An entity’s stock price is often used to determine the number of shares issuable upon conversion of a convertible note. For example, if you have a very simple convertible note and the number of shares issuable is based on the entity’s stock price on the conversion date, you have what is known as stock-settled debt. The conversion feature will probably be considered clearly and closely related to the debt-host contract. Why? Well, the fair value of the conversion feature will always be the amount of convertible debt since the number of shares issuable is variable. So the fair value of the note without the conversion feature and the fair value of the embedded conversion feature move together.
And, yes, I’m ignoring a whole host of potential issues like, for example, the impact stock-settled debt with no limit on the number of shares issuable may have on other equity-linked contracts. Not the point of this post. Onward.
As long as the settlement date of the conversion is the same as the conversion notice date, then you have avoided a potential accounting issue. This is rarely the case. Most conversions have a settlement date that lags at least a few days behind the conversion notice date. For example, let’s say you receive a conversion notice from the note holder and the number of shares issuable is based upon yesterday’s closing price. Let’s also say you contractually settle the conversion (i.e., you issue the shares in exchange for the amount of note being converted) 15 days following the conversion notice. The entity’s stock price on the conversion date will very likely have changed in the 15-day period so that on the date of settlement, the economic value of the transaction will probably have changed, perhaps significantly (since by now the conversion has been publicly announced), from the value of the transaction on the conversion notice date 15 days prior. That change provides an equity-like return to the investor since the company is required to issue a fixed number of shares once the conversion notice has been made. And that equity-forward feature, with it’s equity-like return, is almost certainly not clearly and closely related to the debt-host contract. And if the contract provides for stock-settled interest payments as well, then you have yet another embedded derivative.
For accounting purposes, this embedded feature exists at inception of the contract, not only upon receipt of a conversion notice. So this needs to be evaluated at inception as a potentially bifurcated embedded derivative. Having determined that it is not clearly and closely related to the debt-host contract, the only way out of derivative accounting is to determine that the feature is both indexed to the company’s stock and can be classified in equity.