EITF ABSTRACTS. Title: Application of Issue No to Certain Convertible Instruments. Dates Discussed: November 15 16, 2000; January 17 18, 2001

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1 EITF ABSTRACTS Issue No Title: Application of Issue No to Certain Convertible Instruments Dates Discussed: November 15 16, 2000; January 17 18, 2001 References: FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements FASB Statement No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities FASB Statement No. 128, Earnings per Share 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 FASB Staff Position APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants APB Opinion No. 20, Accounting Changes AICPA Accounting Interpretation 1, Debt Tendered to Exercise Warrants, of APB Opinion No. 26 SEC Accounting Series Release No. 268, Presentation in Financial Statements of Redeemable Preferred Stocks Statement 133 Implementation Issue No. F3, Firm Commitments Statutory Remedies for Default Constituting a Disincentive for Nonperformance ISSUE [Note: Prior to the adoption of FSP APB14-1 (effective for financial statements issued for fiscal years beginning after 12/15/08, an interim periods within those fiscal years), paragraph 1 should read as follows:] 1. Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, addresses the accounting for Page 1

2 convertible debt instruments and convertible preferred stock (collectively, convertible instruments) with nondetachable conversion options that are in-the-money (see Part II, Issue 1 for additional guidance on determining when a conversion option is in-themoney) at the commitment date. Issue 98-5 also addresses an issuer s accounting for convertible instruments that have conversion prices that are variable based on future events. The Task Force reached a consensus on Issue 98-5 at the May 19 20, 1999 meeting. Subsequent to the consensus, a number of issues about the application of the Issue 98-5 model have been raised. [Note: After the adoption of FSP APB14-1, paragraph 1 should read as follows:] 1. Issue No. 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," addresses the accounting for convertible debt instruments and convertible preferred stock (collectively, convertible instruments) with nondetachable conversion options that are in-the-money (see Part II, Issue 1 for additional guidance on determining when a conversion option is in-themoney) at the commitment date. Issue 98-5 also addresses an issuer s accounting for convertible instruments that have conversion prices that are variable based on future events. Issue 98-5 does not apply to instruments within the scope of FSP APB14-1. The Task Force reached a consensus on Issue 98-5 at the May 19 20, 1999 meeting. Subsequent to the consensus, a number of issues about the application of the Issue 98-5 model have been raised. 2. The Task Force has again added the Issue 98-5 model to the EITF s agenda to address certain practice issues resulting from application of the model and, in the event Page 2

3 those issues cannot be adequately addressed within the existing Issue 98-5 model, to consider whether a different model for the instruments subject to Issue 98-5 should be developed. 3. The issues are: Part I Whether the existing Issue 98-5 model is sufficiently operational and, if not, whether embedded beneficial conversion options should be measured using a fair value method Part II Practice issues under the Issue 98-5 intrinsic value model. EITF DISCUSSION Part I 4. The Task Force reached a consensus that the Issue 98-5 intrinsic value model should be retained. Part II Issue 1 In determining whether an instrument includes a beneficial conversion option, whether an issuer should calculate the intrinsic value of a conversion option using (a) the specified conversion price in the instrument or (b) the effective conversion price based on the proceeds received for or allocated to the convertible instrument. 5. The Task Force reached a consensus that the effective conversion price based on the proceeds received for or allocated to the convertible instrument should be used to compute the intrinsic value, if any, of the embedded conversion option. As a result of this consensus, an issuer should first allocate the proceeds received in a financing Page 3

4 transaction that includes a convertible instrument to the convertible instrument and any other detachable instruments included in the exchange (such as detachable warrants) on a relative fair value basis. Then, the Issue 98-5 model should be applied to the amount allocated to the convertible instrument, and an effective conversion price should be calculated and used to measure the intrinsic value, if any, of the embedded conversion option. 6. For example, assume Company A issues for $1 million convertible debt with a par amount of $1 million and 100,000 detached warrants. The convertible debt is convertible at a conversion price of $10 per share (holder would receive 100,000 shares of Company A common stock upon conversion). The fair value of Company A s stock at the commitment date is $10. Further, assume that the ratio of the relative fair values of the convertible debt and the detached warrants is 75 to 25. After allocating 25 percent or $250,000 of the proceeds to the detached warrants (based on relative fair values), the convertible debt is recorded on the balance sheet at $750,000 (net of the discount that arises from the allocation of proceeds to the warrants), and the detached warrants are recorded in paid-in capital in the balance sheet at $250, Company A must evaluate whether the embedded conversion option within the debt instrument is beneficial (has intrinsic value) to the holder. The effective conversion price (that is, the allocated proceeds divided by the number of shares to be received on conversion) based on the proceeds of $750,000 allocated to the convertible debt is $7.50 ($750, ,000 shares). The intrinsic value of the conversion option therefore is $250,000 [(100,000 shares) ($10.00 $7.50)] and is recognized as a reduction to the carrying amount of the convertible debt and an addition to paid-in capital. The total debt discount immediately after the initial accounting is performed is $500,000 ($250,000 from the allocation of proceeds to the warrants and an additional $250,000 from the Page 4

