Convertible debt accounting: Making sense of complex terms

Convertible debt can offer an issuer a lower-cost financing alternative, but the accounting can be complex depending on the instrument’s terms, settlement features, and related transactions. This episode discusses the key accounting models for convertible debt, including bifurcation under ASC 815, the own stock scope exception, substantial premium model, single instrument model, related features such as capped calls and contingent interest, and diluted EPS considerations.  

For further guidance on the accounting for this topic, see chapter 6 of PwC’s Financing transactions guide.   

This is the final episode in our debt-related miniseries. In case you missed any, listen to our previous episodes: 

• Debt restructuring: Accounting for borrowers 
• Beyond debt: Accounting for other liability-classified arrangements 
• Current or noncurrent? Getting debt classification right  

Follow this podcast on your favorite podcast app and subscribe to our weekly newsletter to stay in the loop.  

About our guests  

Bret Dooley is a PwC National Office Deputy Chief Accountant who leads teams focused on the financial services sectors and accounting for financial instruments. He has over 25 years of experience in the financial services, banking, and capital markets industries. Bret focuses on emerging financial reporting issues related to financial instruments, developing interpretive guidance, and assisting clients in resolving complex accounting matters.  

Chip Currie is a partner in PwC’s National office with 30 years of experience assisting companies in resolving complex business and accounting issues. He concentrates on the accounting for financial instruments under both current and emerging standards and works with many of the firm's largest financial services clients and a number of non-financial services clients on treasury-related matters.  

About our guest host  

Diana Stoltzfus is a partner in PwC’s National Office who helps to shape PwC’s perspectives on regulatory matters, responses to rulemakings and policy development, and implementation related to significant new rules and regulations. Prior to rejoining PwC, Diana was the Deputy Chief Accountant in the Office of the Chief Accountant (OCA) at the SEC where she led the activities of the OCA’s Professional Practices Group.   

Transcripts available upon request for individuals who may need a disability-related accommodation. Please send requests to us_podcast@pwc.com.

Transcript

SPEAKER_02 0:00

Thought leadership from PWC's National Office.

SPEAKER_00 0:07

Hello, and welcome to PWC's Accounting Podcast. I'm Heather Horn. Thanks for joining us today as we jump into current topics in accounting and reporting. For today's discussion, I'm pleased to welcome guest host, Diana Stoltzfist, a partner in PWC's National Office and a podcast regular. I'll hand it over to Diana for more details on today's episode.

SPEAKER_01 0:35

Welcome to our mini-series on debt and financing transactions. Today we're focusing on convertible debt, a very active area in the capital markets with important accounting considerations at issuance and throughout the instrument's life. While the accounting guidance has been simplified in some respects over the past few years, convertible instruments can still create significant complexity depending on their terms and settlement features. We're going to talk through the key accounting models, some of the more challenging areas we're seeing in practice, and why it's so important to carefully evaluate the terms of these arrangements up front. Joining me today for this conversation are Brett Dooley, a deputy chief accountant in PWC's national office, and Chip Curry, a partner in our national office, both with deep experience in this area, and I'm really looking forward to the discussion today. So thank you both so much for joining me.

Convertible debt overview

SPEAKER_01 1:26

Brett, maybe we can start with the basics. For our listeners who may not work with these instruments every day, what is convertible debt?

SPEAKER_03 1:34

So at its core, it's just a financial instrument that starts out as debt that includes a feature to allow the investor to participate in the issuer's stock value. It's often structured as a note or bond with stated principal interest and maturity date, like traditional debt, but it has a conversion feature, either permitting or requiring the exchange for equity shares. So most of these arrangements give the investor the option to convert and receive a stated number of shares, or to not convert and just receive par at maturity. And some will also give, or many will give the issuer flexibility in how to settle the consideration that's going to be issued. Some will be settled in cash, some in shares, or some combination. And I think that flexibility is often where some of the these accounting questions arise. So when we put all this in accounting speak, we call this a hybrid instrument. It's a debt host contract. It's got this embedded equity derivative, which is the conversion option. I'd emphasize again the terms here vary wild widely and continue to evolve in the practice. So it's another area where it's really important to read the agreement very carefully to understand what you're dealing with.

