The FASB has simplified the accounting for convertible debt and equity instruments and contracts issued in an entity’s own equity with the issuance of ASU 2020-06. Among other significant changes are the elimination of the beneficial conversion feature (BCF) and cash conversion features (CCF) separation models. Adoption will reduce the complexity of assessing these instruments and in many cases may result in a significant reduction in non-cash interest expense.
As the early adoption date of January 1, 2021, approaches, entities with outstanding instruments (or plans to issue such instruments) should consider early adoption of the standard.
The new guidance is relevant to the following instruments:
- Convertible debt or preferred stock that contains a beneficial conversion feature (BCF).
- Convertible debt that contains a conversion option that is cash or share settleable at the option of the issuer either in any combination or for the conversion premium, (cash conversion feature or CCF). This includes both convertible instruments that upon conversion require cash payment for the principal amount with a combination of cash or shares for the conversion premium at the issuer’s option (Instrument C) and convertible instruments where the entire amount or any combination thereof can be cash or share settled at the issuer’s option (Instrument X).
- Contracts issued in an entity’s own equity that do not qualify for equity classification and are required to be marked to fair value due to a failure to meet any of the following requirements under existing guidance:
- Settlement permitted in unregistered shares.
- No counterparty rights rank higher than shareholder rights.
- No collateral required.
Companies are required to apply either modified retrospective or full retrospective transition methods, which will require a reassessment of any existing or past convertible instruments, respectively, if those transactions contained any of the features and conditions affected by the change in guidance.
On August 5, 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. The ASU simplifies accounting for convertible instruments by removing the BCF and CCF separation models required under current Generally Accepted Accounting Principles (GAAP). Further, the ASU removes certain settlement conditions that are required for equity contracts to qualify for equity classification. The ASU also changes the existing diluted earnings per share (EPS) calculation for convertible debt that contains a CCF and increases disclosure requirements for convertible instruments.
For convertible debt instruments the ASU removes the separation model for instruments that contain a CCF. For both convertible debt and convertible preferred stock, the ASU removes the separation model for instruments that contain a BCF. As compared with current GAAP, more convertible debt instruments will be reported as a single liability instrument measured at amortized cost and more convertible preferred stock as a single equity instrument measured at historical cost. For convertible debt, the separation models previously required entities to record the equity component with an offsetting discount to the debt, resulting in higher interest expense from the amortization of the discount; the new guidance will eliminate the discount resulting in less amortization, thereby bringing GAAP interest closer to the coupon interest rate. For convertible preferred stock, a BCF was required to be separated from the equity instrument with the discount accreted as a dividend to the extent the preferred stock was redeemable; the new guidance eliminates this separation. The ASU does not affect the remaining two separation models that exist under current GAAP for embedded conversion features:
- Conversion options that are not clearly and closely related to the host contract, that meet the definition of a derivative and do not qualify for a scope exception from derivative accounting (for which bifurcation of the conversion feature as a derivative under ASC 815 is required).
- Convertible debt instruments issued with substantial premiums (for which the premiums are required to be recorded as paid-in capital).
Equity Classification Criteria
An entity must determine whether an equity contract qualifies for a scope exception from derivative accounting. The analysis to determine whether a contract meets this scope exception includes two criteria: the contract is indexed to an entity’s own stock (referred to as the indexation guidance) and the contract is equity classified (referred to as the settlement guidance). If both of these criteria are not met, the contract must be recognized as an asset or liability and be marked to fair value with changes through earnings. The ASU removes three of the conditions required to qualify for the settlement guidance related to settlement in unregistered shares, collateral requirements and shareholder rights. As compared to current GAAP, more equity contracts will qualify for the derivatives scope exception.
Earnings Per Share (EPS)
The ASU improves the consistency of EPS calculations by (1) aligning the diluted EPS calculation for CCF convertible instruments with other convertible debt instruments by requiring that an entity use the if-converted and (2) requiring that share settlement be included in the diluted EPS calculation for both convertible instruments and equity contracts when those contracts include an option of cash settlement or share settlement.
The ASU is effective for public business entities that meet the definition of a Securities and Exchange Commission (SEC) filer, excluding entities eligible to be smaller reporting companies as defined by the SEC, for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the standard will be effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. Also, an entity that has not yet adopted ASU 2017-11 can early adopt ASU 2020-06 for convertible instruments that include a down round feature, which is permitted for fiscal years beginning after December 15, 2019. The Board specified that an entity should adopt the guidance as of the beginning of its annual fiscal year.
The guidance can be adopted using either a modified retrospective or full retrospective method. In applying the modified retrospective method, entities should apply the guidance to instruments outstanding as of the beginning of the fiscal year in which the amendments are adopted. Transactions that were settled (or expired) during prior reporting periods are unaffected. The cumulative effect of the change should be recognized as an adjustment to the opening balance of retained earnings at the date of adoption.
If an entity elects the full retrospective method of transition, the cumulative effect of the change should be recognized as an adjustment to the opening balance of retained earnings in the first comparative period presented. Additionally, entities have an irrevocable election of the fair value option in accordance with ASC 825-10 for any liability-classified convertible securities.
How CFGI can help
Please reach out to CFGI’s subject matter experts directly to discuss the impact of the new guidance for your organization and plan for implementation:
Boston – Ryan Dolan, Partner (978-317-9398 or firstname.lastname@example.org).
New York – Josh Verni, Partner (585-748-3687 or email@example.com).
San Francisco – Brian Powell, Partner (714-717-7682 or firstname.lastname@example.org).