Everyone wants the best of all worlds. It’s a notion that explains the existence of everything from tablet computers and glamping to Labradoodles and electric bikes. Why relegate yourself to one thing when you can have two, right?
In a sentence never once uttered by a human being, convertible instruments are the Labradoodles of the finance world. Part liability component, part equity component, we’ve seen these instruments grow in popularity over the last few years, particularly with private equity firms.
But as you might imagine, the tantalizing combination of downside protection and upside potential carries some significant accounting complications with it. Therefore, let’s take a closer look at convertible instruments, the unique benefits they provide to organizations, as well as the new convertible debt accounting debt standard from our friends at the FASB. So let’s get this party started.
What Is a Convertible Instrument?
Note how I keep using the term convertible instrument. That’s because it’s a broad label that encompasses different things, most commonly convertible bonds – debt – and preferred stock. But convertible is actually the crucial word needed to understand the concept, speaking to the hybrid nature of the underlying instrument that either requires or permits the investor to convert into equity securities of the issuer.
While I’ll concentrate on debt-to-equity conversions from here on out because it’s the most common form, the conversion could also apply to other types of equity instruments. To put a finer point on it, though, convertible notes have a few distinct characteristics that distinguish them from other financial instruments:
- The debt has a maturity date as well as stated repayment terms.
- The person or entity that invested in the debt holds an option – or in some cases, is required – to convert it into another type of financial instrument, generally equity shares of the issuer.
- The conversion feature may relate to the occurrence of a contingent future event like, for example, an IPO or change-in-control.
- If the bondholder exercises the option to convert, it extinguishes the debt. Alternatively, repayment of the debt eliminates the option to convert.
- The holder cannot separate the debt from the option. In other words, the conversion feature is not freestanding.
Why Use Convertible Instruments?
Now that I’ve covered the basics behind convertible instruments, I want to change our focus to the benefits of using them for both the investor and issuing entity.
Benefits of Holding Convertible Instruments
As I said up top, convertible instruments are popular amongst investors – both individual and institutional – because they combine the downside protection of traditional debt but offer the upside potential of equity. Naturally, given the depressed interest rate environment we’ve been seemingly slogging through for millennia at this point, the option to convert to equity is attractive for firms looking to maximize their return on capital.
Benefits of Issuing Convertible Instruments
On the flip side, companies are issuing these instruments to raise capital quickly. Once again, thanks to a depressed rate environment, traditional debt isn’t especially appealing to investors these days. And while the lower interest rates on convertible bonds generate smaller coupon payments than non-convertible debt, issuers can spice up what would otherwise be a pretty humdrum offering through the option to convert into equity interests. It also doesn’t hurt that they’re expanding their investor pools to include PE firms, hedge funds, and the like.
Accounting for Convertible Instruments
Now for the reason you probably came to this hefty tome in the first place – accounting for convertible instruments. As you may or may not have known, the previous accounting guidance under GAAP was a bit on the complicated side. And by complicated, I mean it ranked right up there with the blueprints to an F-35.
But the fine folks at the FASB heard the cries from across the accounting badlands and issued a new standard update, ASU 2020-06, in response. Of course, a convertible debt instrument is inherently complex, so there’s only so much that even the accounting gods can do.
Still, this new guidance is a much-needed salve to an accounting process rife with errors and inconsistencies across different entities, mainly due to the once overly-complicated guidelines. This simplification goes hand-in-hand with similar projects from the FASB – like the simplification of goodwill impairment and income taxes, amongst others – to make financial reporting more relevant and life generally easier for preparers and investors.
What’s New in ASU 2020-06
Elimination of Certain Convertible Instrument Models
Under the old guidance, with the exception of an entity electing to apply the fair value option to account for these instruments where applicable, you had to run your convertible instruments through five separate accounting models each with different recognition and measurement requirements:
- Embedded derivative model
- Substantial premium model
- Cash conversion model
- Beneficial conversion feature model
- Traditional convertible debt model
Thankfully, the new guidance has eliminated the cash conversion model and the beneficial conversion feature model, leaving entities with fewer guidelines to navigate while determining what is and is not relevant to their specific circumstances.
Eliminating these models will likely result in companies accounting for more convertible debt instruments as a single unit of account. Because of this, interest expense on these instruments will also likely decrease as there will no longer be an allocation of debt proceeds between the debt and equity components which, otherwise, would create an initial discount on the debt.