5 measurement of the intrinsic value of the conversion option). The same answer would result if the debt had been issued without detachable warrants for $750,000 in proceeds. Issue 2 For a contingent conversion option, Issue 98-5 requires the intrinsic value to be measured using the commitment date fair value of the underlying stock but does not require it to be recognized 1 unless the triggering event occurs and the contingency is resolved. In some cases, it may not be clear which conversion option should be considered the initial conversion option and which option should be considered the contingent conversion option. 8. The Task Force reached a consensus that the most favorable conversion price that would be in effect at the conversion date, assuming there are no changes to the current circumstances except for the passage of time, should be used to measure the intrinsic value of an embedded conversion option. Changes to the conversion terms that would be triggered by future events not controlled by the issuer should be accounted for as contingent conversion options, and the intrinsic value of such conversion options would not be recognized until and unless the triggering event occurs. 9. For example, assume Company A, a private company, issues for $1 million a convertible instrument that is convertible 4 years after issuance at a conversion price of $10 per share (fair value of the stock is $10 at the commitment date). The instrument also contains a provision that the conversion price adjusts from $10 to $7 per share if Company A does not have an initial public offering with a per-share price of $13 or more within 3 years. Company B, a private company, issues for $1 million a convertible instrument that is convertible 4 years after issuance at a conversion price of $7 per share (fair value of the stock is $10 at the commitment date). The instrument also contains a 1 The term recognized is used to mean that the calculated intrinsic value is recorded in equity with a corresponding discount to the convertible instrument. Issue 6 addresses the timing of the periodic charges related to the discount. Page 5

6 provision that the conversion price adjusts from $7 to $10 per share if Company B successfully completes an initial public offering for a per-share price of $13 or more within 3 years. 10. The active conversion price for both Company A and Company B is $7, which is the conversion option price that would apply if there were no change in circumstances after the issuance date other than the passage of time. The intrinsic value of the conversion option of $428,571 [($1 million $7) ($10 $7)] should be recognized at the issuance date of the convertible instrument. If an event occurs that triggers a decrease in the number of shares to the holder upon conversion (the initial public offering in the example), the intrinsic value of the adjusted conversion option should be recomputed using the commitment-date fair value of the underlying stock and the proceeds received for or allocated to the convertible instrument in the initial accounting. 11. If the amortized amount of discount on the convertible instrument resulting from the initial measurement of the intrinsic value of the conversion option before the adjustment exceeds the remeasured intrinsic value of the conversion option after the adjustment, the excess amortization charge should not be reversed. Any unamortized amount of that original discount amount that exceeds the amount necessary for the total discount (amortized and unamortized) to be equal to the intrinsic value of the adjusted conversion option should be reversed through a debit to paid-in capital (as an adjustment to the intrinsic value measurement of the conversion option). The adjusted unamortized discount, if any, should be amortized using the interest method pursuant to the recommended guidance in Issue For example, assume in the examples provided that Company A had an amortized discount of $85,714 and the remaining unamortized discount was $342,857 at the time it completed an initial public offering for a per-share price of more than $13. Company A Page 6

7 would remeasure the intrinsic value of the conversion option based on the adjusted conversion price of $10 per share and determine that there is no intrinsic value of the adjusted conversion option because the adjusted conversion price equals the fair value of the common stock at the initial commitment date. Company A would reverse the entire $342,857 of remaining unamortized discount (credit) with an offsetting entry (debit) to additional paid-in capital. The $85,714 of discount previously amortized is not reversed. Issue 3 Whether a contingent conversion feature that will reduce (reset) the conversion price if the fair value of the underlying stock declines after the commitment date to or below a specified price is a beneficial conversion option if (a) the initial active conversion price is equal to or greater than the fair value of the underlying stock at the commitment date and (b) the contingent conversion price is greater than the then fair value of the underlying stock at the future date that triggers the adjustment to the conversion price. 13. The Task Force reached a consensus that a beneficial conversion amount must be recognized when the reset occurs. The Task Force observed that value has been transferred to the holder through the reset feature, and, if the reset occurs, the holder of this instrument has realized enhanced economic value as compared with a holder of an equivalent instrument without the reset feature. The Task Force noted that if a convertible instrument has a conversion option that continuously resets as the underlying stock price increases or decreases so as to provide a fixed value of common stock to the holder at any conversion date, the convertible instrument should be considered stocksettled debt and the contingent beneficial conversion option provisions of Issue 98-5 Page 7