SPEAKER_01 2:55

Okay. So maybe before we get into the actual accounting considerations, maybe we can step back. So Brett, you told us what convertible debt is, but Chip, maybe you could talk to us a little bit about the economics. And so maybe starting with the issuer's perspective, why do companies issue convertible debt?

SPEAKER_04 3:13

Yeah. So the the convertible debt issuance market's been fairly active over the last couple of years. And so what are the key key appeals for the issuer? So the one that's looking to raise financing? The number one thing is lower cash interest payments when you compare it to like regular non-convertible debt. So the conversion option, as Brett described it, where is is basically a written call option on the company's own stock. The investor has the option to surrender the debt agreement to receive shares in its simplest form. And like Brett said, it's a hybrid instrument. So it's debt with an embedded written option. So what's happening is in exchange for the value of the option that the investor is getting, the investor is willing to accept lower interest payments. So that's how you kind of use the conversion option to buy down the interest payments. It's essentially just a cheaper way to borrow from a cash perspective. And if the company does well and their stock price increases, then the investors will exercise their conversion option. And in many cases, the, you know, while Brett mentioned there is settlement flexibility, in a lot of cases, the issuer will have the option that if the investor converts, they can settle the whole thing in shares. And so in that case, they're also saving the cash that they would otherwise have to pay to redeem the instrument. And that's a great thing for companies that are like in growth stages or in otherwise need of cash liquidity that to settle this debt instrument, they can ultimately end, you know, settle it by issuing shares. You now you said this at the intro. I mean, the accounting guidance for convertible debt changed a number of years ago and and it definitely simplified the accounting guidance, but that doesn't mean the accounting guidance is simple. Right. It's just less complex than it was before.

unknown 5:02

Okay.

SPEAKER_01 5:02

Well, that's helpful. Maybe quickly we'll we'll take the other side of this before we dive into the accounting. So, Brett, we just Chip just walked us through why companies issue it, but maybe you can talk to us what is the benefit for investors or some of the trade-offs as well.

SPEAKER_03 5:18

I think the primary benefit for investors is this hybrid return profile. They have the protection of a debt instrument, you know, with principal repayment, a coupon, but but the benefits of having equity upside through that conversion feature. So if the company does very well, like Chip said, the stock price uh goes up, the investor will participate in that upside. And if it doesn't, they still have a debt claim against the company and its assets. Um usually have priority in the capital structure. This debt host creates that priority in the capital structure, you know, relative to buying common shares or even preferred shares. And then they often come with a coupon. So while you're waiting for that potential conversion and that potential upside, you're getting the investor is getting some coupon income. There are some trade-offs they make in order to get this return profile, right? So when you compare the coupons paid under these instruments compared to comparable regular debt, it it's a it's a lower coupon. So you're giving up some current income in order to pay for that conversion option. And obviously, if the stock price never reaches the conversion price that's out of the money, then the investor over time has earned an otherwise below market return on that debt instrument. Um other potential risks, you know, they still have the credit risk of the issuer. So if the conversion option doesn't um become in the money and they're trying to settle the debt, they still have the credit risk, they're still corporate obligations. Uh and these instruments are complex and less liquid than other types of instruments, especially if it's a private placement. If you're looking to trade out of this instrument, the market for them is going to be much less liquid than maybe traditional debt or or equity.

SPEAKER_01 7:07

Okay. I think that's really helpful to understand the economics of these interests.

Convertible debt accounting models

SPEAKER_01 7:12

So now we can dive into the accounting. So maybe we'll start with the issuer's perspective. Chip, can you walk us through the main accounting models that can apply to convertible debt? I know there's a couple different depending on the different terms.

