Back in August 2020, we published a blog announcing the long-anticipated issuance of ASU 2020-06 Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. ASU 2020-06 simplifies financial reporting for certain convertible debt instruments. At the time, many practitioners may have resisted the urge to burst out in song, much like Julie Andrews in the opening scene of The Sound of Music.

Our first blog on ASU 2020-06 focused on the elimination of one of the five accounting models: beneficial conversion features. This blog will focus on the significant changes made to another accounting model, the derivative model in ASC 815 Derivatives and Hedging.

An entity must first evaluate whether a convertible debt instrument initially in scope of ASC 815 Derivatives and Hedging. If the conversion feature does not qualify as an embedded derivative, an entity should instead apply ASC 470 Debt to account for the convertible debt instrument.

ASC 815 Derivatives and Hedging applies to freestanding financial instruments and embedded features that have the characteristics of a derivative instrument and freestanding financial instruments that potentially may be settled in an entity’s own stock. ASC 815-15 includes specific criteria that must be met for an instrument or feature to be bifurcated from the host instrument and accounted for separately. 

Before diving too deep into the criteria necessary to classify a conversion feature as a derivative, entities must first evaluate some scope exceptions in ASC 815-40. These scope exceptions relate to contracts indexed to an entity’s own equity. If certain conditions are present, the convertible debt instrument and the conversion features within the convertible debt instrument would not require bifurcation and separate accounting as a derivative. These conditions are classified into two criteria:

1. Indexation criterion: The instrument’s or the embedded derivative feature’s settlement amount is based on the difference between (1) a fixed amount of consideration and (2) the fair value of a fixed number of the entity’s shares
2. Settlement criterion: The instrument or the embedded feature would otherwise qualify for equity classification

Both criteria must be present to meet the scope exception and therefore result in an instrument following accounting outside of ASC 815. The intention of this scope exception is one of substance over form. The accounting for instruments should align with the spirit of the underlying arrangement – one that (eventually) results in stock ownership and thus should be classified within equity.

While both of the above criteria require extensive analysis, the conditions identified within ASC 815-40 pertaining to the settlement criteria led to practical implementation issues. The analysis required an evaluation of the settlement optionality as well as conditions necessary for settlement. Legacy guidance included seven conditions to evaluate when performing this analysis, many of which promoted form-over-substance based conclusions in practice. Each of these conditions is summarized below, along with modifications to the conditions as a result of the issuance of ASU 2020-06.

Let’s review the conditions that changed as a result of ASU 2020-06:

(a) Settlement permitted in unregistered shares

The amendments remove the requirement that the convertible debt instrument must permit settlement in unregistered shares in order to meet the settlement criterion. The intention of the revision is to focus the analysis on the contractual features within the agreement. Therefore, if an agreement is silent as to settlement terms or does not specify the form of the settlement, the absence of specific share settlement criteria does not preclude an instrument meeting the settlement criteria. However, if a settlement feature explicitly requires settlement in cash in the event shares are unavailable, this feature would automatically result in the instrument not meeting the settlement criteria.

(d) No required cash payments if entity fails to timely file

The amendments clarify that penalty payments triggered as a result of an entity’s failure to timely file with the SEC do not preclude equity classification. This is because the cash payments associated with filing penalties do not impact the settlement of the instrument or conversion feature. However, the existence of cash settlement features of the underlying instrument or conversion feature would still result in the instrument not meeting the settlement criterion.

(f) No counterparty risks rank higher than shareholder rights

The amendments remove the requirement that shareholder rights must be higher than other counterparty claims in the event of bankruptcy. This feature is often present for certain creditors and precluded certain instruments from meeting the settlement criterion. For example, the ranking of rights in the event of a bankruptcy does not change the nature of the underlying instrument or conversion feature. Rather, it only impacts the priority of proceeds distribution.

(g) No collateral required

The amendments remove the condition that the existence of a requirement to post collateral results in an instrument or conversion feature not meeting the settlement criterion.

Modifications to the settlement criterion conditions described above result in the retention of the spirit of the scope exception in ASC 815-40, which is to ensure proper classification of equity instruments. If settlement of convertible instruments result in anything other than ownership, the instrument should not be classified as equity. This should also reduce the complexity of evaluating convertible debt arrangements by reducing the focus on the form of the arrangements.

Many practitioners should breathe a sigh of relief with the revisions to the required analysis under ASC 815-40 for convertible debt instruments. These modifications should result in an increase in the number of convertible instruments meeting the scope exception in ASC 815-40 and thus precluding bifurcation and separate accounting.

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