One of the more complex areas of financial reporting is accounting for convertible debt. Under current GAAP, there are 5 different accounting models which could apply, based on the facts and circumstances of the debt conversion feature. Each of these models have different accounting outcomes, ranging from the debt with the conversion feature being recorded at its historical cost to the debt and the conversion feature being separated, the proceeds allocated between the two financial instruments and each accounted for separately under applicable guidance. While the purpose of this guidance is to allocate a portion of the debt issuance proceeds to both the debt and conversion feature, the application of these guidance challenging, frequently results in financial reporting error and, according to stakeholder feedback, does not provide useful information for financial analysis.

Accounting for Convertible Securities

As a result of this feedback, in August 2020, the FASB issued ASU No. 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 (ASU No. 2020-06). ASU No. 2020-06 reduces the number of accounting models for convertible debt and preferred stock from five to two. Under the first model, the convertible security is no longer separable, with the convertible debt security carried at its amortized cost and the convertible preferred stock security carried at its historical cost.  Separation of the host security from the conversion feature, with a related allocation of the issuance proceeds to each security, will only be required in the following circumstances:

• A security with an embedded conversion feature that is not clearly and closely related to the host instrument, that meets the definition of a derivative and that do not qualify for a scope exemption from derivative accounting, and
• Convertible debt instruments issued with substantial premiums for which the premiums are recorded as paid-in capital

This change primarily impacts the accounting for instruments issued with beneficial conversion features or cash conversion features, as the models for these types of securities were removed through this update. Also to that ASU No. 2020-06 adds certain disclosure requirements for convertible instruments, including:

• A disclosure objective
• Information about events or conditions that occur during the reporting period that cause conversion contingencies to be met or conversion terms to be significantly changed
• Information on which party controls the conversion right
• Alignment of disclosure requirements for contingently convertible instruments with those for other convertible instruments
• Require that the existing fair value disclosures in AS 825be provided at the individual convertible instrument level rather than aggregated

Accounting for Contracts for an Entity’s Own Stock

ASU No. 2020-06 also impacts the accounting for contracts for an entity’s own stock, namely freestanding instruments and embedded features that are accounted for as derivatives under current guidance because of their failure to meet the settlement conditions. The change addressed stakeholder feedback that the existing guidance emphasized the form of the arrangement over its substance.

Specifically, an entity must determine whether an equity contract qualifies for a scope exception from derivative accounting. This analysis includes two criteria: (1) the contract is indexed to an entity’s own stock, the indexation guidance and (2) the contract is equity classified, 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 FASB 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. This ASU removes three conditions required to qualify for the settlement guidance related to settlement in unregistered shares, collateral requirements, and shareholder rights. Accordingly, as compared to current GAAP, more equity contracts will qualify for the derivatives scope exception.

Earnings per Share (EPS)

Lastly, ASU No. 2020-06 impacts the computation of (EPS) by focusing on the areas included in the project’s overall scope of convertible instruments and contracts in an entity’s own equity. ASU No. 2020-6ASU 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.

Effective Date and Transition

ASU No. 2020-06 is effective for public business entities that meet the definition of an SEC filer, excluding 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 ASU should be adopted as of the beginning of its annual fiscal year. An entity that has not yet adopted ASU No. 2017-11, 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.

Rich Daisley, CPA, is Vice President of Accounting and Financial Reporting Curriculum for Surgent CPE. With over 26 years of experience in the accounting and auditing field, Mr. Daisley has worked in both the client service setting, mainly for PwC’s Capital Markets and Accounting Advisory Services Group and for PECO Energy’s Merger and Acquisition Group, and in the internal capacity setting as a course developer and facilitator creating leading training courses for PwC and Surgent. Rich lives in suburban Philadelphia.