ASU 2020-06: New Accounting for Convertible Instruments

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-06 to simplify the complex accounting for certain financial instruments, specifically convertible instruments and contracts in an entity’s own equity. The update responds to feedback that previous rules were overly complex and costly, aiming to make financial statements more understandable and comparable.

Simplified Accounting for Convertible Instruments

Previously, accounting for convertible instruments under Accounting Standards Codification (ASC) 470-20 involved complex models. ASU 2020-06 eliminates two of these: the cash conversion feature (CCF) and the beneficial conversion feature (BCF) models. The BCF model, for instance, required measuring an “in-the-money” conversion option at issuance, creating a separate equity component. The CCF model applied to instruments that could be settled in cash upon conversion, also requiring separation into liability and equity parts.

This separation created complexity. For example, a company issuing $1 million of convertible debt might have attributed $100,000 of the proceeds to the conversion feature. This resulted in recording a liability of $900,000 and an equity component of $100,000. The company would then amortize the resulting debt discount back to the full $1 million face value over the debt’s term, increasing interest expense.

The new guidance simplifies this by eliminating the BCF and CCF models. Under ASU 2020-06, a convertible instrument is accounted for as a single liability or equity instrument unless a feature requires bifurcation as a derivative under ASC 815. Using the same example, a company issuing $1 million of convertible debt would now record the entire amount as a liability. This change removes the need for the initial separation and subsequent amortization, resulting in a more straightforward balance sheet and reduced non-cash interest expense.

Revised Guidance for the Derivatives Scope Exception

ASU 2020-06 revises the derivatives scope exception in ASC 815-40, which applies to contracts in an entity’s own equity. This exception allows contracts like warrants or conversion options to be classified as equity instead of as derivatives. Derivative accounting requires marking instruments to fair value each reporting period, with value changes impacting the income statement and causing earnings volatility.

The previous guidance contained stringent conditions that could prevent a contract from qualifying for the exception. For example, a contract could be forced into derivative accounting if it could be settled in cash under circumstances outside the company’s control. Another condition related to settlement in unregistered shares, which could also cause the contract to be classified as a liability.

The new update removes three of the more restrictive conditions, including the one related to settlement in unregistered shares. Under the new guidance, the potential for settlement in unregistered shares no longer automatically prevents a contract from being classified as equity. These modifications increase the likelihood that freestanding warrants and other equity-linked instruments will qualify for the scope exception and be classified as equity, reducing the number of contracts subject to derivative accounting.

Amendments to Earnings Per Share Calculations

The update also standardizes the calculation of diluted Earnings Per Share (EPS) for companies with convertible instruments. Previously under ASC 260, companies could use different methods to calculate the dilutive impact of these securities. For many instruments, the “if-converted” method was used, but for others, the “treasury stock” method might have been applied.

ASU 2020-06 mandates the use of the if-converted method for all convertible instruments in the diluted EPS calculation. This change eliminates variability and simplifies the process. The if-converted method assumes the convertible security was converted into common stock at the beginning of the reporting period, or at the time of issuance if later.

To apply the if-converted method, two adjustments are made to the diluted EPS formula. First, the numerator (net income) is increased by the after-tax interest expense associated with the convertible debt, as this interest would not be paid upon conversion. Second, the denominator (weighted-average shares) is increased by the number of additional common shares that would have been issued.

A significant change relates to instruments that may be settled in cash or shares. Previously, companies could sometimes overcome the presumption of share settlement if they had a policy of settling in cash. ASU 2020-06 requires entities to presume share settlement for such instruments when calculating diluted EPS, ensuring the calculation reflects maximum potential dilution.

New Disclosure Requirements

ASU 2020-06 enhances disclosure requirements to provide users with more transparent information about a company’s convertible instruments and equity-linked contracts. The expanded disclosures are intended to compensate for the simplification of the accounting models. The goal is to give investors a complete picture of the nature and risk of these instruments, including their effect on liquidity, capital resources, and potential EPS dilution.

New disclosures for all entities must detail the rights and privileges of convertible instruments, including conversion features and any events that could alter them. Companies must also disclose information about events or changes in circumstances during the reporting period that cause a change in the instrument’s accounting.

Public business entities have additional disclosure requirements. For convertible debt accounted for as a single liability, these entities must disclose the instrument’s fair value at the financial statement date. They must also provide information about the debt’s subordination level and details about interest rate coupons.

Adoption Dates and Transition Guidance

The effective dates for ASU 2020-06 varied. For public business entities that are SEC filers, excluding smaller reporting companies, the standard was effective for fiscal years beginning after December 15, 2021. For all other entities, the amendments were effective for fiscal years beginning after December 15, 2023. Early adoption was permitted for fiscal years beginning after December 15, 2020.

Companies had two transition options, the first being the modified retrospective method. Under this method, a company applies the new guidance to instruments outstanding as of the beginning of the fiscal year of adoption. The cumulative effect of the change is recorded as an adjustment to the opening balance of retained earnings, and prior period financial statements are not restated.

The second option, the full retrospective method, requires a company to apply the new guidance as if it had always been in effect. This involves restating the financial statements for all prior periods presented in the report. While this method provides greater comparability across periods, it is more operationally intensive.