New convertible debt guidance for public companies

The FASB’s new convertible debt guidance went into effect in December 2021 with all entities being required to apply it in years beginning after December 2023. Here’s what you need to know about adopting and complying with the new guidance. 

The Financial Accounting Standards Board (FASB) has published new convertible instrument guidance in Accounting Standards Update (ASU) 2020-06, which amends Subtopics 470-20 and 815-40 of the FASB Accounting Standards Codification. The update focused on accounting for convertible instruments and the analysis of contracts in an entity’s own equity. 

The FASB issued the update to help reduce the complexity of applying U.S. Generally Accepted Accounting Principles (GAAP) for certain financial instruments having both debt-like and equity-like characteristics. For example, by reducing the number of accounting models companies must apply, the FASB’s goal is to simplify the accounting for convertible instruments and reduce complexity for preparers and practitioners.  

“Complexity associated with the accounting is a significant contributing factor to numerous financial statement restatements and results in complexity for users attempting to understand the results of applying the current guidance,” the FASB stated in its update. “In addressing the complexity, the Board focused on amending the guidance on convertible instruments and the guidance on the derivatives scope exception for contracts in an entity’s own equity.”

Here’s what you need to know 

The amendments in ASU 2020-06 went into effect for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2021, for Securities and Exchange Commission filers other than smaller reporting companies (SRCs) and emerging growth companies (EGCs) that have availed themselves of the extended transition period for adopting accounting standards. Those amendments are effective for all other entities including SRCs, EGCs that utilize the extended transition period, and private companies for fiscal years (and interim periods within those fiscal years) starting after Dec. 15, 2023. Early adoption is permitted, but no earlier than for periods starting after Dec. 15, 2020   (e.g., 2021 for a company with a calendar year end). The ASU requires entities to use a modified or full retrospective transition method.  

The new guidance addresses three key areas, two of which relate directly to the analysis, balance sheet classification, and accounting recognition for conversion features such as those embedded in certain debt instruments, and a third that concerns earnings per share (EPS). Here’s a short synopsis of each of those key changes:

1. Convertible instruments. The FASB simplified the accounting for convertible instruments by removing the separation models for cash conversion features and beneficial conversion features from Subtopic 470-20 Debt – Debt with Conversion and Other Options. As a result, separate accounting is not required for a conversion feature embedded in a debt instrument to the extent that such conversion feature is not separately accounted for as an embedded derivative, and the convertible debt instrument within which such feature is embedded was not issued at a substantial premium. A premium on issued convertible debt is presumed to represent paid-in capital of the issuing entity. Consideration will still be given to whether a convertible debt instrument is stock-settled debt.
2. Derivatives scope exception for contracts in an entity’s own equity. The new guidance simplifies the second part of the derivatives scope exception for contracts in an entity’s own equity by, for example, removing the preclusion from equity classification caused by a requirement that a party post collateral. The new guidance also removed the criterion precluding equity classification if a holders’ rights rank higher than those of shareholders in the event of the issuer’s bankruptcy and eliminated the requirement to assess whether a contract or embedded feature could be settled in unregistered shares. Contracts that allow settlement in unregistered shares, or that are silent about settlement terms when registered shares are not available, may qualify for equity classification. Equity classification would, however, be precluded if a contract or feature explicitly requires settlement in cash when registered shares are not available. Similar to their treatment prior to the new guidance, uneconomic penalties that would be avoided under other settlement alternatives are excluded when determining classification. It should also be noted that freestanding equity contracts that do not meet the definition of a derivative and that are not indexed to an entity’s own equity are initially and subsequently measured at fair value through earnings.
3. Earnings per share (EPS). To improve the consistency of EPS calculations, the FASB also amended its guidance to align EPS calculations by requiring entities to use the if-converted method for diluted EPS (eliminating the treasury method for such instruments). Among other things, the if-converted method assumes conversion at the beginning of the period, unless the instrument was issued at a later date. Further, the new guidance requires diluted EPS calculations to include the dilutive effect of instruments that may be settled in cash or shares, including when the company has a history or policy of cash settlement. Additionally, the amendments provide that diluted EPS is calculated in consideration of equity-classified convertible preferred stock with down round features. It also clarifies that an average market price must be used to calculate the diluted EPS denominator, under both the if-converted and treasury stock methods, when changes in a company’s stock price could impact the exercise price of a financial instrument.

The scope of each of these changes is fairly broad and the FASB’s guidance drills down into the various concepts that companies must consider when evaluating the accounting impact for convertible instruments and contracts in an entity’s own equity. 

Steps to Take Now 

Companies that have not already factored ASU 2020-06 into their accounting policies and procedures should start the process now. In most cases, this will require changes to operationalize, the internal control impacts, and employee training. Employee training provides internal associates who are handling these responsibilities an understanding of how to apply the changes. 

Companies should also assess the enhanced disclosure required by these amendments. The FASB is looking to enhance those disclosures in general, and not just through the guidance discussed in this article, to help investors and other financial statement users make educated decisions based on the financial information companies provide.  

For some, adopting the FASB’s new convertible instrument guidance may be secondary to the new lease accounting standard (ASC 842). Whether your organization is already applying ASU 2020-06 or is preparing for a 2024 adoption date, it’s never too early to enlist outside specialists and internal associates to evaluate the potential impact on your company’s accounting for convertible instruments and equity indexed contracts. 

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