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ASU 2020-06 and You: Simplifying Accounting for Convertible Instruments

asu 2020-06-heroIt wasn't so long ago when the very thought of accounting for convertible debt sent shivers down the spines of even veteran accountants. Thankfully, the FASB heard the screams and night terrors, giving the guidance a much-needed overhaul in the form of Accounting Standards Update (ASU) 2020-06.

However, although the updated guidance certainly makes life easier, accounting for such complexities still isn't a walk in the park – far from it. So on that note, let's take a closer look at ASU 2020-06, what changes it brings to the fold, and who it will impact. Spoiler alert – it doesn't just affect issuers of convertible instruments. Cue the foreboding background music.

 

The ASU 2020-06 Backstory: Why Was a Change Needed?

Before we dive headfirst into the nitty-gritty, we recommend looking over our previous insights on convertible instruments if you need a high-level refresher on why these financial gremlins are unique and beneficial in the right circumstances.

That said, note our use of the term gremlin. Obviously, we used it to convey an almost sinister demeanor to convertible debt and its fellow complex financial instruments. Yes, they are inherently more complicated than "traditional" instruments like plain-vanilla debt. However, aside from their innate complexities, much of the fear and confusion around them stemmed from the accounting guidance.

Suffice it to say, the FASB wasn't doing accountants any favors with the way Generally Accepted Accounting Principles (GAAP) treated instruments occupying the fuzzy border between liabilities and equity. But thanks to changes stemming from a Financial Accounting Standards Advisory Council survey, the cavalry has officially arrived in the form of ASU 2020-06.

Long story short, the ASU has removed much of the complexity associated with the existing guidance, eliminating a primary culprit behind numerous restatements and countless migraines in finance organizations. As we're about to discuss, however, accounting for convertible debt and the like still requires accounting functions to sit up straight and take notice.

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What Has Changed with the ASU? Who Does It Impact?

If you happen to be a reporting entity without any convertible instruments, you might think you've dodged a bullet. Unfortunately, while we'll go deeper into specifics in just a bit, these changes in the equity guidance also impact nonconvertible financial instruments subject to ASC 815-40, Derivatives and Hedging – Contracts in Entity’s Own Equity, not to mention companies that may enter into convertible instruments down the line.

In other words, ASU 2020-06 doesn't exclusively focus on accounting for convertible instruments. Instead, it concentrates on three key areas:

  • Accounting for convertible instruments like convertible debt or convertible preferred stock
  • Accounting for certain contracts in an entity's own equity, particularly when applying specific aspects of ASC 815-40
  • Some elements of the earnings-per-share (EPS) guidance

On that note, let's take a closer look at these three areas and better understand what ASU 2020-06 brings to the accounting table.

 

Accounting for Convertible Instruments

As you probably know, the existing guidance required convertible instrument issuers to apply one of five different accounting models, where the terms of the instrument determined which model to use.

  1. Embedded derivative model
  2. Cash conversion feature model
  3. Beneficial conversion feature (or BCF) model
  4. Substantial premium model
  5. No separation / single instrument model

If in-scope for the instrument, the first four required separate accounting for convertible features, each having its own specific set of measurement guidance. Further, you had to evaluate each model in succession if the previous one wasn't in-scope. Suffice it to say, this was a long, drawn-out, often infuriating process.

Thankfully, this is one of the areas where the ASU really did a solid for your accounting team, eliminating two of the five models – the cash conversion feature and the BCF model. Since financial statement users, namely investors, often view convertible instruments as a single instrument anyway, it's not as if the simplified guidance will limit insights they depend on for their decision-making. Still, the ASU also includes new disclosure requirements to make everything as straightforward and transparent as possible for the statement users.

Entities Using an Eliminated Model

Now, if you had an instrument accounted for under one of the eliminated models, you’ll have to unwind your accounting for the separately-recognized equity component upon adoption of the ASU. Going forward, you'll simply account for the convertible instrument as a single instrument under the no separation model in most cases.

We have a big ol' caveat for you to consider, though. Remember, in many cases, reporting entities likely didn't originally assess whether they issued the convertible instrument at a substantial premium or not if it met the scope of a previous model eliminated by the ASU. Therefore, for all convertible instruments other than equity-classified convertible preferred instruments, you should verify if there is, in fact, a substantial premium in the instrument before concluding the instrument is just a single debt instrument since that model – number four in our list – still exists after the ASU.

