Convertible Instruments: FASB Encourages Early Adoption of New Rules

In August 2020, the Financial Accounting Standards Board (FASB) issued updated guidance to simplify the accounting rules for convertible instruments and contracts in an entity’s own equity. The changes will provide investors with less-costly, more-comparable information that’s easier to understand.

The updated guidance allows for early adoption but generally no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. A company can adopt the guidance only as of the beginning of its fiscal year. The FASB recently reminded public companies that the simplified rules can be applied in the first quarter this year, as opposed to waiting until the actual effective date next year.

Complex Rules Lead to Restatements, Confusion
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, modifies the accounting rules for reporting convertible instruments. 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.

Historically, accounting for these arrangements has been a complicated issue. Multiple models were used for economically similar instruments, creating 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 separation models for convertible instruments useful and relevant because users generally view and analyze those instruments on a whole-instrument basis.

Keep It Simple
FASB member Gary Buesser recently called the updated guidance “a win-win both for companies and investors.” As a result of the changes, 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. So, more equity contracts will qualify for the accounting exception. The updated guidance also simplifies the diluted earnings-per-share calculation in certain areas, and eliminates noncash interest expense, thereby making the information more relevant.

The update calls for better disclosures about convertible instruments, giving investors more useful information. The old requirements typically covered information about the terms, features and accounting effects of convertible instruments in the financial statements. The new rules provide investors with fair value information for the whole instrument, rather than simply the debt component. And new disclosures will explain events or conditions that cause the conversion contingencies to be met. For example, if the conversion features changed in the event of a business combination, the disclosures would enable investors to understand what that potential impact would be.

Effective Dates Vary By Company Size
Companies must choose between the following methods to transition the rules:
A modified retrospective method. This technique requires an adjustment to opening retained earnings during the year of adoption of the new rules to reflect the accounting difference between the new standard and prior guidance. Opening retained earnings will usually increase under this method, because the adjustment reverses noncash interest expense recognized under prior guidance.

A full retrospective method. Under this technique, an adjustment for the accounting difference is made to the opening retained earnings of the first comparative year presented in the financial statements.

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 and for all other entities (including private companies), it’s effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.

Adopt Now or Later?
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.