EITF ABSTRACTS. Title: The Meaning of "Conventional Convertible Debt Instrument" in Issue No

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1 EITF ABSTRACTS Issue No Title: The Meaning of "Conventional Convertible Debt Instrument" in Issue No Date Discussed: June 15 16, 2005 References: FASB Statement No. 123 (revised 2004), Share-Based Payment FASB Statement No. 129, Disclosure of Information about Capital Structure FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity SEC Accounting Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stocks" ISSUE 1. Paragraph 12 of Statement 133 provides guidance on the bifurcation of embedded derivatives within a host contract (for example, bonds, insurance policies, and leases) that do not meet the definition of a derivative in its entirety. Specifically, subparagraph 12(c) of Statement 133 indicates that one of the three necessary criteria for bifurcation is that "a separate instrument with the same terms as the embedded derivative instrument would, pursuant to paragraphs 6 11, be a derivative instrument subject to the requirements of this Statement." 1 1 The other two criteria in Statement 133 are (a) the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract and (b) the contract that embodies both the embedded derivative and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur. Page 1

2 2. Paragraph 11 of Statement 133 provides guidance to identify those contracts that should not be considered and accounted for as derivative instruments. Specifically, paragraph 11(a) of Statement 133 indicates that "contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders' equity in its statement of financial position" should not be considered derivative instruments. 3. Issue No , "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," provides guidance in determining whether an embedded derivative would be classified in stockholders' equity in accordance with paragraph 11(a) of Statement 133 if it were freestanding. During its deliberations of Issue 00-19, the Task Force decided to include, in paragraph 4, an exception to the criteria in paragraphs when evaluating whether a "conventional convertible debt instrument" in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer) contains an embedded derivative indexed to the company's own stock that would require bifurcation. 4. The variety of contractual terms included in convertible debt instruments has increased dramatically since the Task Force deliberated Issue These contractual terms include, but are not limited to, contingent conversion features (including single or multiple triggers), variable conversion ratios, and call options. Since the term conventional convertible debt is not defined in detail in Issue 00-19, there is diversity in Page 2

3 practice in evaluating whether convertible debt instruments containing these features are considered "conventional" for purposes of determining whether the instrument qualifies for the exception provided in paragraph 4 of Issue A similar practice issue exists in evaluating whether convertible preferred stock with debt-like features (such as convertible preferred stock with a mandatory redemption date) qualifies for consideration under this exception. In accordance with paragraph A9 of Statement 150, convertible preferred stock with a mandatory redemption date would generally not be classified as a liability because the redemption is contingent upon the holders' not exercising their option to convert the instrument into a fixed number of shares (if conversion was into a variable number of shares, the instrument could be a liability in accordance with Statement 150). For these instruments, SEC registrants are required to follow the guidance in ASR 268 and Topic No. D-98, "Classification and Measurement of Redeemable Securities." Accordingly, public companies classify these instruments on the balance sheet between liabilities and permanent equity in a caption commonly referred to as "mezzanine" or "temporary" equity. 6. The issues are: Issue 1 Whether the exception to the requirements of paragraphs of Issue for "conventional convertible debt instruments" should be removed or further clarified Issue 2 Whether a contingency related to the exercise of the conversion option should impact the assessment of whether an instrument is "conventional" for evaluating the exception in paragraph 4 of Issue Issue 3 Whether convertible preferred stock with a mandatory redemption date can qualify for the exception included in paragraph 4 of Issue Page 3

4 EITF DISCUSSION 7. The Task Force reached a consensus on Issue 1 that the exception to the requirements of paragraphs of Issue for "conventional convertible debt instruments" should be retained and, accordingly, the Task Force considered Issue 2 and Issue On Issue 2, the Task Force reached a consensus that instruments that provide the holder with an option to convert into a fixed number of shares (or equivalent amount of cash at the discretion of the issuer) for which the ability to exercise the option is based on the passage of time or a contingent event should be considered "conventional" for purposes of applying Issue Instruments that contain "standard" antidilution provisions would not preclude a conclusion that the instrument is convertible into a fixed number of shares. Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction (as defined in the glossary of Statement 123(R) 2 ) that are designed to maintain the value of the conversion option. 9. On Issue 3, the Task Force reached a consensus that convertible preferred stock with a mandatory redemption date may qualify for the exception included in paragraph 4 of Issue if the economic characteristics indicate that the instrument is more akin to 2 Statement 123(R) defines an equity restructuring as "a nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying the option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend." Page 4

5 debt than equity. An entity should consider the guidance in subparagraph 61(l) of Statement 133 in assessing whether the instrument is more akin to debt or equity For instruments that are within the scope of this Issue, entities should include the applicable disclosures required by Statement 129. Transition 11. The consensus in this Issue should be applied to new instruments entered into and instruments modified in periods beginning after June 29, Board Ratification 12. At its June 29, 2005 meeting, the Board ratified the consensus reached by the Task Force in this Issue. STATUS 13. No further EITF discussion is planned. 3 If the preferred stock is more akin to equity than debt, an equity conversion feature would be "clearly and closely related" to that host instrument. Page 5