The elimination of these models was driven primarily by feedback collected by the FASB from financial statement users during its research on the project, many who indicated they view and analyze convertible instruments as a single unit of account.
This haircut of the models is far and away the most significant change in ASU 2020–06, reducing the burden on preparers that previously absorbed substantial amounts of time and effort.
In conjunction with a more straightforward approach, entities must now also include certain targeted disclosures concerning these convertible instruments in their financial statements. Like most of the more significant changes to accounting and reporting standards of late, these disclosures all focus on increased transparency to provide more useful information to investors and their decision-making process.
Further, the underlying intent with these additional disclosures is mainly to walk the reader through the many moving parts behind these convertible instruments. Obviously, just looking at the quick overview I provided earlier, instruments like convertible debt and convertible preferred stock can be unique and not always intuitive to an outsider. With these disclosures, the FASB wants to help investors – as best as it can – make well-informed decisions.
Clarifying Debt vs. Equity
Historically under ASC 815-40, for a contract settled in an entity’s own equity to be classified as equity, it had to meet certain requirements. The guidance also included seven additional conditions that could preclude equity classification because they may require settlement in cash rather than shares. As part of the ASU, the FASB eliminated some of those conditions and clarified application of others.
Specifically, the FASB has whittled that list from seven down to four, eliminating the following conditions:
- If a contract allows for settlement in unregistered shares
- If counterparty rights rank higher than shareholder rights
- If collateral is required to be posted
Remember, this simplification is an ongoing process, so while reducing the evaluation of the settlement criterion is obviously helpful in distinguishing liabilities from equities, that’s not to say the FASB is done. In fact, it’s still considering additional changes to this area of GAAP, particularly around the indexation criteria for contracts in an entity’s own equity as part of a Phase 2 project on their technical agenda.
Put another way, this is the guidance as it stands – or will stand once the effective dates hit, but more on those in a bit. However, the guidance could very well continue to evolve with time.
Computing Diluted Earnings Per Share (EPS)
Another of the significant changes stemming from ASU 2020-06 concerns how companies compute diluted earnings per share. In yet another simplification, the new guidance removes some of the judgment from the old standards and, thus, the diversity in practice that sprang from it.
More specifically, under current GAAP, entities can calculate diluted EPS under one of two methods:
- If-converted method, or
- Treasury stock method
However, under the new ASU, companies are now required to apply the if-converted method to all convertible instruments. In some cases, keep in mind there may be a modification to the if-converted method for convertible instruments where it is partially settled in cash and partially in shares under the new guidance.
Going forward, the new guidance provides a more consistent framework for calculating diluted EPS, including a few other diluted EPS changes to quickly mention as they relate to the ASU:
- Clarification on the average market price, stating it should be used to calculate the diluted EPS denominator
- Removal of the rebuttable presumption around share settlement that exists under current GAAP in the calculation of diluted EPS
- Expansion on the recognition and measurement guidance on financial instruments with down-round features to equity-classified convertible preferred stock with down-round features
All in all, just like many of the other changes I’ve discussed, this newly streamlined and clarified approach to diluted EPS will undoubtedly benefit both preparers and investors.
With the exception of Smaller Reporting Companies, the new standard is effective for year-end SEC filers starting in 2022, including interim periods within the year. For all other companies, it’s effective for fiscal years beginning after December 15, 2023.
While early adoption is permitted beginning in 2021, please note that if you choose that route, the early adoption must occur as of the beginning of the year. For example, if you’re adopting in 2021, then your Q1 2021 filing must reflect the adoption.
Embark’s Final Word
Given the rising popularity of convertible instruments, this new guidance will affect more issuing companies than it would have not so long ago. When looking at the possible impact on your organization, consider potential effects on your net income and EPS which, in turn, can impact your performance metrics. Likewise, if the new ASU results in increased debt levels on the balance sheet and fewer debt discounts recognized, they could also affect things such as capitalized interest, debt covenant financial ratios, and deferred income taxes, to name a few.
Long story short, while the new guidance eliminates many unnecessary complexities, there’s more to them than meets the eye. And like it or not, you don’t have a heck of a lot of time to adopt the standard, meaning your team must ramp-up relatively quickly.
Of course, you’re not alone when it comes to sifting through the immediate and ongoing effects of this new guidance for issuers. Embark’s elite squad of accounting and finance consultants is ready to help you sort through the guidance and better understand what it means for your organization, both today and down the road.