8 would not apply when those resets subsequently occurred. 2 However, Issue 98-5 would apply to the initial accounting for the convertible instrument including any initial active beneficial conversion feature. 14. For example, assume Company A issues for $1 million a convertible debt instrument with a conversion option that allows the holder to convert the instrument at $12.50 per share for 80,000 shares of Company A s common stock. The fair value of the common stock is $10 at the commitment date. The debt instrument also provides that if the market price of Company A s common stock falls to $7 or less at any point during the conversion term, then the conversion price resets to $8.75 per share (the instrument would then become convertible into 114,286 shares). 15. A contingent beneficial conversion amount of $142,858 [($1 million $8.75) ($10.00 $8.75)] is required to be calculated at the commitment date but only recognized when and if Company A s stock price falls to $7 or less. The accretion of this discount would be required from the date the stock price falls to $7 or less (regardless of the fact that the conversion price resets to $8.75 per share) in accordance with Issue 6. Issue 4 When a commitment date should occur for purposes of determining the fair value of the issuer s common stock to be used to measure the intrinsic value of an embedded conversion option. 16. The Task Force reached a consensus that the commitment date definition in Issue 98-5 should be replaced with a definition that is consistent with the firm commitment definition in Statement 133 and in Statement 133 Implementation Issue F3 and, therefore, 2 For example, if the conversion price in the previous example was described as $1 million divided by the market price of the common stock on the date of the conversion, the holder is guaranteed to receive $1 million in value upon conversion and, therefore, there is no beneficial conversion option. However, if the conversion price does not fully reset (for example, resets on specified dates prior to maturity), the reset represents a contingent beneficial conversion feature subject to Issue Page 8

9 requires the agreement to be binding on both parties. The definition of a commitment date for purposes of Issue 98-5 is as follows: An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment. 17. The Task Force observed that if an agreement includes subjective provisions that permit either party to rescind its commitment to consummate the transaction (for example, a provision that allows an investor to rescind its commitment to purchase a convertible instrument in the event of a material adverse change in the issuer s operations or financial condition or a provision that makes the commitment subject to customary due diligence or shareholder approval), a commitment date should not occur until the provisions expire or the convertible instrument is issued, whichever is earlier. Issue 5 Whether the commitment date, as defined in Issue 4, should also be the date on which the assumptions, including the fair value of the issuer s stock, should be determined in order to allocate the proceeds pursuant to Opinion 14 on a relative fair value basis to the separate instruments in a financing transaction that includes a convertible instrument with an embedded beneficial conversion option. Page 9

10 18. The Task Force reached a consensus that the measurement dates should be the same under both Opinion 14 and Issue 98-5 to ensure the use of measurement attributes as of the same point in time for purposes of allocating the proceeds from a transaction to the separable components and then measuring the intrinsic value of the conversion option. Accordingly, the commitment date defined in Issue 4 also must be used to determine the relative fair values of all instruments issued together with a convertible instrument when allocating the proceeds to the separate instruments pursuant to Opinion 14. Issue 6 Whether it is appropriate to accrete (amortize) the discount resulting from the allocation of proceeds on a relative fair value basis to the separate instruments in the transaction over the life of a convertible instrument and the discount resulting from recording a beneficial conversion option under Issue 98-5 over the period to the first date the convertible instrument may be converted. 19. The Task Force reached a consensus that the Issue 98-5 model should be modified for convertible instruments that have a stated redemption date (such as debt and mandatorily redeemable preferred stock) to require a discount resulting from recording a beneficial conversion option to be accreted from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs. 20. For convertible instruments that do not have a stated redemption date, such as perpetual preferred stock, the Task Force decided to retain the current guidance in Issue The Task Force noted that in those situations all discounts retain their character such that (a) a discount resulting from the accounting for a beneficial conversion option is amortized from the date of issuance to the earliest conversion date and (b), for SEC registrants, other discounts on perpetual preferred stock that has no stated redemption date but that is required to be redeemed if a future event that is outside the control of the Page 10

11 issuer occurs (such as a change in control) should be accounted for pursuant to ASR 268 (and the related SEC staff guidance). 21. The Task Force reached a consensus that for instruments with beneficial conversion features all of the unamortized discount (both the discount from an allocation of proceeds under Opinion 14 to other separable instruments included in the transaction and the discount originated by the beneficial conversion option accounting) remaining at the date of conversion should be immediately recognized as interest expense or as a dividend, as appropriate. 3 If the amount of unamortized discount is recognized as an expense (because the convertible instrument was debt in form), the expense should not be classified as extraordinary. Extinguishments of instruments with beneficial conversion options are discussed in Issue The Task Force reached a consensus that costs of issuing convertible instruments do not affect the calculation of the intrinsic value of an embedded conversion option. Issuance costs should not be offset against the proceeds received in the issuance in calculating the intrinsic value of a conversion option. The Task Force observed that with respect to this consensus, (a) issuance costs are limited to incremental and direct costs incurred with parties other than the investor in the convertible instrument and (b) any amounts paid to the investor when the transaction is consummated represent a reduction in the proceeds received by the issuer (not issuance costs) and would affect the calculation of the intrinsic value of an embedded option. Issue 7 How an issuer should apply Issue 98-5 if the terms of a contingent conversion option do not permit the number of shares that would be received upon 3 For convertible debt that does not include a beneficial conversion option, Accounting Interpretation 1 of Opinion 26 and Issue No , Accrued Interest upon Conversion of Convertible Debt, continue to apply. Those pronouncements state that the net carrying amount of the convertible debt, including any unamortized premium or discount, is credited to equity upon conversion. Page 11

