Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity

 

Background

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 is expected to reduce complexity and improve comparability of financial reporting associated with accounting for convertible instruments and contracts in an entity’s own equity.

Why Is the FASB Issuing This ASU?

In 2017, the FASB took on a project to address complexity associated with applying generally accepted accounting principles (GAAP) for certain financial instruments with characteristics of liabilities and equity. Stakeholders noted that complexity in this area contributes to a high number of financial statement restatements. Investors and other financial statement users have also cited its complexity when attempting to understand the results of applying the guidance.

The amendments in the ASU aim to improve those complex areas of the current guidance, specifically the guidance related to both convertible instruments and the derivatives scope exception for contracts in an entity’s own equity.

What Are the Main Provisions in the ASU and How Would They Improve Existing GAAP?

Convertible Instruments

For convertible instruments, the ASU reduces the number of accounting models for convertible debt instruments and convertible preferred stock by eliminating the beneficial conversion feature model and cash conversion model.  As compared with current GAAP, more convertible debt instruments will be reported as a single liability instrument and more convertible preferred stock as a single equity instrument. The interest rate of more convertible debt instruments will be closer to the coupon interest rate.

Convertible instruments that continue to be subject to separation models, which already exist under current GAAP, are (1) those with embedded conversion features that are not clearly and closely related to the host contract, that meet the definition of a derivative, and that do not qualify for a scope exception from derivative accounting and (2) convertible debt instruments issued with substantial premiums for which the premiums are required to be recorded as paid-in capital.

The ASU also enhances information transparency by making targeted improvements to the related disclosures guidance based on feedback from financial statement users.

Derivatives Scope Exception

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: (1) the contract is indexed to an entity’s own stock (referred to as the indexation guidance) and (2) 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 potentially accounted for as a derivative. The Board observed that the application of the derivatives scope exception guidance results in accounting for some contracts as derivatives while economically similar contracts are accounted for as equity. The ASU removes three 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 improvements to the EPS guidance focus on the areas included in the project’s overall scope of convertible instruments and contracts in an entity’s own equity. The ASU improves the consistency of EPS calculations by (1) aligning the diluted EPS calculation for convertible instruments by requiring that an entity use the if-converted method 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.
 

Who Will Be Affected by the Amendments in This ASU?

The amendments in the ASU affect entities that issue convertible instruments and/or contracts in an entity’s own equity.

For convertible instruments, the instruments primarily affected are those issued with beneficial conversion features or cash conversion features because the accounting models for those specific features are removed. However, all entities that issue convertible instruments are affected by the amendments to the disclosure requirements in the ASU.

For contracts in an entity’s own equity, the contracts primarily affected are freestanding instruments and embedded features that are accounted for as derivatives under the current guidance because of failure to meet one or more of the three settlement conditions of the derivatives scope exception that are removed by the ASU.

Additionally, the ASU affects the diluted EPS calculation for instruments that may be settled in cash or shares and for convertible instruments.
 

When Will the Amendments Be Effective and What Are the Transition Requirements?

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. The Board specified that an entity should adopt the guidance as of the beginning of its annual fiscal year. An entity that has not yet adopted the amendments in Accounting Standards Update No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features,  (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception, can early adopt the amendments in the ASU for convertible instruments that include a down round feature. This early adoption is permitted for fiscal years beginning after December 15, 2019.

The ASU allows entities to adopt the guidance through either a modified retrospective method of transition or a fully retrospective method of transition.

Because the ASU simplifies the accounting for convertible instruments and contracts in an entity’s own equity, entities, including private companies, may want to evaluate early adoption of the amendments in the ASU that are expected to reduce accounting complexities for preparers and practitioners.

The ASU is available at www.fasb.org. Additional implementation support resources—including how to submit questions through the  FASB’s Technical Inquiry Service—are available through the FASB Implementation Web Portal.

 
 
Postscript: Phase 2 Project

In its original July 2019 Exposure Draft, the FASB proposed simplifying the accounting for equity contracts by reducing form-over-substance-based accounting conclusions that are driven by remote contingent events in the assessment of the derivatives scope exception. However, based on mixed feedback from stakeholders during the public comment period, the FASB decided not to include those proposed changes in the ASU. Consequently, the FASB plans to continue to explore improvements on this aspect of the guidance in a separate Phase 2 project.