This article was updated February 10, 2021.

An entity that issues convertible instruments is likely to find the recent changes in accounting for the accounting for convertible instruments and contracts in an entity’s own equity to be favorable. The amended guidance is provided for in Accounting Standards Update (ASU) 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity.

An entity is required to adopt the amendments as of the beginning of its annual fiscal year. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The required effective dates, as detailed below, follow the FASB’s two bucket approach that staggers the effective dates between larger public companies and other entities.

This article addresses the key provisions that an entity should consider when applying the new guidance.

Key Provisions

The amended guidance is expected to result in more convertible debt instruments being reported as a single liability instrument and more convertible preferred stock as a single-equity instrument with no separate accounting for embedded conversion features as the amendments remove major separation models required under current Generally Accepted Accounting Principles (GAAP).

The ASU also removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, which will permit more equity contracts to qualify for the scope exception.

The diluted earnings per share (EPS) calculation is also simplified in certain areas.

An entity is required to adopt the amendments as of the beginning of its annual fiscal year. This means that an entity isn’t allowed to adopt the amended guidance in a subsequent interim period.

Convertible Instruments

Under current GAAP, there are five accounting models for convertible debt instruments:

• Traditional convertible debt
• Convertible instrument with a bifurcated embedded derivative
• Convertible debt issued at a substantial premium
• Convertible debt issued with a cash conversion features
• Convertible debt issued with a beneficial conversion features

Except for the traditional convertible debt model that recognizes a convertible debt instrument as a single debt instrument, the other four models require a convertible debt instrument to be separated into a debt component and an equity or a derivative component. Convertible preferred stock is required to be assessed under similar models.

The amended guidance eliminates the cash conversion and beneficial conversion feature accounting models under Topic 470-20, Debt with Conversion and Other Options, which required an issuer of a convertible instrument with a cash conversion feature or beneficial conversion feature to separately account for the embedded conversion feature as a component of equity.

Under the amended guidance, an embedded conversion feature is no longer separated from its host contract and should be accounted for as a single unit of account, unless the conversion feature meets the criteria in Topic 815 to be recognized as a derivative or the convertible instrument was issued at a substantial premium.

Under legacy GAAP, a conversion feature was assessed under the substantial premium model if the conversion feature wasn’t accounted for separately in accordance with the cash conversion or beneficial conversion feature models. With the elimination of the cash conversion or beneficial conversion feature models, a conversion feature previously accounted for separately under those two models will no longer be separated from its host contract, which may result in a substantial premium.

Disclosure

The amendments expand the disclosure requirements for convertible instruments to provide information about the terms and features of convertible instruments, an understanding of how the instruments have been reported, and information about events, conditions, and circumstances that can impact the amount or timing of future cash flows. Examples of the updated disclosures include, but aren’t limited to:

• The pertinent rights and privileges of each convertible debt instrument outstanding
• Incremental information for contingently convertible instruments, including events or changes in circumstances that would adjust or change the contingency or would cause the contingency to be met, information on whether the shares that would be issued if the contingently convertible securities were converted are included in the calculation of diluted EPS, and other information that is helpful in understanding the nature of the contingencies and the potential impact of conversion
• Information for each convertible debt instrument, including the unamortized premium, discount, or issuance costs, the net carrying amount, and fair value information for public business entities only
• The amount of interest recognized, including the effective interest rate
• The amount of dividends declared for each period presented
• Information about events or changes in circumstances that significantly impact the conversion terms
• Number of shares issued upon conversion, exercise, or satisfaction of required conditions during the reporting period
• Maturities and sinking fund requirements for convertible debt instruments for each of the five years following the date of the most recent statement of financial position

Contracts in an Entity’s Own Equity

Under Topic 815, Derivatives and Hedging, contracts that involve an entity’s own equity—including freestanding financial instruments, such as warrant contracts, and embedded features—must be evaluated to determine whether the contract qualifies for a scope exception from derivative accounting. A contract qualifies for the derivatives scope exception when both of the following criteria are met:

• The contract is indexed to an entity’s own stock
• The contract is equity classified

A contract must be recognized as an asset or a liability if both of the above criteria aren’t met.

