Koch’s Corner: Confused About Accounting for Convertible Instruments & Contracts in an Entity’s Own Equity? Relief is on the Way!

Koch’s Corner delivers concise, “need to know” summaries of important updates on accounting and assurance issues for privately-held companies.

By Richard Koch, CPA
Director of Quality Control at Gray, Gray & Gray

Many small businesses – particularly microcaps – undertake financing in the form of convertible debt and convertible preferred stock, as they may not qualify for a traditional bank term loan and line of credit. These microcaps may frequently engage in transactions involving their own securities to raise funds or pay for goods and/or services due to limited cash reserves.

But accounting for financial instruments with characteristics of liabilities and equity have typically involved complexities that can contribute to multiple financial statement restatements and confusion among users. Thankfully, relief is on the way, in the form of more clear-cut guidance from the Financial Accounting Standards Board (FASB).

In August 2020, FASB issued Accounting Standards Update No. 2020-06, “Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity.” The update amends two previous updates concerning “Debt-Debt with Conversion and Other Options” and “Derivatives and Hedging – Contracts in Entity’s Own Equity.”

Convertible Instruments

For convertible instruments, FASB decided to reduce the number of accounting models for convertible debt instruments and convertible preferred stock. Current guidance provides for five accounting models for convertible debt instruments – the traditional convertible debt model that recognizes a convertible debt instrument as a single debt instrument – and four other models under different measurement guidance requiring the convertible debt instrument be separated into a debt component and an equity or a derivative component.  Convertible preferred stock also is required to be assessed under similar models.

In response to the feedback received from users, FASB has simplified the accounting for convertible instruments by removing certain separation models. Under ASU No. 2020-06, the embedded conversion features will no longer be separated from the host contract for convertible instruments with conversion features that are not required to be accounted for as derivatives. Consequently, a convertible debt instrument will be accounted for as a single liability measured at its amortized cost, while a convertible preferred stock will be accounted for as a single equity instrument measured at its historical cost (as long as no other features require bifurcation and recognition as derivatives).

FASB also increased information transparency by making amendments which expand disclosures of convertible instruments.

Derivatives Scope Exception for Contracts in an Entity’s Own Equity

Under current guidance regarding contracts in an entity’s own equity, an entity must determine whether a contract qualifies for a scope exception from derivative accounting. The scope exception includes two criteria: (1) the contract is indexed to an entity’s own stock; and (2) the contract is equity classified.  If both of these criteria are not met, the contract must be recognized as an asset or liability. The current guidance includes seven conditions for performing an assessment of the settlement criterion.

The amendments in ASU No. 2020-06 remove settlement in unregistered shares, collateral, and shareholder rights from the settlement guidance; in addition to providing scope clarifications and the addition of a few requirements.

Earnings Per Share (“EPS”)

FASB believes the above amendments improve the consistency of the EPS calculations by aligning the diluted EPS calculation for convertible instruments by requiring an entity to use the “if-converted” method. The treasury stock method should no longer be used to calculate diluted EPS for convertible instruments.  FASB also added a few other requirements and clarifications.

Effective Dates and Transition

ASU No. 2020-06 is effective for SEC filers (excluding smaller reporting companies) for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.  Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years.  This new guidance should be adopted at the beginning of an entity’s fiscal year.

Entities may adopt the guidance through either a modified retrospective method of transition or a fully retrospective method of transition. In applying the modified retrospective method, entities should apply the guidance to transactions outstanding as of the beginning of the fiscal year in which the amendments are adopted.  Transactions that were settled (or expired) during prior reporting periods are unaffected.  The cumulative effect of the change should be recognized as an adjustment to the opening balance of retained earnings at the date of adoption.  If an entity elects the fully retrospective method of transition, the cumulative effect of the change should be recognized as an adjustment to the opening balance of retained earnings in the first comparative period presented.

If you have questions regarding the early adoption of ASU No. 2020-06, please contact me at (781) 407-0300, or via e-mail at rkoch@gggcpas.com.

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