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

Background

On July 31, 2019, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU) intended to reduce complexity and improve comparability of financial reporting associated with accounting for convertible instruments and contracts in an entity’s own equity.

Stakeholders are encouraged to review and provide comments on the proposed ASU by October 14, 2019.

 

Why Is the FASB Issuing This Proposed 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 proposed ASU aim to improve those troublesome 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 Proposed ASU and How Would They Improve Existing GAAP?

 

Convertible Instruments

For convertible instruments, the proposed ASU would reduce the number of accounting models for convertible debt instruments and convertible preferred stock as shown in the chart below.

Limiting the accounting models for convertible instruments would result in fewer embedded conversion features being separately recognized from the host contract and the interest rate of more convertible debt instruments being closer to the coupon interest rate, as compared with current GAAP.  Therefore, it would simplify the accounting for convertible instruments, reduce complexity for preparers and practitioners, and improve the relevance of the information provided to financial statement users. In addition to eliminating certain accounting models, the Board also decided to enhance information transparency by making targeted improvements to the disclosures for convertible instruments and earnings-per-share (EPS) guidance based on feedback from financial statement users.
 

Derivatives Scope Exception

An entity must determine whether a 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 those criteria are not met, the contract must be recognized as an asset or liability. The Board observed that the strict 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 proposed ASU would amend guidance for the derivatives scope exception for contracts in an entity’s own equity.  The proposed changes would:

• Allow an entity to qualitatively screen out any contingent events that are considered to have a remote likelihood of occurring and disregard these events in the assessment of the derivatives scope exception, and
• Remove three conditions required to qualify for the settlement guidance related to settlement in unregistered shares, collateral requirements, and shareholder rights.

The proposed amendments would reduce form-over-substance-based accounting conclusions that are driven by remote contingent events. The Board decided that the proposed amendments would provide immediate relief for private companies and small public companies that continue to have errors in their financial statements because of the form-based (or rules-based) accounting requirements. The proposed ASU also would improve and amend the related disclosure and EPS guidance.
 

Who Would Be Affected by the Amendments in This Proposed ASU?

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

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

For contracts in an entity’s own equity, the contracts primarily affected would be freestanding instruments and embedded features that are accounted for as derivatives under the current guidance because of form-over-substance-based accounting conclusions. For example, contracts that include certain remote settlement features would no longer be required to be accounted for as derivatives.

Additionally, the amendments in this proposed ASU would affect the diluted EPS calculation for instruments that may be settled in cash or shares and for convertible instruments.
 

When Would the Amendments Be Effective?

The effective date would be determined after the Board considers stakeholders’ feedback on the proposed ASU.