FASB Finalizes Guidance for Simplification of Certain Complex Debt and Equity Instruments
During August 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (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.
With this ASU, the FASB moved forward with its project to reduce the complexity associated with applying U.S. generally accepted accounting principles (GAAP) for certain financial instruments with characteristics of liabilities and equity. Specifically, the ASU results in amendments to the guidance on convertible instruments and the derivatives scope exception for contracts in an entity’s own equity, intended to reduce complexity of accounting while also providing financial statement users with more meaningful information.
As discussed further below, at a boarder level, the FASB’s simplification project on complex debt and equity instrument is ongoing; the objective of this simplification project continues to be reducing the complexity of applying the relevant guidance and associated costs of fair value measurements for certain debt and equity instruments.
What Was Simplified: Convertible Instruments
The accounting update eliminates the cash conversion and beneficial conversion feature models in ASC Topic 470-20 that require an issuer of certain convertible debt and preferred stock to separately account for embedded conversion features as a component of equity. Instead, an issuer will account for these securities as a single unit of account under the traditional convertible debt model.
Conversely, two existing accounting models will continue to require bifurcation from the host contract, and are retained in the revised standard. If the conversion feature: a) meets the criteria for accounting under the substantial premium model, or b) meets the criteria in ASC Topic 815-15 to be considered a derivative, the conversion feature would continue to be separated from the host.
The new guidance also requires entities to disclose all pertinent terms and features of the instruments and information about events or conditions that significantly affect conversion, in other words how users assess the amount or timing of an entity’s future cash flows related to those instruments. In addition, public companies will need to disclose the fair value of the entire instrument and the level of the fair value hierarchy for each convertible debt instrument issued, not in the aggregate as required under legacy guidance.
Simplified: Contracts in an Entity’s Own Equity
Secondly, the ASU simplifies the settlement assessment that entities are required to perform to determine whether a contract qualifies for equity classification by removing certain of the equity classification criteria included in ASC Topic 815-40-25.
With this change, the FASB eliminates a complexity within the legacy guidance that oftentimes required an in-depth understanding of the Securities Act, namely removing the need to assess whether an equity contract permits settlement in unregistered shares. Instead, entities will analyze whether the contract explicitly requires them to settle the contract in cash when registered shares are unavailable. Only contracts that require settlement in cash will be precluded from being classified as equity. Contracts that permit settlement in unregistered shares or are silent about how they will be settled when registered shares are unavailable can be classified as equity.
Further, entities will no longer have to assess whether an equity contract requires any collateral or provides the holder with rights that rank higher than shareholder rights upon bankruptcy. Entities will also now exclude penalty payments related to not filing timely with the Securities and Exchange Commission (SEC) from the equity classification assessment under ASC Topic 815-40-25, because such payments do not result in settlement of the equity contract.
The disclosure requirements for convertible instruments discussed above, with respect to the pertinent terms and features of the instruments and information about events or conditions that significantly affect conversion, will also apply to contracts in an entity’s own equity.
Clarification: Changes to Earnings Per Share Guidance
ASU 2020-06 clarifies that the use of an average market price is required to calculate the diluted earnings per share (EPS) denominator for instruments where the number of shares included in the denominator is variable, such as when the exercise price or number of shares required to settle the contract may change based on an entity’s share price.
The accounting standards update requires entities to use the if-converted method to calculate diluted EPS for convertible instruments, whereas the treasury method was considered acceptable in certain circumstances under legacy GAAP.
For instruments that may be settled in cash or shares, the ASU requires entities to presume share settlement, regardless of whether the entity or the holder can choose between cash and share settlement, in order to reflect the maximum potential dilution in diluted EPS.
The ASU also scopes equity-classified convertible preferred stock that has a down round feature into the recognition and measurement guidance in ASC Topic 260, due to removal of the beneficial conversion feature model from the convertible instrument guidance, discussed above.
Not Included in the Final ASU: Remote Contingent Event Changes
Notably, as part of this initiative, the FASB initially proposed removing the requirement that an entity evaluate potential settlement adjustments if the likelihood of an adjustment occurring is remote, and disregard those provisions under the assessment required in Section 815-40-15 until triggered. The FASB believed it would reduce asserted form-over-substance-based accounting conclusions that are driven by remote contingent events and may result in an outcome that can be difficult to understand.
Due to mixed feedback, the FASB decided to exclude the proposed amendments that would have added a remote threshold to existing guidance in Section 815-40-15 from the scope of this update. Instead, the FASB decided to add a separate project to its technical agenda, Distinguishing Liabilities from Equity Phase 2, to explore improvements to aspects of the derivatives scope exception guidance in Subtopic 815-40. The objective and scope of that separate project will be determined at a future date.
Effective Date and Transition
The amendments in ASU 2020-06 are effective for public business entities that meet the definition of an SEC filer (excluding entities eligible to be smaller reporting companies as defined by the SEC) for fiscal years beginning after Dec. 15, 2021, including interim periods within those fiscal years (generally calendar year 2022). For all other entities, the amendments are effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years (generally calendar year 2024). Early adoption is permitted for all entities for fiscal periods beginning after Dec. 15 2020, including interim periods within the same fiscal year.
The ASU allows entities to elect either a modified, or full retrospective transition method for adopting the standard. Under the modified approach, entities will apply the guidance to all financial instruments outstanding as of the beginning of the year of adoption, with the cumulative effect recognized as an adjustment to beginning retained earnings. Under the full retrospective method, they will apply it to all outstanding financial instruments for each reporting period presented.
For more information about the accounting change, please contact Pieter Combrink at PCombrink@CBIZ.com or 858-232-8681.
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