ASU 2020-06: Streamlined Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity

Background and Overview

In August 2020, the FASB issued ASU 2020-06, Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, which is intended to simplify the accounting for certain financial instruments with characteristics of liabilities and equity. This includes convertible instruments and contracts in an entity’s own equity. The Board issued such guidance as a result of the accounting complexity associated with these financial instruments. The key provisions, disclosures, transition requirements and effective dates are discussed below.

Key Provisions and Changes

Convertible Instruments

Current GAAP for convertible instruments contains five methods for determining the proper accounting for convertible debt. Most of the models require the convertible instrument be separated into a debt or equity component (and in some cases, derivative component).

Affected convertible instruments are those that are issued with beneficial conversion features or cash conversion features. These accounting models have now been removed to simplify the accounting requiring these features to be separated from their host contract. Convertible debt is treated as a liability (at amortized cost), and convertible preferred stock is treated as equity (at historical cost). More importantly, interest rates for these debt instruments will match the stated coupon rate.

However, the Update requires entities that have convertible instruments to provide enhanced disclosures including “information about events, conditions, and circumstances that can affect how to assess the amount or timing of an entity’s future cash flows related to those instruments.”

Derivatives Scope Exception

Current GAAP includes and requires a contract in an entity’s own equity or embedded derivative to meet certain requirements for the derivative scope exception to be classified as equity. Other conditions that may require cash settlement generally lead to derivative accounting (adjusting to fair value every period through earnings).

The Update simplifies the derivatives scope exception when evaluating the contract’s settlement and the conditions necessary for share settlement. It removes some of the conditions (including collateral requirements and certain counterparty rights) required to avoid derivative accounting along with clarifying the scope of the disclosure and reassessment requirements. Under current GAAP, the issuer must be able to substantiate that settlement of the contract is permitted in unregistered shares to meet the derivative scope exception. Under ASU 2020-06, this condition is removed and clarifies that the requirement to deliver registered shares does not, in itself, imply the inability of the issuer to deliver shares, unless the contract specifically requires that the issuer must settle in cash if registered shares are unavailable. The removal of these conditions simplifies the process on preparers and auditors when financial statements are issued in registered or unregistered offerings.

Updates and Improvements for EPS Calculations

Current GAAP uses two methods to calculate diluted EPS for the different convertible instruments, as follows:

• If-converted method – This calculates the change in shares outstanding if convertible securities are to be converted into shares. This calculation is performed only if the market price is higher than the exercise price for the securities. The effect is that the number of shares outstanding increases, which reduces the EPS reported on the income statement. The amount of earnings also increases in the EPS calculation as interest expense is eliminated.
• Treasury stock method – This calculates the net increase in shares outstanding if the entity’s options and warrants are exercised. The calculation, used in the diluted EPS determination, expands the number of shares, thereby reducing the amount of EPS. It permits the issuer to cash settle the value upon this conversion.

The Update disallows the treasury stock method, which is no longer permitted, and entities must apply the if-converted method to all convertible instruments.

Transition requirements

Entities may use the modified or full retrospective transition approach upon adoption.

• Modified retrospective approach – The entity recognizes the “cumulative effect of the change…as an adjustment to the opening balance of retained earnings at the date of adoption.”
• Full retrospective approach – The entity recognizes the cumulative effect of the Update in the opening balance of retained earnings in the first comparative period presented.

Entities are also permitted to make a one-time irrevocable election for applying the fair value option as set forth in ASC 825-10.

Effective Dates

Entities may early adopt for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years.