SPEAKER_04 7:27

Yeah. So so basically there's three models that you might end up applying for an issuer of convertible debt. And these are not models you can choose from. Um, you sort of follow through them linearly. It's a, it's, you start with one, see if it qualifies. If not, you move to the next. And if not, you move to the third. I told a client that this was like a linear model, and and they recently and they told me it's that's the most crooked line that I've ever seen before in my life. But um, so the first model that we start with is the bifurcation model. So whether the conversion option needs to be bifurcated and separately accounted for as a derivative under the guidance under ASC 815. Okay, so what am I talking about? So we started this podcast, and Brett started by saying that a convertible debt is a hybrid instrument. And it it's a hybrid instrument because it's debt with an embedded equity derivative. The embedded equity derivative, as Brett mentioned when he was going through some of the economics as well, um, the embedded equity derivatives, the value of that embedded derivative is driven off of the company's stock price. So when you think about that in the terms of embedded derivatives under 815, it is not clearly and closely related, the conversion option to the host debt instrument. The conversion options based upon equity prices, the economics of the host instrument are based upon interest rates and credit. Okay. So now that I know it's not clearly and closely related, the next thing you have to look at under the embedded derivative model is does the conversion option meet the definition of a derivative? And if it does, does it qualify for a scope exception? In 815, there is a scope exception for derivatives indexed to your own stock. If it meets the definition of a derivative and it does not qualify for the scope exception, we have to bifurcate it. So that's why we call model one the bifurcation model. We're accounting for the conversion option separately from the debt as a derivative. We're fair valuing it through PL. Okay. So when does a conversion option meet the definition of a derivative? Um, that analysis usually comes down to whether the conversion option has net settlement, as that term is defined in 8815. So if Brett mentioned earlier that a lot of times people have settlement flexibility in how they want to settle the instrument. So if that flexibility exists where the issuer could settle the conversion option by just paying cash, like net cash settlement, or just issue like net shares, like settle the liability component in cash and issue shares for the conversion spread. If you have that feature, you automatically have net settlement. If you don't have that feature, if you the only way it could be exercised is by the investor handing in the debt instrument and getting a whole bunch of shares, what we call that gross settlement, then what it'll depend on is whether those shares are readily convertible to cash. Readily convertible to cash, we have net settlement. If they are not readily convertible into cash, we do not have net settlement. If you don't have net settlement, we're not going to bifurcate it. And we're done analyzing under this model and go into the next. If we do have net settlement and it meets the definition of a derivative, we're still not done with this model.

unknown 10:46

Okay.

SPEAKER_04 10:47

I mentioned earlier now what we would do is we go look to see if that derivative qualifies for the own stock scope exception. Um, and that basically is looking at is it indexed to the company's own stock? And does the company control the method of settlement? Can the company be forced to settle in cash? And if you meet that criteria, it could be excluded from derivative accounting. Um, we have pages and pages and pages and pages in our financing guide going through that model. It's very complex, so we won't go into it here. Um, but your two outs of bifurcation are either the conversion option doesn't meet the definition of a derivative, or um, it qualifies the embedded conversion option qualifies for the scope exception. Okay, so just a recap if we're in bifurcation, we're gonna take the conversion option, we're gonna strip it out of the debt instrument, market to market is a derivative contract. That's our first model.

SPEAKER_01 11:40

Okay.

SPEAKER_04 11:41

That was a lot.

SPEAKER_01 11:42

Yes.

SPEAKER_04 11:42

And we're only through model one.

SPEAKER_03 11:44

I can't believe you described this as linear.

SPEAKER_04 11:48

I said it was a didn't say it was a well, I did say it was linear.

SPEAKER_03 11:51

Three rabbit holes does not make something a linear process, but okay, continue.

SPEAKER_04 11:58

All right. So we're not in bifurcation. We've gotten through that model. So then the next one we have to look to is what we call the substantial premium model. Um, so what is the substantial premium model? So if we're not following the bifurcation model, what we're gonna look at is did we issue the convertible debt at a substantial premium? So was the proceeds that we received upon issuance a substantial premium to, let's say, the par amount of the debt. If it, if we if it was issued at a substantial premium, that premium over the par amount is presumed to be a capital contribution. Why? Because it's as we've been talking about, it's a hybrid instrument. It has debt components and it has equity components. And so if you issue it at a substantial premium, what we're gonna do is we're gonna take that premium and we're gonna record it in equity. So our entry is gonna be sort of I love this part, debit cash, credit debt, and then credit additional paid and capital. So it's sort of a bifurcation approach because we've put the instrument in two line items on the balance sheet, but it's very different than the derivative because we're not gonna be marking anything to market and we're not separating the conversion option based upon fair value, we're putting the premium into equity.

