On Aug. 5, 2020, the FASB issued ASU 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).” This addresses concerns from preparers and practitioners regarding the complexity of accounting rules for certain financial instruments and their respective features – namely, convertible debt, convertible preferred stock, and other forms of equity contracts, such as warrants and forward contracts, that reflect both debtlike and equitylike characteristics.
The ASU eliminates several legacy accounting models to simplify the accounting for convertible instruments. In addition, the ASU modifies the derivative scope exception guidance to remove certain criteria and clarify others, which likely will result in more instruments being equity classified or having more embedded features remain embedded. The ASU also improves the related financial statement disclosures and EPS guidance.
This is a summary of the impact of the ASU:
Examples of instruments potentially affected
Convertible instruments issued with:
These accounting models have been removed from U.S. GAAP.
This ASU affects diluted EPS calculations, including:
Under the new ASU, convertible instruments will now more frequently be accounted for as a single unit of account. That is, a conversion feature and the host instrument in which it is embedded now generally will be treated as a single unit of account unless the conversion feature requires bifurcation under Topic 815. The result is that fewer conversion features will be separated from their host contract than under legacy GAAP. The substantial premium model has not been affected by these changes.
The common result is that for convertible debt instruments, a single liability would be measured at its amortized cost, and convertible preferred stock would be accounted for as a single equity instrument measured at its historical cost as long as no other features require bifurcation. A significant consideration is that by reducing the number of accounting models, the interest rate of convertible debt instruments typically would be closer to the coupon interest rate when applying the guidance in Topic 835, “Interest.”
The disclosure requirements for convertible instruments also have been expanded – namely, the ASU added a disclosure objective, a requirement to explain the pertinent rights and privileges, alignments between contingently convertible instruments and other convertible instruments, and other information as of the date of the financial statement period being presented. In addition, for public business entities only, entities that do not account for a conversion feature separately from the debt host will be required to disclose the fair value of the convertible debt instrument at the individual instrument level.
For instruments that fall under the scope of ASC 815-40 (warrants, forward contracts, equity conversion features, etc.), the settlement guidance was modified with the expectation that more instruments would be classified as equity, thus simplifying the accounting upon inception and in subsequent reporting periods.
When considering the settlement guidance for instruments within the scope of ASC 815-40, the ASU makes modifications to the equity classification considerations, specifically the following conditions found in the current guidance:
As a result of these modifications, for a free-standing instrument, if the instrument qualifies for the derivatives scope exception with the modifications under the ASU, an entity would record the instrument in equity. For an embedded feature, if the feature qualifies for the derivatives scope exception under the amendments, an entity no longer would bifurcate and account for the feature separately.
With the changes in convertible instruments and Topic 815-40 instruments, the related disclosures of EPS that are affected by these instruments also were updated. The ASU modifies Topic 260, “Earnings Per Share,” in four areas:
The amendments in this ASU are effective as follows:
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
Fiscal years beginning after Dec. 15, 2021, including interim periods within those fiscal years
All other entities
An entity should adopt the guidance as of the beginning of its annual fiscal year using either a modified retrospective or fully retrospective method of transition with the cumulative effect of the change recognized as an adjustment to opening retained earnings in the period of adoption or earliest comparative period presented, respectively. Transactions that were settled (or expired) during prior reporting periods would not be affected. The cumulative effect of the change would be recognized as an adjustment to the opening balance of retained earnings at the date of adoption.
Early adoption of the amendments in this ASU is permitted, but no earlier than fiscal years beginning after Dec. 15, 2020, including interim periods within those fiscal years (that is, an entity must adopt as of the beginning of the year and not in a subsequent interim period).
Specific to convertible instruments with down round features, entities that have not yet adopted ASU 2017-11 may early adopt the amendments in ASU 2020-06 in annual or interim financial statements for fiscal years beginning after Dec. 31, 2019, that have not yet been issued or made available for issuance. The FASB provided this accommodation specifically for convertible instruments that include down round features in order to avoid requiring those entities to apply multiple costly transitions for the same instrument with no benefit to financial statement users. Other instruments affected by the amendments in this ASU should follow the overall effective date guidance previously described.
The ASU also allows for entities to irrevocably elect the fair value option in accordance with Topic 825-10, “Financial Instruments – Overall,” for any instrument that has a conversion feature upon adoption.
While the simplified model for convertible instruments and warrants does provide relief to preparers and practitioners, several key considerations for implementation exist:
Identify outstanding instruments that could be affected.
Document the accounting entries for the affected instruments.
Once all the applicable instruments have been identified, transition entries might need to be prepared that might have an impact on opening retained earnings due to the change in accounting principles. For example:
Consider the impacts on the financial statements, including the presentation of single-year financial statements versus comparative financial statements.