Granted, it would've been nice if the ASU also eliminated the substantial premium model, something the FASB actually contemplated at one point. However, through research and comments letters, there were concerns regarding a convertible debt instrument issued at a substantial premium – and accounted for as a single unit – could give rise to net interest income rather than interest expense in certain circumstances. This concern led the FASB to retain the model. So there you have it.

 

Accounting for Certain Contracts in an Entity's Own Equity

Moving forward, the second main area of change in the ASU – accounting for certain contracts in an entity's own equity – primarily revolves around parts of the "own equity" guidance.

If you recall, freestanding equity-linked instruments and embedded equity-linked features often met the criteria to be a derivative. These derivatives, including those embedded in a contract that are required to be bifurcated, would be classified as a liability and recorded at fair value unless they meet the “own equity” scope exception.  The “own equity” scope exception applies if both of the following are met:

  1. The contract is indexed to the entity’s own stock – the indexation guidance
  2. The contract meets the equity classification guidance – the settlement guidance  

The changes introduced by the ASU amended the settlement guidance. Previously, in order to classify freestanding, equity-linked instruments as equity – or to meet the derivative scope exception for equity-linked embedded features – you had to meet all of the following:

  • Settlement is permitted in unregistered shares
  • Entity has sufficient authorized and unissued number of shares
  • Contract contains an explicit share limit
  • No required cash payment if the entity fails to file timely
  • No cash-settled top off or make whole provisions
  • No counterparty ranks higher than shareholder rights
  • No collateral is required

Quite the laundry list, huh? It's no wonder why people were clamoring for a simplified standard with such tangled webs of guidance to sort through. Thankfully, the ASU eliminates three of the seven conditions:

  • Settlement is permitted in unregistered shares
  • No counterparty ranks higher than shareholder rights
  • No collateral is required

One thing to keep in mind with the first one, though – if the contract explicitly states the entity must settle in cash if registered shares are unavailable, then the "settlement is permitted in unregistered shares" condition still applies.

Also, as a point of clarification around penalty payments, the ASU notes that penalty payments made upon an entity's failure to make timely SEC filings will not preclude equity classification.

Overall, though, these improvements are a massive victory – for lack of a better term – for accounting functions since these were some of the most difficult sections of the guidance, often requiring legal interpretations and analysis to assess properly. Simply put – good riddance.

That said, if one of the three eliminated conditions were driving liability classification of a freestanding equity instrument or causing an embedded equity-linked feature to be accounted for as a derivative, you would unwind that accounting so long as you meet the four remaining conditions.

Drilling down even further, this could result in residual changes as well, possibly including:

  • Eliminating the need to recognize the changes in fair value of the liability, creating the need to record a transition adjustment at the adoption date to unwind any of the prior accounting on the contract. 
  • Depending on the type of instrument, the change in classification could also impact any related discounts on debt and, therefore, interest expense. 
  • The change in interest expense could also impact your deferred tax balances, meaning you should also consider them relevant.

     

Who the "Own Entity" Changes Benefit

 Of course, some reporting entities will benefit more than others from these particular updates to the guidance. Specifically, issuers of warrants, convertible instruments, and other derivatives on their own stock are the ones that reap most of these particular rewards.

However, as we've said, these changes are beneficial to everyone as they help simplify ongoing accounting. Ultimately, these changes will yield less freestanding financial instruments and embedded derivatives reported at fair value, with changes in fair value now reported in earnings.

Likewise, investors or even counterparties for these types of contracts are also smiling from these changes. Now, they can still include some of the eliminated conditions and rights within the context of the contract without impacting the accounting. That's what people in the know call a win-win.

Transitioning to the Updated Standard

If you need to transition to the ASU, we recommend starting with a review of all your contracts and embedded features you've classified as assets or liabilities, or bifurcated due to these provisions in the past. In some cases, you might have to perform a more robust analysis to ensure there aren't any other conditions that would require you to classify the contract as an asset or liability, or bifurcated.

