Convertible Instruments to Become Less Complex

Companies within the technology and life sciences industries have a plethora of financing options. Depending on the stage of the company, convertible instruments (both debt and equity) are commonly utilized. Most users view and analyze convertible instruments on a whole-instrument basis rather than separating the instrument into two components (which often is the case). Under current GAAP, companies have to go through complex evaluations and determine which one of five accounting models to utilize and make a determination whether to separate a debt or equity component from a derivative component.

In August 2020, the Financial Accounting Standards Board (FASB) attempted to solve some of these issues in Accounting Standards Update (ASU) No. 2020-06, Debt – Debt Conversion and Other Options (Subtopic 470-02) and Derivatives and Hedging – Contracts in Entity’s Own Equity. The new guidance reduces the complexity of convertible instrument accounting by establishing the convertible debt instrument as a single liability at amortized cost, and convertible preferred stock as a single equity instrument at historical cost.

Main Provisions

Unfortunately, this update does not eliminate any of the requirements under Topic 815, Derivatives and Hedging. Therefore, outside of conversion features accounted for as derivatives under Topic 815 or conversion features that do not result in substantial premiums accounted for as paid-in-capital, embedded conversion features are no longer separated from the host contract. Due to the simplification of the accounting, however, the FASB is requiring more comprehensive disclosures. These expanded disclosures include details regarding contingencies, which party has conversion rights, and fair value disclosures at the individual convertible instrument level rather than in the aggregate.

This guidance also amended a scope exception that many companies currently utilize. Convertible instruments with embedded features that are linked to an entity’s own equity and which are equity classified qualify for this scope exception. In short, if an entity can settle a contract by issuing its own equity rather than a cash settlement, in most cases, the company would qualify for this scope exception. Among other things, this amendment updates settlement guidance, including removing considerations of collateral, shareholder rights, and unregistered shares. Therefore, the amendment will allow more companies to fall under the exception and be exempt from recognizing a derivative liability or asset.

Another significant change regards earnings per share (EPS). The guidance requires the if-converted method of calculating diluted EPS and no longer allows the treasury stock method, thus eliminating an inconsistency in practice. The final significant change is the elimination of the beneficial conversion features model, including equity-classified convertible preferred stock with a down-round feature.

Implementation

The ASU is effective for public business entities other than smaller reporting companies, for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023. Although some companies may want to adopt in 2020, early adoption is only permitted for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years.

The Take Away

Overall, the FASB seems to be taking steps in the right direction for both users and preparers of financial statements, making accounting for convertible instruments less complex and including additional required disclosures for maximum clarity. Not only does this provide additional clarity to the users of financial statements, this update will help companies save accounting and valuation related costs surrounding these instruments.