Published Date:
3/5/2025
Updated Date:
March 12, 2025
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In November of 2024, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2024-04. The update came because of issues with relevance and consistency in the application of the induced conversion of debt. This update addresses ambiguity of convertible debt instruments and the application of induced conversion versus extinguishment accounting for certain settlements that deviate from preexisting terms. The new standard introduces a preexisting contract approach that helps maintain consistency in accounting practices and reduces potential variability in earnings impact.
What it is and why it matters:
In August of 2020, the FASB introduced ASU 2020-06 to simplify the treatment for convertible debt instruments, especially related to cash conversion features in these instruments, which have become more prevalent. Previously, companies were required to split these instruments into separate debt and equity components. The new guidance removed this bifurcation model and allowed companies to account for the entire instrument as debt unless it meets specific equity classification criteria. Additionally, ASU 2020-06 permitted the use of conversion accounting for convertible debt settlements if they followed the original terms of the agreement.
While the update simplified some aspects of the convertible debt accounting, it also created new challenges. Specifically, it widened the gap in how companies report earnings under two different accounting methods: induced conversion and extinguishment accounting. Induced conversion accounting only recognizes the incremental cost of the incentives offered to encourage debt holders to convert, whereas extinguishment accounting captures the full difference between the carrying value of the debt and the settlement amount.
Stakeholders voiced concerns as these changes coincided with a surge in convertible debt instruments with cash conversion and other complex features. Market conditions prompted many companies to offer incentives or adjust terms, blurring the lines between induced conversions and extinguishments. As a result, stakeholders sought clarification on how to navigate these scenarios and ensure consistency in financial reporting. This need for clearer guidance eventually led to the development of EITF issue No.23-A, which aims to address these issues.
In November of 2024, ASU 2024-04 was released. The new guidance requires companies to evaluate the inducement offer in the context of the preexisting conversion privileges outlined in the debt instrument’s original terms. This ensures that the offer aligns with the nature of the conversion agreement. Additionally, to qualify as an induced conversion, the offer must preserve the form of consideration specified in the original terms. For example, if the original terms allowed conversion into equity, the inducement must also involve equity. Offering cash or other non-equity forms of settlement would not qualify under induced conversion accounting, potentially triggering extinguishment accounting instead. Further, the inducement must result in a total value of consideration that is equal to or greater than the amount issuable under the original conversion terms. This ensures that the inducement benefits the debt holder and reflects an enhancement to the original agreement rather than a complete renegotiation of terms.
ASU 2024- 04 also introduces a one-year “lookback” period to account for recent modifications to the debt instrument’s terms as they stood one year prior to the offer acceptance date if any modifications occurred within that timeframe. This provision prevents companies from altering terms shortly before offering an inducement to manipulate accounting outcomes.
To better understand the update and how it will impact preparers and users, it is important to understand the accounting differences between the two permittable accounting treatments. These two treatments are outlined below.
Induced Conversion Accounting
When a company offers additional incentives to encourage investors to convert their debt (like convertible bonds) into equity, this process is called an “induced conversion. Under GAAP standards, the company needs to record two key things: (1) an inducement charge and (2) reclassification of debt to equity.
An inducement charge represents the cost of the extra incentive, like cash or additional shares, that the company offers to make the conversion more attractive. It’s recorded as an expense on the company’s income statement because it’s considered a cost of settling the debt early.
The remaining amount of the debt, the amount already on the books, is moved over to the equity section of the balance sheet. This happens because the debt is no longer owed and has been exchanged for stock.
Extinguishment Accounting
Under the new guidance in EITF Issue No. 23-A, extinguishment accounting applies when a company settles convertible debt without inducing the holder to convert, meaning no extra incentives like bonus shares, or additional cash are offered.
In extinguishment accounting there are there are two primary components: (1) consideration transferred and (2) the carrying amount of the debt. The consideration transferred is what the company gives to the debt holders to settle and the carrying amount of the debt is the total value of the convertible debt on the company’s books prior to the settlement.
If the value of the consideration given is less than the carrying amount of the debt, the company records a gain. If the value of the consideration given is more than the carrying amount of the debt, the company records a loss.
Unlike induced conversion accounting (where only the cost of the incentive is recorded as a charge), extinguishment accounting focuses on the total difference between what was owed and what was paid or settled.
Now let’s address how things have changed due to the update.
Prior to EITF 23-A
The accounting treatment for induced conversions was inconsistent. Some companies recorded a charge for the entire difference between the fair value of the equity issued and the carrying amount of the debt, like extinguishment accounting. Others only recorded a charge for the incremental cost of the inducement.
Additionally, extinguishment accounting was inconsistently applied to convertible debt settlements. Some companies used it even when offering inducements and recorded a gain or loss for the entire difference between the consideration transferred and the carrying amount of the debt.
After EITF 23-A
After the standard was updated, the accounting treatment for induced conversion and extinguishment accounting became much more consistent and transparent.
More specifically, the EITF explicitly requires companies to use induced conversion accounting, where: Only the incremental consideration is recorded as an inducement charge in earnings and the carrying amount of the debt is reclassified to equity with no gain or loss recognized.
Extinguishment accounting is only used when there is no inducement. In that case, the full difference between the amount paid and the debt’s carrying value is recorded as a gain or loss.
Illustration
Cosmo Capital Group (Cosmo) holds a convertible debt instrument with a net carrying amount of $100. If the debt is converted into equity under its original terms, the fair value of the equity issued would be $150. However, to incentivize the debt holder to convert, Cosmo offers an additional $10 in cash or other consideration, increasing the total value of the settlement to $160.
Under induced conversion accounting, the key focus is on the incremental consideration offered to encourage the conversion. In this case, Cosmo’s $10 inducement is treated as an expense. The accounting steps are as follows:
- The $10 offered as additional consideration is recorded as a pre-tax loss on Cosmo’s income statement. This reflects the cost of inducing the conversion.
- The remaining $150 is reclassified from the debt to equity. No gain or loss is recognized on this portion of the transaction.
- The total financial impact is limited to the $10 fees incurred to settle the debt. The rest of the settlement is treated as a reclass between accounts.
If Cosmo applies extinguishment accounting, the entire transaction is viewed as a debt settlement rather than a conversion. This method measures the total difference between the carrying amount of the debt and the fair value of the settlement. The accounting steps are as follows:
- The $100 carrying amount of the debt is removed from Cosmo’s balance sheet.
- The total settlement value, including the original conversion value of $150 and the additional $10 settlement cost, is recognized as $160.
- The loss on extinguishment is calculated as the settlement value minus the carrying amount of the debt, resulting in a pre-tax loss of $60.
- The full $60 loss is recognized in the income statement.
Conclusion
ASU 2024-04 provides much-needed clarity on induced conversions of convertible debt instruments to promote consistency and reduce variability in financial reporting. The ASU becomes effective for annual reporting periods beginning after December 15, 2025. Organizations must assess their accounting policies for convertible debt instruments and apply the preexisting contract approach to ensure compliance and accurate financial reporting.
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Footnotes
3/5/2025