 

Earnings Per Share (EPS) Guidance

Finally, getting to the last of the three major areas of change – earnings-per-share – one of the biggest impacts ASU 2020-06 has on EPS is eliminating the treasury stock method to calculate diluted EPS for convertible instruments. Previously, certain convertible instruments could use the treasury stock method to compute diluted EPS. Now, the guidance requires the if-converted method for all convertible instruments.

Another significant change revolves around an instrument that may be settled in shares or cash. Previously, if the decision was at the issuer’s option, the share settlement presumption could have been rebutted. However, with the ASU, there is no option to rebut share settlement for purposes of calculating diluted EPS where share settlement is more dilutive.  

Note, this change on share settlement presumption does not include certain liability-classified, share-based payment agreements where the presumption can still be rebutted based on past experiences or a settlement policy.

One last significant change introduced by the ASU relates to the effects of a down-round feature in a convertible preferred stock. To level-set, a down-round feature reduces the conversion price of a convertible preferred stock instrument if the issuer sells shares of its stock for an amount less than the conversion price.

Previously, for convertible preferred stock instruments with a down-round feature, the BCF model applied and measured the feature when triggered. Because the BCF is now eliminated, the ASU clarifies that a down-round feature is measured as the difference in the fair value of a convertible instrument before and after the down-round feature is triggered. Also, the effects of a down-round feature are only reflected in EPS when triggered.  

Other EPS-Related Clarifications

Before we move on, there are a couple of other minor EPS-related clarifications we want to point out. The first regards average market price, with the FASB stating you should use it to calculate the diluted EPS denominator in cases where the conversion rate or exercise price is variable.

Further, they also clarified that an entity should use the weighted-average share count from each quarter when calculating the year-to-date weighted average share count. The exception is in cases where one of the quarters has a loss.

 

ASU 2020-06 Effective Dates

Now that the heavy lifting is out of the way, let's segue to something a bit more breezy. Although the FASB issued the ASU back in 2020, there weren't many companies opting for early adoption of ASU 2020-06 in 2021. Obviously, the pandemic threw a wrench into almost everything, so we can only guess more companies would have already adopted it if it weren't for pandemic-related operational and financial reporting hurdles.

We also imagine some companies, or at least ones that hadn't looked at the transition guidance for the ASU, were surprised to find they couldn't subsequently adopt in a later quarter in 2021. That said, except for Smaller Reporting Companies or Emerging Growth Companies that elect to apply the private entity adoption dates, the new standard is effective for calendar year-end SEC filers starting in 2022, including interim periods within the year. In other words, most calendar year-end SEC filers will need to adopt the guidance in their Q1 2022 quarterly filing.

For private companies, it's effective for fiscal years beginning after December 15, 2023. Note that early adoption is allowed but, similar to public business entities applying the ASU, it would have to be adopted as of the beginning of a private company's fiscal year.

 

Adoption Methods for ASU 2020-06

Finally, on the adoption method front, the board is allowing entities to either adopt using a modified retrospective method or a fully retrospective method.

Under the modified retrospective method, entities will apply the ASU to financial instruments outstanding as of the beginning of the fiscal year of adoption. You would recognize the cumulative effect of the adjustment at the adoption date to your opening retained earnings. Also, you do not restate EPS amounts in prior periods presented.

Alternatively, under the full retrospective method, you would apply the ASU to financial instruments outstanding as of the beginning of the first comparative reporting periods presented. Additionally, you should also restate EPS for all periods presented.

 

Looking Down the Road

As significant as some of these changes are, this ASU only constituted the first phase of this project from the FASB. Remember, the original objective for the project was to improve and align the two parts of the own equity guidance.

 The FASB had a phase 2 of the project set to focus on improvements and alternatives to the indexation guidance. However, at its April 13, 2022 board meeting, the FASB decided to deprioritize improvements to this guidance and removed the second phase of the project from its technical agenda.

 

Final Words from Your Friends at Embark

Now, is all of this a lot to take in? You betcha. But is it also a clear improvement from previous guidance? For sure. Still, none of it really rolls off of the tongue with ease. For that reason, we would be remiss if we did it mention how Embark's technical accounting dynamos are ready to step in and lead the way whenever you need us.

In the meantime, we'll continue to publish these somewhat lengthy, somewhat technical, but always illuminating insights to keep you from getting lost in the accounting badlands. It's what we do.

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