Settlement Criterion

The amendments simplify the conditions required for an instrument to qualify for equity classification—referred to as the settlement criterion. The general concept behind the settlement criterion is that a contract settled in an entity’s own equity shares meets the criteria, whereas a contract that may, or will, require settlement in cash, doesn’t meet the criteria. Under current GAAP, there are seven conditions that must be met in order for a contract to be classified as equity. The amendments simplify the settlement guidance by removing three of those conditions. Under the ASU, the following conditions are no longer required to be considered:

• Whether a contract permits settlement in unregistered shares—only contracts that explicitly state an entity must settle in cash if registered shares are unavailable will be precluded from equity classification
• Whether counterparty rights rank higher than shareholder rights
• Whether collateral is required to be posted

Additionally, the amendments modify the settlement condition on failing to timely file by clarifying that penalty payments do not preclude equity classification.

Subsequent Measurement

Current GAAP requires freestanding instruments that don’t meet the indexation criterion to be classified as an asset or liability, but doesn’t provide specific subsequent measurement guidance for those instruments that also don’t meet the definition of a derivative. For example, a freestanding warrant issued by a private company often doesn’t meet the definition of a derivative because it requires physical settlement.

The amended guidance requires a freestanding instrument that doesn’t meet the indexation criterion and doesn’t meet the definition of a derivative to be subsequently measured at fair value, with changes reported in earnings. This approach is consistent with the existing subsequent measurement guidance for instruments that don’t meet the definition of a derivative and don’t meet the settlement criterion.

Diluted EPS

Under current GAAP, entities may calculate diluted EPS using the following two methods:

• If-Converted Method. Under this method, the conversion of convertible securities is assumed to have occurred at the beginning of the reporting period, or at the time of issuance if later, and the resulting common shares are included in the denominator. Preferred dividends and interest expense are added back to the numerator.
• Treasury Stock Method. Under this method, exercise of options and warrants are assumed at the beginning of the period, or at the time of issuance, if later, and common shares are assumed to be issued. The proceeds from exercise are assumed to be used to purchase common stock at the average market price during the period and the incremental shares are included in the denominator.

Currently, the if-converted method is used for many convertible instruments, but the treasury stock method is also used for certain convertible securities that permit or require payment of cash at conversion. The amended guidance aligns the diluted EPS calculation for all convertible instruments by requiring an entity to use the if-converted method. The treasury stock method can no longer be used to calculate diluted EPS for convertible instruments. Additionally, under the amended guidance, interest expense is not added back to the numerator for convertible debt for which the principal is required to be paid in cash under the if-converted method.

Contracts Settled in Stock or Cash

Share settlement is presumed for contracts that may be settled in cash or shares at the election of either the entity or the counterparty. Under current GAAP, an entity may rebut this presumption if it has a history or policy of cash settlement.

The amendments remove the ability to rebut the presumption of share settlement and the effect of a potential share settlement is required to be included in the diluted EPS calculation when an instrument may be settled in cash or shares.

Equity-Classified Preferred Stock with Down Round Features

As a result of eliminating the beneficial conversion feature model, the scope of the recognition and measurement guidance under Topic 260, Earnings Per Share, was amended to include equity-classified convertible preferred stock with a down round feature—if the conversion feature hasn’t been bifurcated. This means when the down round feature is triggered, the effect should be treated as a dividend and as a reduction of income available to common stockholders in basic EPS.

Average Market Price

The amendments clarify that the average market price should be used to calculate the diluted EPS denominator when the number of shares that may be issued is variable, except for certain contingently issuable shares.

Effective Dates

For public business entities that meet the definition of a SEC filer, excluding entities eligible to be smaller reporting companies, the amendments are effective 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, including interim periods within those fiscal years.

The amendments should be adopted as of the beginning of an entity’s annual fiscal year. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.

Fair Value Option

The amendments provide entities with a one-time irrevocable election, as of the date of adoption of ASU 2020-06, to apply the fair value option under Subtopic 825-10, Financial Instruments, to liability-classified financial instruments that are convertible securities within the scope of Subtopic 825-10.

The FASB’s Investor Educator Video

The FASB released an investor education video to help explain how the guidance in ASU 2020-06 simplifies the accounting for convertible instruments and improves relevance and comparability of information available. This video walks through examples that demonstrate how the amended guidance will impact the income statement, earnings-per-share calculations, and other related areas.

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For more information on how the amended guidance may affect your business, contact your Moss Adams professional.