FASB Definition of a Derivative Impact of Daily Transaction Volume on Assessment of Whether an Asset Is Readily Convertible to Cash

FASB: Definition of a Derivative: Impact of Daily Transaction Volume on Assessment of Whether an Asset Is Readily Convertible to Cash

Derivatives Implementation Group

Statement 133 Implementation Issue No. A12

Title: Definition of a Derivative: Impact of Daily Transaction Volume on Assessment of Whether an Asset Is Readily Convertible to Cash
Paragraph references: 9(c), Footnote 5 (to paragraph 9)
Date cleared by Board: June 28, 2000

QUESTIONS

Question 1

An investor holds a convertible bond classified as an available-for-sale security under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The convertible bond is not exchange-traded and can be converted into common stock of the debtor, which is traded on an exchange. The convertible bond has a face amount of $100 million and is convertible into 10 million shares of common stock. The bond may be converted in full or in increments of $1,000 immediately or at any time during the next two years. If the debt were converted in a $1,000 increment, the investor would receive 100 shares of common stock. The market condition for the debtor's stock is such that up to 500,000 shares of its stock can be sold rapidly without the share price being significantly affected. For purposes of this issue, the embedded conversion option meets the criteria in paragraph 6(a) and 6(b) but does not meet the criteria in paragraphs 9(a) and 9(b), in part because the option is not traded and it cannot be separated and transferred to another party.

From the investor's perspective, does the convertible bond contain an embedded derivative that must be separately accounted for?

It is clear that the embedded equity conversion feature is not clearly and closely related to the debt host instrument. In determining whether the embedded derivative meets the definition of a derivative, it is not clear whether the equity conversion feature meets the net settlement criteria in paragraph 9(c) because the bond may be converted in $1,000 increments and those increments, by themselves, may be sold rapidly without significantly affecting price, in which case the criteria in paragraph 9(c) would be met. However, if the holder simultaneously converted the entire bond, or a significant portion of the bond, the shares received could not be readily converted to cash without incurring a significant block discount.

Question 2

Would the answer to Question 1 change if, instead, the investor had 100,000 individual $1,000 bonds that each convert into 100 shares of common stock? Assume those bonds are individual instruments but they were issued concurrently to the investor.

BACKGROUND

Paragraph 61(k) of Statement 133 states, in part, the following:

   ...for a debt security that is convertible into a specified number of shares of the debtor's common stock or another entity's common stock, the embedded derivative (that is, the conversion option) must be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Statement. (For example, if the common stock was not readily convertible to cash, a conversion option that requires purchase of the common stock would not be accounted for as a derivative.)

As indicated in footnote 5, the term readily convertible to cash refers to assets that "have (i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price." That footnote also states "For contracts that involve multiple deliveries of the asset, the phrase in an active market that can rapidly absorb the quantity held by the entity should be applied separately to the expected quantity in each delivery."

RESPONSE

Question 1

Yes. From the investor's perspective, the conversion option should be accounted for as a compound embedded derivative in its entirety, separately from the debt host, because the conversion feature allows the holder to convert the convertible bond in 100,000 increments and the shares converted in each increment are readily convertible to cash under paragraph 9(c). The investor need not determine whether the entire bond, if converted, could be sold without affecting the price. Because the $100 million convertible bond is convertible in increments of $1,000, the convertible bond is essentially embedded with 100,000 equity conversion options, each with a notional amount of 100 shares. Each of the equity conversion options individually has the characteristic of net settlement under paragraph 9(c) because the 100 shares to be delivered are readily convertible to cash. Because the equity conversion options are not clearly and closely related to the host debt instrument, they must be separately accounted for. However, because an entity cannot identify more than one embedded derivative that warrants separate accounting, the 100,000 equity conversion options must be bifurcated as a single compound derivative. That guidance is consistent with Statement 133 Implementation Issue No. B15, "Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument," which concludes that an entity is not permitted to account separately for more than one derivative feature embedded in a single hybrid instrument. There is a substantive difference between a $100 million convertible debt instrument that can be converted into equity shares only at one time in its entirety and a similar instrument that can be converted in increments of $1,000 of tendered debt; the analysis of the latter should not presume equality with the former.

Question 2

From the investor's perspective, the individual bonds each contain an embedded derivative that must be separately accounted for. Each individual bond is convertible into 100 shares and the market would absorb 100 shares without significantly affecting the price of the stock. Thus, the form of the financial instrument is important; individual instruments cannot be combined for evaluation purposes to circumvent compliance with the criteria in paragraph 9(c). That guidance is consistent with Statement 133 Implementation Issue No. A3, "Impact of Market Liquidity on the Existence of a Market Mechanism," that concludes that contracts should be evaluated on an individual basis, not on an aggregate-holdings basis.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.