12 conversion if the contingent event occurs to be calculated at the commitment date. 23. The Task Force reached a consensus that if the terms of a contingent conversion option do not permit an issuer to compute the number of shares that the holder would receive if the contingent event occurs and the conversion price is adjusted, an issuer should wait until the contingent event occurs and then compute the resulting number of shares that would be received pursuant to the new conversion price. The number of shares that would be received upon conversion based on the adjusted conversion price would then be compared with the number that would have been received prior to the occurrence of the contingent event. The excess number of shares multiplied by the commitment date stock price equals the incremental intrinsic value that results from the resolution of the contingency and the corresponding adjustment to the conversion price. That incremental amount would be recognized when the triggering event occurs. 24. For example, assume Company A issues for $1 million a convertible debt instrument that is convertible into 100,000 shares of Company A common stock ($10 conversion price) when the fair value of the stock is $10. This instrument provides that if Company A subsequently issues common stock at a price less than $10, the conversion price adjusts to 90 percent of that subsequent issue price. 25. If Company A subsequently issues common stock at a price of $8 per share, the holder s conversion price adjusts to $7.20 ($8 90%) and the holder now would receive 138,888 shares ($1 million $7.20) upon conversion, an increase of 38,888 shares from the 100,000 shares that would have been received prior to the occurrence of the contingent event. The incremental intrinsic value that results from triggering the contingent option is $388,888 (calculated as 38,888 shares $10 stock price at the commitment date or, alternatively, ($1 million $7.20) ($10 $7.20)) and would be Page 12

13 recognized upon the subsequent issuance of common stock at the $8 per share price. The accretion of this discount would be required from the date the common stock was subsequently issued at $8 per share in accordance with Issue 6. Issue 8 How Issue 98-5 should be applied when a beneficial conversion option terminates after a specified time period and the instrument is then mandatorily redeemable at a premium. 26. The Task Force reached a consensus that Issue 98-5 should be applied and any resulting discount accreted to the mandatory redemption amount. [Note: See STATUS section.] The Task Force observed that this accounting is consistent with the economics of the transaction because the holder received an in-the-money embedded conversion option and is entitled to receive a premium upon redemption of the instrument. 27. For example, assume Company A issues for $1 million a convertible debt instrument that is convertible by the holder 1 year from issuance into 120,000 shares of Company A common stock (fair value of Company A s common stock at the commitment date is $10). If the instrument is not converted at the end of 1 year, Company A is required to redeem it for $1.2 million. 28. The debt instrument contains a beneficial conversion option with an intrinsic value of $200,000 [(120,000 shares $10 per share) (which is equal to the fair value of stock to be received upon conversion) $1 million (proceeds received)]. The total proceeds of $1 million are therefore allocated as follows: $800,000 to the convertible debt and $200,000 to the conversion option (recognized as additional paid-in capital). The debt is then accreted from $800,000 to the $1.2 million redemption amount over the 1-year period to the required redemption date in accordance with Issue 6. Page 13

14 Issue 9 The accounting that should be applied to a convertible instrument that is issued to a provider of goods or services. 29. The Task Force added this Issue to its agenda as a separate Issue and requested that a Working Group consider the Issue. See Issue No. 01-1, Accounting for a Convertible Instrument Granted or Issued to a Nonemployee for Goods or Services or a Combination of Goods or Services and Cash. Issue 10 Whether the commitment date for convertible instruments that are issued as paid-in-kind (PIK) interest or dividends is (a) the commitment date of the original convertible instrument to which the PIK issuance relates or (b) the date that the interest is recognized as a liability or the dividend is declared. 30. The Task Force reached a consensus that if dividends or interest on a convertible instrument must be PIK with the same convertible instruments as those in the original issuance and are not discretionary (that is, (a) neither the issuer nor the holder can elect other forms of payment for the dividends or interest and (b) if the original instrument or a portion thereof is converted before accumulated dividends or interest are declared or accrued, the holder will always receive the number of shares upon conversion as if all accumulated dividends or interest have been PIK), the commitment date for the original instrument is the commitment date for the convertible instruments that are issued to satisfy interest or dividends requirements. In that case, the intrinsic value of the embedded conversion option in the PIK instruments is measured using the fair value of the underlying stock of the issuer at the commitment date for the original issuance. Otherwise, the commitment date for the convertible instruments issued as PIK interest or dividends is the date that the interest or the dividends are accrued and the fair value of the underlying issuer stock at the recognition or declaration date should be used to measure the intrinsic value of the conversion option embedded in the PIK instruments. Page 14