SPEAKER_01 13:11

Okay.

SPEAKER_04 13:12

So that's your substantial premium model.

SPEAKER_01 13:14

Okay. And you just look to the par value of the debt when you're comparing it to generally that's right.

SPEAKER_04 13:19

I mean, some debt instruments could be a little bit more complex, but generally, you know, generally that's right. Okay. So here's the linear part. If it's not bifurcated under 815, if we're not in the substantial premium model, then we're in what I creatively call the single instrument model. What is the single instrument model? What it basically means is, and here we go again with journal entries, we're gonna debit cash and we're gonna credit debt.

SPEAKER_01 13:47

Just one line item.

SPEAKER_04 13:48

One line item. We're not gonna put a bifurcated derivative, we're not gonna put something in equity, we're gonna account for it as if it was a single instrument, and the debt's gonna go on the balance sheet, sort of at the proceeds that were received.

SPEAKER_01 14:00

Okay.

SPEAKER_04 14:01

Lines over.

SPEAKER_01 14:02

Okay, got it. We made it through. Brett, it seems like one of the really important things that Chip highlighted going through the various models was this own stock scope exception, especially when we're talking about the bifurcation model. And I know we've talked about it a number of times. This is a very complicated area of gap, but maybe are there some things that you could highlight for companies to think about here?

SPEAKER_03 14:25

Yeah, the the scope exception is important because as Chip went through the bifurcation model, it kept coming to my mind, like in in practice, most companies uh try try to structure this transaction to avoid the bifurcation model. So we actually don't see that very often in practice. We see most issuers trying to uh structure this, the these instruments in order to avoid that. And so you end up looking at this own stock uh scope exclusion as a real gating issue uh to make sure when you have an instrument where the conversion option meets a definition of a derivative that it doesn't require bifurcation. So there's two parts of the guidance uh that need to be satisfied in order to meet that scope exception. The first is whether uh the conversion option is indexed to the company's own stock price. And there's guidance in 815-40-15 that gives this guidance. We call it indexation guidance. And in our experience, it's one of the most difficult parts in applying this guidance, uh, this indexation piece. And uh it's it's an area where the FASBE is currently looking at this indexation guidance because it is so complicated to apply to try to simplify it. Once you're through that analysis, you also need to look at the second part. Uh, and there's some additional equity classification conditions that need to that need to be met in the guidance. And so that part can be tricky too. And a lot of that uh that second analysis focuses on the settlement provisions of the of the provision. So my my advice to people going through this is that remember that even terms without a lot of significant economic value can matter a lot when you're in the details of of the indexation guidance in particular, and also uh in this, in this uh, in this second step. So as we keep telling people in this area, you really need to read and understand every word of the agreement to know how you're stepping through that that model.

SPEAKER_01 16:29

Okay, that's

Common features and related instruments

SPEAKER_01 16:30

helpful. So convertible debt agreements often have other features beyond just the conversion option itself. So, Chip, what are some of the other features that we typically see?

