and [on] the date the inducement offer is accepted,”[3] even when the conversion feature is not exercisable at the time of the inducement offer.

The amendments also clarify that:

• If the conversion terms under the existing convertible debt or the inducement offer are based on a future share price or average future share price (such as a volume-weighted average price), the fair value as of the date the inducement offer is accepted should be used to calculate the amount of cash (or other assets) as well as the number of shares issuable under the existing convertible debt and the inducement offer (rather than the date on which it is settled).
• Any change that causes the amount of cash (or other assets) and number of shares issuable not to be indexed to the future price of the issuer’s shares is considered a change in the form of consideration that is not eligible for induced conversion accounting.
• If the convertible debt is modified within the one-year period prior to the date when the inducement offer is accepted by the convertible debt holder, it must compare, in a manner consistent with the principles of ASC 470-50, the conversion privileges under the inducement offer with those that existed one year before the date of the offer (or, if outstanding for less than a year, whenever the instrument was issued).

Impact

We expect more companies will now be able to use the induced conversion model, lowering the impact of settling convertible bonds early if their stock price increases after issuance. Pre-inducement, this is either the carrying value under the extinguishment scenario or the as-converted value under the inducement scenario. Post-inducement, this is a fair value and may be as simple as a security at exercise, such as additional shares from an improved exchange ratio. In other cases, however, the payoff may be in other financial instruments like a more valuable note or warrant sweetener, and determining the fair value may require complex calculations.

We appreciate that the FASB continues to provide clarification on this complex topic. Following down-round in 2017 and convertible bond guidance in 2020, we believe this latest rule further simplifies the framework.

If you have more questions about this article or would like to discuss your particular situation in more detail, please contact us.

[1] FASB, ASU 2024-04, Amendments to the FASB Accounting Standards Codification, Amendments to Subtopic 470-20, 470-20-40-13

[2] Ibid.

[3] Ibid.