15 31. The Task Force discussed when a commitment date should occur for convertible instruments that are issued upon exercise of underlying warrants that provide only for physical settlement upon exercise. The Task Force was not asked to reach a consensus on this issue but requested that the Working Group further evaluate this question and return to the Task Force with a recommendation. Issue 11 How an issuer should account for the issuance of a convertible instrument that is issued as repayment of a nonconvertible instrument at the nonconvertible instrument s maturity, including whether the Issue 98-5 model applies to the embedded conversion option in the instrument issued as payment of the matured debt. 32. The Task Force reached a consensus that if the original debt has matured and the exchange of debt instruments is not a troubled debt restructuring that would be accounted for by the issuer under Statement 15, the fair value of the newly issued convertible instrument equals the redemption amount owed at the maturity date of the old debt. The Task Force believes that the fair value of the convertible instrument can be no greater than the redemption amount due on the original debt (because the issuer could have repaid the debt in cash for that amount). In other words, the carrying (redemption) amount of the old debt equals the proceeds received by the issuer for the new convertible instrument. After the exchange accounting occurs, any intrinsic value of the embedded conversion option in the new debt should be measured and accounted for under the Issue 98-5 model based on the proceeds received for that instrument (the satisfaction of the redemption amount of the old debt). 33. The Task Force observed that if the original instrument had been extinguished prior to maturity in the above example, Issue No , Debtor s Accounting for a Modification or Exchange of Debt Instruments, must be applied first. Page 15

16 Issue 12 If a convertible instrument that included a beneficial conversion option under Issue 98-5 is extinguished prior to its stated maturity date, how Issue 98-5 should be applied to the reacquisition of the embedded conversion option. Issue 12(a) Whether it is appropriate to allocate a portion of the reacquisition price to the conversion option based on the intrinsic value of that option at the extinguishment date if no separate accounting for the conversion option under Issue 98-5 has occurred. 34. The Task Force reached a tentative conclusion that no portion of the reacquisition price should be allocated to the conversion option if that option had no intrinsic value required to be accounted for under Issue Issue 12(b) How the requirement to allocate a portion of the reacquisition price to the beneficial conversion option for convertible debt should be applied if the intrinsic value of that option at the date of extinguishment is greater than the originally measured intrinsic value. 35. The Task Force reached a tentative conclusion that Issue 98-5 does not provide for a different measurement of the amount of the reacquisition price that is allocated to the reacquisition of the conversion option if the intrinsic value of the conversion option is greater at the extinguishment date than the amount measured at the commitment date. In other words, the amount of the reacquisition price allocated to the conversion option is always calculated based on the option s intrinsic value at the extinguishment date, which could result in a reduction in additional paid-in capital that exceeds the amount recorded in additional paid-in capital for the beneficial conversion option when the instrument was issued. The Task Force asked the Working Group for Issue 98-5 to evaluate this question further. Page 16

17 Issue 12(c) Whether it is ever appropriate to allocate a portion of the reacquisition price to an embedded beneficial conversion option on the issuer s common stock upon the early redemption of convertible preferred stock The Task Force reached a tentative conclusion to require allocation of a portion of the reacquisition price of convertible preferred stock to an embedded beneficial conversion option based on the intrinsic value of the conversion option at the reacquisition date. The Task Force believes that the accounting for the extinguishment of convertible debt and convertible preferred stock should be similar. The reacquisition of an embedded conversion option for common stock of the issuer is similar to the reacquisition of other residual common equity interests, such as freestanding options and warrants. The numerator adjustment in Topic D-42 in computing earnings per share should be calculated as the carrying value of the convertible preferred stock less the difference between the reacquisition price of the convertible preferred stock and the amount allocated to the beneficial conversion option. For example, assume Company A reacquires its convertible preferred stock for a price of $150 when the carrying amount was $100 and the intrinsic value of the beneficial conversion option at the reacquisition date was $80. In that fact pattern, $80 would be allocated to acquire the equity component (based on its intrinsic value) and $70 would be allocated to acquire the debt. Therefore, the numerator adjustment required to compute earnings per share pursuant to Topic D-42 is an increase of $30. The Task Force asked the Working Group for Issue 98-5 to evaluate this question further and discuss the issue with the SEC staff and return to the Task Force with a recommendation. (See paragraphs ) 4 Topics No. D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock, and No. D-53, Computation of Earnings per Share for a Period That Includes a Redemption or an Induced Conversion of a Portion of a Class of Preferred Stock, relate to the computation of earnings per share when an entity redeems preferred stock and does not relate to the income statement impact of such redemptions. Page 17

