The Financial Accounting Standards Board (FASB) recently issued new guidance to simplify the accounting rules for convertible instruments and contracts in an entity’s own equity. Though narrower than initially proposed, the changes will provide investors with more-comparable information that’s easier to understand. Here are some FAQs about the changes.
Why are the rules changing?
A convertible instrument is a bond or a preferred stock that can be converted into shares of a company’s common stock. Some companies use convertible debt as an alternative financing solution.
Accounting for these arrangements is a complicated issue. Under current U.S. Generally Accepted Accounting Principles (GAAP), there are multiple models for economically similar instruments. This creates unnecessary complexity and significant cost when accounting for convertible instruments.
In turn, difficulty navigating and understanding the guidance often contributes to accounting restatements. Plus, most financial statement users don’t find the current separation models for convertible instruments useful and relevant because users generally view and analyze those instruments on a whole-instrument basis.
Accounting Standards Update (ASU) No. 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, was issued on August 5. Under the new rules, more convertible instruments will be reported as a single liability or equity with no separate accounting for embedded conversion features.
Another change is the removal of certain types of settlement conditions that were required for equity contracts to qualify for the exception under derivative rules. As a result, more equity contracts will qualify for the accounting exception. The updated guidance also simplifies the diluted earnings-per-share (EPS) calculation in certain areas.
“The ASU is an important step in simplifying a complex area of accounting guidance that has been a frequent source of financial statement restatements,” said FASB Vice Chairman James Kroeker. “We expect it to improve comparability of information for financial statement users and reduce cost and complexity for preparers and auditors.”
When do the changes go into effect?
For large public companies, ASU 2020-06 takes effect for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For smaller reporting companies as defined by the Securities and Exchange Commission (SEC) and for all other entities, it’s effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.
ASU No. 2020-06 allows for early adoption but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. A company can only adopt the guidance as of the beginning of its fiscal year.
The rules state that a company can early adopt the amendments in ASU No. 2020-06 for convertible instruments that include a down-round feature if the company hasn’t yet adopted ASU No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. For these instruments, early adoption is permitted for fiscal years beginning after December 15, 2019.
To early adopt or wait?
ASU 2020-06 simplifies the accounting for convertible instruments and contracts in an entity’s own equity — and significantly lowers the risk of misstating financial results. So, companies that use this alternative form of financing should consider taking advantage of the option to adopt the rules early. Contact your CPA to determine what’s right for your organization.