October 14, 2020

Convertible Debt & Equity-Linked Instrument Accounting Simplified


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Companies tapping the capital markets in 2020 still need to apply old complex rules to account for convertible debt and equity-linked instruments. Accounting for these instruments has been considerably simplified, but most calendar year-end companies will only benefit after 2020[1]&[2].

More Convertible Debt Accounted For as a Whole

As simplified, convertible debt will only require separate accounting for an embedded conversion feature that is either an embedded derivative or the instrument was issued at a substantial premium[3]. This will result in more convertible debt being accounted for as a single liability measured at amortized cost with an interest rate closer to the coupon interest rate. Because this guidance is also applicable to convertible preferred stock, more instruments will be considered a single equity instrument measured at historical cost.

Historically, the accounting analysis of convertible debt considered multiple complex models. Two of those models have been eliminated, which will generally result in fewer embedded conversion features requiring separation.

This table illustrates the typical convertible debt analysis sequence and highlights the steps eliminated:

Step Analysis Yes No
Derivative Derivative and no exception from derivative accounting? Debt is measured as residual after deducting fair value of derivative Next step
Cash Conversion Settled in cash or other assets? Liability component measured at fair value (including any embedded features other than the conversion feature) with difference from proceeds, being the conversion feature recognized in additional-paid-in-capital. Debt is measured as residual of liability component after deducting other embedded derivatives Next step Eliminated
Beneficial Conversion Nondetachable conversion feature in the money at commitment date (i.e., exercise price is less than the current fair value of the share)? Debt is measured as residual after deducting intrinsic value of beneficial conversion feature recognized as additional-paid-in-capital and other embedded derivatives Next step
Substantial Premium Issued at substantial premium? Debt is measured as residual after deducting premium recognized as additional-paid-in-capital No accounting for conversion feature
SEC registrants Consider conversion features separated into equity for presentation in temporary equity[4] Temporary equity Permanent equity

More Equity-Linked Instruments Accounted For in Equity

Currently, when determining if a contract indexed to, and settled in, its own stock can be classified in equity through an exception to derivative accounting, companies will perform a detailed analysis of whether the contract meets specific conditions to be classified as equity, such as settlement in unregistered shares[5], which often requires legal analysis and can result in form-over-substance-based accounting conclusions.

This guidance is also used to determine if instruments are in scope of the SEC’s redeemable equity guidance. A common example requiring this analysis is a redeemable non-controlling interest when the issuer has the option to settle the redemption in cash or its shares.

The analysis has been simplified to remove the requirement to analyze whether the contract permits settlement in unregistered shares (along with other simplifications). Now, if the contract specifies, or is silent on, settlement in unregistered shares, the contract will be classified in equity, provided there is no other explicit requirement to settle in cash[6].

This means that more contracts will be classified in equity with fewer form-over-substance-based accounting conclusions.

Our Viewpoint

The simplifications are significant and welcomed. However, as they can only be adopted by calendar year-end companies from 2021, most companies issuing instruments in 2020 will have to apply the current complex rules in their 2020 financial statements, and shortly thereafter, amend their future financial statements to reflect the new accounting if early adopting the simplifications.

Example

A company completes its Initial Public Offering in late 2020 and determines that its redeemable non-controlling interest, settleable at the company’s option in its shares or cash, needs to be classified as temporary equity because settlement is required in registered shares.

If the company adopts the new guidance in 2021, the non-controlling interest will be reclassified to permanent equity in its first quarter financial statements.

 

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[1] ASU 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.

[2] For most public companies, the guidance is effective for annual periods beginning after 15 December 2021, and interim periods therein. For other entities, it is effective for annual periods beginning after 15 December 2023, and interim periods therein. Early adoption is permitted in fiscal years beginning after 15 December 2020. Entities with convertible instruments that include a down round feature who have not yet adopted the amendments in ASU 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, and (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, can early adopt the amendments for fiscal years beginning after December 15, 2019.

[3] ASC 470-20, Debt with Conversion and Other Options [Debt].

[4] ASC 480-10-S99, SEC Materials [Distinguishing Liabilities from Equity]

[5] ASC 815-40-25, Contracts in Entity’s Own Equity [Derivatives and Hedging].

[6] And the other requirements in ASC 815-40-25 as amended by ASU 2020-06 are met.