18 Transition 37. The Task Force reached a consensus that transition for Issues 2 8, 10, and 11 for which consensuses have been reached should be applied prospectively to instruments issued after November 16, 2000, for which a commitment date, as previously defined in Issue 98-5, has not occurred prior to November 16, However, the SEC Observer stated that the consensus on Issue 1 of Part II must be applied to all transactions subject to Issue 98-5, including those transactions for which a commitment date occurred before November 16, The effect, if any, of initial application of the consensus on Issue 1 of Part II to all prior transactions (including existing, terminated, and converted) subject to Issue 98-5 should be reported as of the beginning of a registrant s quarter that includes the date of this consensus (November 16, 2000) in a manner similar to the cumulative effect of a change in accounting principle in accordance with Opinion 20. The amount of such cumulative effect, if any, should be recognized and accounted for in accordance with the requirements of Issue 98-5 before considering the effect of the other consensuses in this Issue (see examples of the calculation of the cumulative effect of adoption of the consensus on Issue 1 of Part II in Exhibit 00-27A). The pro forma disclosures described in paragraph 21 of Opinion 20 are not required. Also, the requirement in paragraph 10 of Statement 3 that a cumulative effect of a change in accounting principles be applied and reported in the first quarter of a fiscal year does not apply to a change to adopt this consensus. 38. At the January 17 18, 2001 meeting, the Task Force discussed Issues 12 16, below. Issue 12 If a convertible instrument that included a beneficial conversion option under Issue 98-5 is extinguished prior to its stated maturity date, how Issue 98-5 should be applied to the reacquisition of the embedded conversion option. Page 18

19 39. The Task Force discussed the tentative conclusions on Issues 12(a) and 12(b) reached at its November 15 16, 2000 meeting and did not change the tentative conclusions. The Task Force also discussed the tentative conclusions on Issue 12(c) reached at its November 15 16, 2000 meeting and reached a different tentative conclusion, given the SEC staff s decision not to modify the guidance in Topic D-42. The Task Force reached a tentative conclusion consistent with Topic D-42, while acknowledging that this tentative conclusion is inconsistent with the tentative conclusion on Issue 12(b). Thus, if an entity redeems a convertible preferred security with a beneficial conversion option, the excess of (a) the fair value of the consideration transferred to the holders of the convertible preferred security over (b) the carrying amount of the convertible preferred security in the issuer s balance sheet plus (c) the amount previously recognized for the beneficial conversion option should be subtracted from net earnings to arrive at net earnings available to common shareholders in the calculation of earnings per share. That is, upon extinguishment, the issuer allocates an amount to the reacquisition of the embedded conversion option equal to the intrinsic value that previously was recognized for the embedded conversion option. The remaining reacquisition price is allocated to the reacquisition of the convertible preferred stock, and any excess of that portion of the reacquisition price over the carrying amount of the convertible preferred stock is a reduction of earnings available to common shareholders for purposes of calculating earnings per share. Similarly, if the portion of the reacquisition price allocated to the reacquisition of the convertible preferred stock is less than the carrying amount of the convertible preferred stock, the amount of the shortfall is an increase to earnings available to common stockholders for purposes of computing earnings per share. 40. To illustrate, assume Company A receives total proceeds of $100 from issuing preferred stock (that is not mandatorily redeemable) that is immediately convertible by Page 19

20 the holder into Company A s common stock. The intrinsic value of the beneficial conversion option at the commitment date is $10. In accordance with Issue 98-5, Company A makes the following entry to record the preferred stock issuance: Cash 100 Preferred Stock Discount 10 Preferred Stock 100 APIC Beneficial Conversion Amount In accordance with Issue 6, Company A also makes the following entry to amortize the preferred stock discount on the date of issuance because the preferred stock is not mandatorily redeemable and is immediately convertible into common stock: Retained Earnings 10 Preferred Stock Discount Assume that Company A subsequently extinguishes the convertible preferred stock. Also assume that the reacquisition price is $175, the intrinsic value of the beneficial conversion option at the extinguishment date is $80 (although the current intrinsic value of the beneficial conversion option is $80, the originally recognized intrinsic value of $10 is the amount debited to additional paid-in capital), and the carrying amount of the preferred stock is $100. The adjustment to reduce earnings available to common shareholders for purposes of calculating earnings per share is $65, and the entry to record the extinguishment under the Task Force s tentative conclusion is: Preferred Stock 100 APIC Common Stock 10 Retained Earnings 65 Cash 175 Issue 13 A company issues a warrant that allows the holder to acquire a convertible instrument for a stated exercise price. The warrant provides only for physical settlement (that is, delivery of the convertible instrument in exchange for the stated exercise price) and is classified as an equity instrument (either Page 20

