ASU 2020-06 Summary: Key Accounting Changes

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-06 to reduce the complexity associated with accounting for certain financial instruments. This update primarily targets convertible instruments, such as convertible debt and preferred stock, which have features of both liabilities and equity. The main objective is to simplify the accounting treatment for these instruments by removing complex separation models previously required under U.S. Generally Accepted Accounting Principles (GAAP). Consequently, these changes also affect the calculation of diluted earnings per share (EPS), aiming for greater comparability and transparency in financial reporting.

Simplifying the Accounting for Convertible Instruments

Previously, accounting for convertible instruments under Accounting Standards Codification (ASC) 470-20 required companies to separate a single instrument into debt and equity components. This was necessary if the instrument contained a beneficial conversion feature (BCF) or a cash conversion feature (CCF). These features were identified, measured, and accounted for separately, a process that was complex and led to reporting inconsistencies.

ASU 2020-06 streamlines this process by eliminating the BCF and CCF accounting models. Under the new guidance, most convertible instruments are accounted for as a single unit. The embedded conversion feature is no longer separated from the host debt instrument unless it must be bifurcated as a derivative under ASC 815, which simplifies initial accounting and subsequent measurements.

By accounting for the convertible instrument as a single liability, the full principal amount is recorded as debt on the balance sheet. This results in a higher reported debt balance compared to the previous method where a portion was allocated to equity. This approach also leads to a reduction in the periodic interest expense, as the debt discount created by the equity component is no longer amortized.

This revised approach provides financial statement users with a clearer picture of a company’s obligations. The single-unit method ensures that the carrying amount of the debt more closely reflects its settlement value.

Revisions to the Earnings Per Share Calculation

The changes under ASU 2020-06 directly influence how companies calculate diluted earnings per share (EPS). The update mandates using a single method for determining the dilutive effect of these instruments, which enhances consistency and provides investors with a more uniform measure of per-share performance.

The new guidance requires all companies to use the “if-converted” method for calculating diluted EPS for their convertible instruments. Under this method, the calculation assumes the convertible securities were converted into common stock at the beginning of the reporting period, or at the time of issuance if later. The numerator of the EPS calculation is adjusted by adding back the interest expense, net of tax, while the denominator is increased by the number of common shares that would have been issued upon conversion.

This marks a departure from previous rules, where methods like the treasury stock method could be used, often resulting in less reported dilution. The guidance also requires an assumption of share settlement for instruments that can be settled in cash or shares, which increases the share count in the diluted EPS calculation.

New Disclosure Requirements

ASU 2020-06 introduces new and amended disclosure requirements to provide financial statement users with more transparent information. These requirements are designed to offer insight into the terms of convertible instruments and how they affect a company’s financial position and performance within the footnotes.

The updated guidance mandates that companies provide information about the rights and privileges of the instruments. For public business entities, new disclosures include:

• The fair value of the convertible instrument as a whole, at the individual instrument level.
• The principal amount of the debt.
• Any unamortized discount or premium.
• Information about events or conditions that could cause conversion.

The disclosures must also explain how the convertible instruments were treated in the diluted EPS calculation. This includes detailing the number of shares that were included in the denominator for the potential conversion of the securities.

Effective Dates and Transition Guidance

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 rules became effective for fiscal years beginning after December 15, 2023. Early adoption was permitted, but not before fiscal years beginning after December 15, 2020.

Companies have two primary methods for transitioning to the new standard: the modified retrospective method and the full retrospective method. Under the modified retrospective approach, a company applies the new rules to the beginning of the fiscal year of adoption, recording a cumulative-effect adjustment to the opening balance of retained earnings. Prior period financial statements are not restated.

Alternatively, the full retrospective method requires a company to restate its financial statements for all prior periods presented as if the new guidance had always been in effect. This approach provides greater comparability across all periods shown in the financial statements but requires more effort to implement.