SPEAKER_04 16:40

Yeah, I mean, we when companies issue convertible debt, they'll sometimes enter into additional transactions that are related to the convertible debt. Um in addition, you also mentioned that sometimes the convertible debt instrument has other features that need to be analyzed under the conversion option. So, what are some examples of those things? So, one thing you might see when companies issue convertible debt is something that's called a call option overlay. You might also hear it referred to as a capped call or a call spread. So, so what is that? So an issuer issues convertible debt, and then what they'll do is they'll turn around and they'll buy a call option from an investment bank where the terms of the call that they buy from the investment bank match the terms of the conversion option. What they'll also do is they'll sell a call option to the investment bank at a higher strike price than the option they just bought. Thus the term call spread or capped call. So economically, if you looked at the convertible debt and the call spread together, what it effectively you've done is you've raised the conversion price in the debt because the call you purchased from the investment bank sort of nets off against the call you wrote in the convertible debt. And then you're left with this new higher strike call option that you wrote. Um and in some cases, what issuers will do for tax purposes is integrate the call spread into the convertible debt, and they do that to get certain tax benefits. Um that's tax. Not my expertise, so I'll come back to accounting. Okay. Um so from an accounting perspective, if the call spread is considered a freestanding financial instrument from the convertible debt, and it typically is because typically with a different counterparty, the convertible debts owned by investors, the call spreads with an investment bank, then we notwithstanding that the tax folks might integrate them together from an accounting perspective, we won't. We'll account for them as separate instruments. Um to account for the call spread, we'll follow the model that that Brett referred to. Um we'll start with 480 to determine if the thing should be reported as a liability under 480. Uh, and then we'll apply a 1540 to determine if it should be reported as a mark-to-market asset or if it should be reported as um within equity. So, so the the the key point that I want to leave people with, though, with this guidance on call spreads is because it's not embedded, it's a freestanding instrument. It doesn't really matter whether it meets the definition of a derivative. So when I went through my maybe nonlinear model and started with embedded derivatives that had to meet the definition of a derivative, that part of the model is really not relevant if you're talking with a freestanding instrument because 815.40 is really going to tell you whether it gets reported as a mark-to-market asset or liability versus equity. So that's an example of something that might enter into in connection with the convertible debt. Um, you might see things, other features embedded in the convertible debt agreements. So some convertible debt agreements have contingent interest features where the issuer will have to pay additional interest. And usually that's based upon like the trading price of the convertible debt instrument. Um, that's an embedded derivative. It's not going to be clearly and closely related to the debt host because the convertible debt's value is going to be driven in part by equity prices, not interest rates and credit. And since it's being cash settled, we're generally going to have to bifurcate and separately account for as a derivative, these contingent interest features.

SPEAKER_01 20:19

So you could have multiple embedded derivatives in these contracts.

SPEAKER_04 20:23

Absolutely. You could have a conversion option, you could have contingent interest. You could also have redemption rights. You could have issuer call options or investor put options. And we'd have to separately analyze those embedded derivatives to determine whether or not they should also be bifurcated. And they have a different set of clearly and closely related rules. So those are examples of other features that are embedded in the convertible debt instrument that you might have to run through 815 to determine if they need to be bifurcated. Two others I'd mentioned, maybe jumping back to things that are entered into sort of around the convertible debt offering. So one is green shoe or overallotment options. So what are these? These don't just exist with convertible debt. You'll see them with debt offerings and equity offerings as well. But basically, what they are is they're options that you give to the underwriter. So the bank that's helping you place the convertible debt and issue the debt. And what it allows the underwriter to do is buy additional securities from you at a fixed price. These can be structured many different ways, but a lot of times what ends up happening is they end up being written options that get fair value through earnings. So those are green shoes or overallotment options. The other thing you'll see sometimes that people will enter into when they do convertible debt is share lending arrangements, where what they'll do is they'll lend their own shares out into the market. Why are they doing that? Um one of the main folks that invest in convertible debt. Are people that like to try to do arbitrage strategies? So they'll buy the convertible debt and then they'll short the underlying common stock. To short common stock, you need to borrow common stock. To be able to borrow common stock, there has to be sufficient liquidity in the marketplace to borrow. And so what some of these share lending agreements do is sort of introduce additional liquidity to the stock borrow market to enable investors to hedge their positions by borrowing shares and shorting them. Generally, these share lending agreements will analyze them under the same guidance Brett talked about 480, 815, 40 to determine if they have to be marked to market or not.

SPEAKER_01 22:40

So there's a lot of different transactions that happen around the convertible debt and then within the convertible debt, a lot of making sure you're analyzing all the different features to identify how to account for them and what needs to be bifurcated.