21 temporary or permanent). The issue is how to measure and when to recognize a beneficial conversion option in the underlying warrant. Issue 13(a) Whether the commitment date for purposes of measuring the intrinsic value of the conversion option in the convertible instrument that is the underlying for the warrant is (a) the commitment date for the warrant or (b) the exercise date of the warrant. 43. The Task Force reached a tentative conclusion that the date used to measure the intrinsic value of a conversion option in a convertible instrument that is the underlying for a warrant that provides only for physical settlement upon exercise and that is classified as an equity instrument should be the commitment date for the warrant, provided the issuer receives fair value for the warrant (or for the warrant and for any other instruments issued at the same time as the warrant) upon its issuance. The Task Force also reached a tentative conclusion that if the holder transfers consideration upon issuance of the warrant that is less than the fair value of the warrant (or for the warrant and for any other instruments issued at the same time as the warrant), the exercise date of the warrant should be used to measure the intrinsic value of the conversion option. Issue 13(b) When measuring the intrinsic value of a conversion option embedded in a convertible instrument that is the underlying for the warrant, how the deemed proceeds for the convertible instrument should be computed. 44. The Task Force reached a tentative conclusion that the deemed proceeds for the convertible instrument are equal to the sum of the proceeds received for (or allocated to) the warrant and the exercise price of the warrant. Issue 13(c) Whether the measured intrinsic value of a beneficial conversion option in a convertible instrument that is the underlying for the warrant should be Page 21

22 recognized at the date the warrant is issued or at the date the warrant is exercised and the convertible instrument is issued. 45. The Task Force reached a tentative conclusion that if the sum of the proceeds received for or allocated to the warrant and the exercise price of the warrant is less than the fair value of the common stock that would be received upon exercising the conversion option in the convertible instrument that is the underlying for the warrant, the excess (limited to the total proceeds originally received for or allocated to the warrant) represents a deemed distribution to the holder of the warrant for the convertible instrument that should be recognized over the life of the warrant. Any intrinsic value in excess of the proceeds received for or allocated to the warrant upon its issuance should be recognized when the warrant is exercised. On the date the warrant is exercised, that excess intrinsic value and any remaining unamortized intrinsic value measured at the date the warrant was issued should be combined and amortized over the period specified in Issue 98-5 (as interpreted by Issue 6, above) based on the characteristics of the convertible instrument. 46. The following example illustrates the application of the Task Force s tentative conclusions on Issues 13(a), 13(b), and 13(c). Assume Company A issues a freestanding warrant to Company B on January 15, 20X0, for its fair value, $20. Also assume the commitment date for the warrant is the date of issuance. The warrant provides Company B with the right during the next 2 years to exercise the warrant for $100 in cash and receive 1 share of Company A $100 par value nonredeemable convertible preferred stock. The preferred stock is convertible into 10 shares of Company A common stock 1 year after the preferred stock s issuance date. Also assume that the terms of the warrant require physical settlement upon exercise and Company A has determined that the warrant is classified in equity. The fair value of Company A common stock on January 15, 20X0, is $15 per share. Company B exercises the warrant on July 15, 20X0, when the fair value of Company A stock is $20 per share. Page 22

23 47. The sum of the proceeds received for the warrant ($20) and the warrant s exercise price ($100) equals $120, which is considered to be the proceeds of issuance of the convertible instrument pursuant to the Task Force s tentative conclusion on Issue 13(b). The fair value (as of the commitment date of the warrant pursuant to the Task Force s tentative conclusion on Issue 13(a)) of Company A s common stock that would be received upon exercising the conversion option in the convertible instrument is equal to $150 ($15 per share 10 shares). The difference between the fair value of the common stock ($150) and the proceeds of issuance of the convertible instrument ($120) is $30, which represents the intrinsic value of the conversion option in the instrument underlying the warrant (that is, a beneficial conversion option exists). 48. The amount of the beneficial conversion option recognized upon issuance of the warrant would be limited to $20, the amount of proceeds received for the warrant (pursuant to the Task Force s tentative conclusion on Issue 13(c)). That amount would be recognized over the life of the warrant as a distribution to the warrant holder. Through the date the warrant is exercised, Company A recognized approximately $5 in amortization of the $20 beneficial conversion amount as a distribution to the warrant holder (that is, the remaining unamortized balance is $15). When the warrant is exercised and the convertible preferred stock is issued, the amount of the originally measured intrinsic value of the conversion option ($30) in excess of the proceeds received for the warrant ($20) of $10 is recognized. The sum ($25) of that $10 increment and the $15 unamortized amount of the $20 intrinsic value measured at the date the warrant was issued is immediately recognized as a deemed distribution to the holder of the convertible preferred stock because the instrument is not redeemable and is immediately convertible by the holder. Issue 14 A company issues a warrant that allows the holder to acquire a convertible instrument for a stated exercise price. The warrant provides only for physical Page 23

