Financial reporting simplified? Too good to be true, you ask? Well, this is now the case for certain convertible debt instruments! The FASB listened to constituents and recently issued ASU 2020-06 Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. Existing guidance in ASC 815 Derivatives and Hedging and ASC 470 Debt require an extensive evaluation of the characteristics of convertible instruments or contracts linked to an entity’s own equity. This analysis results in one of five possible accounting models. Four of these accounting models require an entity to separately recognize and measure certain features of convertible instruments.
After considerable feedback, the Board decided to reduce the number of accounting models from five to three. This should reduce the likelihood that entities will have to separately recognize components of convertible instruments or contracts linked to an entity’s own equity. This blog will focus on how ASU 2020-06 impacts one of the existing accounting models, beneficial conversion features, for convertible debt instruments.
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Convertible debt instruments are popular funding vehicles. Such debt instruments are an efficient financing method to raise cash with favorable terms without issuing stock or incurring the cost to secure conventional debt instruments. Convertible debt instruments provide a consistent rate of return to holders in the form of interest, regardless of the operating results of the entity. From an entity’s standpoint, what remains from operations after payment of interest is available for re-investment or to return to existing shareholders via dividends.
Convertible debt instruments allow a holder to transform an existing obligation into stock. Beneficial conversion features represent a nondetachable conversion feature that is “in the money” at the commitment date. Therefore, such features allow the holder to obtain stock at a lower conversion price than the value of the underlying stock at the time of issuance. This conversion price could be a stated value or a stated percentage. The difference between the conversion price and the proceeds at issuance represents the intrinsic value of the conversion feature. Said another way, this difference represents the cost to obtain the funding at the time of issuance.
So, how do entities account for convertible debt instruments with beneficial features? The intrinsic value of the conversion feature is recorded in equity and the difference between the proceeds and the conversion feature is recognized in debt. The intrinsic value is then amortized on a straight-line basis over the term of the debt instrument (unless a conversion occurs prior to maturity).
Users of financial statements informed the Board that convertible debt instruments are normally evaluated as a single unit with a greater focus on the interest rate. What does this mean for the financial statements? Instead of recognizing the theoretical cost of a convertible debt instrument, users of the financial statements can instead focus their time evaluating the features of these instruments, including cash obligations of an entity (i.e. actual interest payments).
You may feel a brief sense of relief knowing financial statement preparers will no longer have to spend significant time evaluating and measuring convertible debt instruments with beneficial conversion features. But wait, there’s more! Truth be told, simplification normally comes with a caveat. So, what’s the catch?
ASU 2020-06 requires additional disclosures to better inform financial statement users of the terms and features of convertible debt instruments. Additional disclosures include:
- Information about events or conditions that occur during the reporting period that cause conversion contingencies to be met or conversion terms to be significantly changed.
- Additional information on which party controls the conversion rights.
Therefore, the catch is the additional time incurred by management to prepare these additional disclosures.
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Early adoption is available for this new guidance, but only for fiscal years beginning after December 15, 2020. Any changes as a result of this ASU apply as of the beginning of the fiscal year of adoption.
For those entities that do not wish to early adopt, the amendments outlined in ASC 2020-06 are effective for public entities for fiscal years beginning after December 15, 2021. The amendments are effective for all other entities, including smaller reporting SEC filers, for fiscal years beginning after December 15, 2023.
Many financial statement preparers are likely sleeping a little more soundly knowing change is in the air! These amendments will provide transparent and useful information for investors and significantly reduce the complexity of recognition and measurement requirements for convertible debt instruments.
ASU 2020-06 also amends guidance for calculated diluted earnings per share, as well as simplifying the settlement assessment for certain contracts in an entity’s own equity, but that’s a topic for a different day!
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