INSIGHT: Simplified Accounting for Convertible Instruments and an Increase in Equity Classification for Contracts in an Entity’s Own Equity

In an Aug. 5, 2020, press release, FASB Vice Chairman James L. Kroeker stated that “The ASU [2020-06] is an important step in simplifying a complex area of accounting guidance that has been a frequent source of financial restatements. We expect it to improve comparability of information for financial statements users and reduce cost and complexity for preparers and auditors.”

Accounting Standards Update No. 2020-06 focuses on two specific accounting areas where improved and simplifying guidance was warranted—Convertible instruments that can be converted to shares, and contracts on an entity’s own equity, which may qualify for an exception from derivative accounting. The new guidance is expected to reduce accounting complexities for preparers and practitioners while representing a partial convergence relative to IAS 32 – Financial Instruments Presentation.

Ultimately, ASU 2020-06 achieves its purpose. Upon its implementation, more financial instruments—freestanding contracts and embedded derivatives—will qualify for equity classification and avoid the generally more complex accounting procedures underlying an asset or liability classification. Here are the key takeaways:

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Convertible Debt

Convertible instruments are debt or equity instruments (or features) that either require or permit the investor to convert the instrument into equity securities of the issuer. The accounting treatment for such instruments depends on the underlying terms and conditions, including the manner in which the instrument is settled upon conversion. Some convertible instruments are settled upon conversion entirely in shares, some in a combination of cash and shares, and less commonly, entirely in cash. The terms and conditions may mandate a settlement method, or the reporting entity may have its option.

In addition, many convertible instruments contain a number of provisions, such as put and call options, or contingent interest features, which should be assessed to determine whether the features should be bifurcated and accounted for separately.

Navigating the guidance in U.S. GAAP on convertible instruments can be challenging considering there are multiple sets of classification and measurement requirements under several of its accounting standards codifications (ASCs) whose interactions can be complex and inconsistent. The beneficial conversion feature (BCF), for example, is one of the areas accounting professionals, auditors, and readers of financial statements spend tremendous amount of time and energy in interpreting the multipart guidance stipulated by ASC 470 - Debt, ASC 480 – Distinguishing Liabilities from Equity, ASC 815 – Derivatives and Hedging, and ASC 825 – Financial Instruments.

ASU 2020-06 aims to simplify this particular accounting complexity by eliminating the more complex of the currently prescribed models—the beneficial conversion and cash conversion features. Compared to current GAAP guidance, this will result in the interest rate of more convertible instruments being closer to the underlying stated coupon rate and a lower interest expense. Further, more convertible instruments will be accounted for as a single unit while more contracts will be eligible for the fair value option under ASC 825.

ASC 470 addresses classification and measurement requirements that might apply to different types of convertible debt instruments. The following illustration summarizes the accounting models under the current GAAP guidance along with the impact presented by ASU 2020-06:

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Contracts on an Entity’s Own Equity

Accounting for contracts on an entity’s own equity shares, such as warrants, options, convertible instruments, futures, forwards, or embedded derivatives involves many rules and scope exceptions. While the ultimate goal—classifying the underlying contract (or feature) in equity or as an asset or liability and accurately capturing the potential corresponding earnings effects—is well defined, the path may not be as forthright.

In order to be classified in equity, ASC 815-40 requires a contract (or feature) that is indexed to the underlying entity’s own stock to further meet several conditions. For a contract (or feature) to qualify for equity classification, it must require or permit the issuing entity to settle it via shares. Any requirement to settle the contract in cash generally precludes equity classification. As illustrated below, only a contract that meets both requirements qualifies for equity classification and avoids the complexities of derivative accounting under ASC 815:

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Specifically, ASC 815-40 prescribes seven conditions that could potentially result in the contract being settled in cash rather than shares and therefore preclude an equity classification. ASU 2020-06 removes three of these conditions, while clarifying another, because, based on feedback from preparers and practitioners, they are inconsistent and difficult to apply. As a result, more contracts will qualify for equity classification. The following illustration summarizes the conditions under the current GAAP guidance along with the impact presented by ASU 2020-06:

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Effective Date

ASU 2020-06 is effective for SEC filers, excluding small reporting companies, for fiscal years beginning Dec. 15, 2021. Early adoption and effective dates for all other entities are summarized as follows:

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This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Michael B. Shekel, CPA/ABV, MBA is with the Valuation Advisory Services at Cherry Bekaert LLP.