24 settlement (that is, delivery of the convertible instrument in exchange for the stated exercise price) and is classified as a liability instrument. The issues are (1) whether the commitment date for purposes of measuring the intrinsic value of a conversion option in a convertible instrument that is the underlying for a warrant is (a) the commitment date for the warrant or (b) the exercise date of the warrant, (2) how the deemed proceeds for the convertible instrument should be computed, and (3) when the intrinsic value of a beneficial conversion option in the underlying convertible instrument should be recognized. 49. The Task Force reached a tentative conclusion that the date used to measure the intrinsic value of a conversion option in a convertible instrument that is the underlying for a warrant that provides only for physical settlement upon exercise and that is classified as a liability instrument should be the exercise date for the warrant. The Task Force observed that a warrant that is classified as a liability is being marked to fair value through earnings while it is outstanding and that warrant s fair value depends in part on the value of the conversion option in the underlying convertible instrument. 50. Assume that Company A issues a freestanding warrant to Company B on January 15, 20X0, for its fair value, $20. Also assume the commitment date for the warrant is the date of issuance. The warrant provides Company B with the right during the next 2 years to exercise the warrant for $100 in cash and receive Company A $100 par value convertible debt. The debt is convertible into 10 shares of Company A common stock. The fair value of Company A stock on January 15, 20X0, is $11 per share. Company B exercises the warrant on February 15, 20X1, when the fair value of Company A stock is $20 per share and the fair value and carrying amount of the warrant is $105. Also assume that the warrant terms require physical settlement upon exercise and Company A has determined that the warrant is classified as a liability. Page 24

25 51. Because Company A has classified the warrant as a liability instrument, the exercise date for the warrant should be used to measure and recognize the intrinsic value of the conversion option in the convertible instrument that is the underlying for the warrant. Accordingly, the fair value of the stock on the exercise date of $20 per share should be used to calculate the intrinsic value of the conversion option. When the warrant is classified as a liability instrument, the deemed proceeds for the convertible instrument ($205) should equal the sum of the carrying amount of the warrant at the exercise date ($105) and the warrant s exercise price ($100). In this example, there is no beneficial conversion option because the amount of proceeds ($205) exceeds the fair value of the common stock into which the instrument can be converted ($200, calculated as $20 per share 10 shares). The exercise of the warrant and resulting issuance of the convertible debt would be recorded as follows: Cash 100 Warrant Liability 105 Convertible Debt 100 Additional Paid-in Capital Issue 15 How a beneficial conversion amount should be measured when an entity issues a convertible instrument that, if converted, will result in the holder receiving common stock and other equity instruments of the issuer, such as warrants to acquire common stock of the issuer. 52. The Task Force reached a tentative conclusion that the intrinsic value of the conversion option should be computed based on a comparison of (a) the proceeds of the convertible instrument allocated to the common stock portion of the conversion option and (b) the fair value at the commitment date of the common stock to be received by the holder upon conversion. The excess of (b) over (a) is the intrinsic value of the embedded 5 The Task Force observed that in this example the accounting resulted in recording the convertible debt at a substantial premium. In this situation, paragraph 18 of Opinion 14 indicates that there is a presumption that the premium represents additional paid-in capital. Page 25

26 conversion option that should be recognized by the issuer at the issuance date for the convertible instrument. 53. For example, assume Company A issues for $1 million, convertible debt with a par value of $1 million. The convertible debt is immediately convertible at a conversion price of $10 per share (that is, holder will receive 100,000 shares of Company A stock upon conversion). In addition, upon conversion, the holder also will receive 100,000 warrants to acquire Company A s common stock. Each warrant entitles the holder to purchase 1 share of common stock at $10 per share. The warrants (which have not yet been issued) would have a fair value of $250,000 at the commitment date, and the fair value of Company A s common stock at the commitment date is $ The beneficial conversion option amount related to the convertible instrument is $117,391 and is calculated as the difference between the $900,000 fair value of the common stock on the commitment date and the $782,609 proceeds allocated to the common stock conversion option ($1,000,000 total proceeds received $900,000 fair value of the common stock at the commitment date $1,150,000 total fair value of all instruments received by the holder upon conversion at the commitment date). Upon conversion, the warrants would be recognized at $217,391 ($1,000,000 $250,000 $1,150,000, or $1,000,000 $782,609). Issue 16(a) Whether there should be specific presentation or disclosure requirements for convertible instruments subject to Issue 98-5 (as interpreted by Issue 00-27). 55. The Task Force noted that paragraph 4 of Statement 129 states: An entity shall explain, in summary form within its financial statements, the pertinent rights and privileges of the various securities outstanding. Examples of information that shall be disclosed are dividend Page 26