SPEAKER_04 22:52

I guess the the I guess the punchline for some of these podcasts in this series on liabilities is it's complicated.

SPEAKER_01 22:59

Yes. So

Diluted EPS considerations

SPEAKER_01 23:01

maybe another area where there's also can be complication, Brett, is how companies think about how this convertible debt can impact their EPS calculations, especially diluted EPS. So maybe you can talk to us about how those how it needs to be factored into EPS calculations.

SPEAKER_03 23:17

Sure. And and maybe I'll simplify the the question a little bit. And let's assume for this that the convertible debt is accounted for under that third model that Chip talked about, the single instrument model, most common thing we see in practice. So we're going to look to the if-converted method to do uh to compute diluted EPS. So assuming that the convertible debt is settled entirely in shares, this what we would do is assume conversion at the beginning of the period, add back interest uh expense instead of tax to the numerator, because you wouldn't have that if you had converted, and then add the potential shares to the denominator. And this can result in dilution even if that conversion option is out of the money. Um and if it's anti-dilutive, then we don't apply the if-converted method uh to to uh diluted EPS. And for instruments that we see where the issuer will settle par amount in cash and then the conversion spread uh in in shares, only that, only the share settlement amount above par would go into the denominator, still kind of the if-converted method. And I encourage companies to think about this EPS impact throughout the life of the instrument as stock price moves. It's not just not just at issuance.

SPEAKER_01 24:34

Okay. That's an important reminder.

Key takeaways in accounting for convertible debt

SPEAKER_01 24:36

We've covered a lot today and a lot of complexity. Maybe as a final takeaway, what advice would you give companies as they evaluate and account for convertible debt arrangements? Maybe, Chip, I'll start with you.

SPEAKER_04 24:48

Well, maybe I'll say the same thing I say on most of the podcasts, which is re-read the care the agreement very, very carefully. Uh Brett Brett hit on this earlier, but it's definitely worth mentioning again and again because even seemingly immaterial terms that don't have a tremendous amount of economic value can drive very different accounting outcomes. And we're talking about settlement provisions, conversion triggers, even the instruments where you have free convertibility periods, um, all of those features can create accounting complexity. So you really need to understand the facts. Um, and the other thing I would say is involve specialists early. Um, when you think about accounting for convertible debt, it sort of sits at the intersection between a lot of complicated topics, debt accounting, derivatives, equity classification, earnings per share. So um get get your specialists involved early.

SPEAKER_01 25:41

Okay. Brad, I'll turn to you.

SPEAKER_03 25:44

A couple things. I would uh encourage companies to keep an eye on market developments here. We've been talking about convertible debt for a long time, but we continue to see new arrangements, new features being added and emerging. And so, you know, like Chip said, you got to read the agreement carefully, but also just don't assume that you issued convertible debt several years ago that this is kind of the same or or a peer had issued it and and this will work the same. You got to make sure you understand um, you know, what differences could exist in in some of the details. I also think it's an area that it's really important to keep different areas of the organization really aligned, you know, between treasury, who often knows like the the real economics of the transaction, get legal involved to make sure you understand the details of the contract and your accounting folks that need to put it all together into this accounting analysis. A lot of times, you know, operational decisions will have a really important accounting impact.

SPEAKER_01 26:41

Well, thank you, Brett and Chip, so much for joining me today and sharing your perspectives. It's been very helpful. Maybe one final thing to mention for our listeners is to check out chapter six of PWC's financing transactions guides, which covers convertible debt and the related accounting considerations. But as we've talked about, there are other pieces of the literature too that we need to consider. So that's maybe a starting point. Thank you so much for joining me.

SPEAKER_00 27:06

That's our show for today. Tune in next week for more fresh episodes so that you never miss any of our audio content. Follow the PWC Accounting Podcast wherever you listen to your podcasts. And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com. From Thought Leadership at PwC, I'm Heather Horn. Thanks for tuning in.

SPEAKER_02 27:39

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