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10.3 ASU 2020-06 transition approach

Publication date: 28 Feb 2021

us Financing guide

ASU 2020-06 requires adoption using one of following two methods:

Modified retrospective method: Apply the ASU to financial instruments outstanding as of the beginning of the fiscal year of adoption, with the cumulative effect of adoption recognized at the date of initial application through an adjustment to the opening balance of retained earnings. Under this method, EPS amounts are not restated in prior periods presented. For example, if a calendar year public business entity early adopts the ASU, the cumulative effect of adoption would be recognized on January 1, 2021.
Full retrospective method: Apply the ASU to financial instruments outstanding as of the beginning of the first comparative reporting period presented and financial instruments issued thereafter in accordance with the guidance on accounting changes in ASC 250-10-45-5 through ASC 250-10-45-10. Under this method, EPS for all prior comparative reporting periods should be restated.

Both methods of adoption require a reporting entity to calculate the impact of adopting the new guidance assuming they had been applying the ASU as of the issuance date for all instruments outstanding as of:

the date of adoption (e.g., January 1, 2022 for a calendar year public business entity that does not early adopt) for a reporting entity electing the modified retrospective method, or
the beginning of the first comparative reporting period presented for a reporting entity electing the full retrospective method.

ASC 815-40-65-1(d) also allows a reporting entity to make a one-time irrevocable election to apply the fair value option in ASC 825-10 as of the date of adoption for any liability classified convertible securities that are within the scope of ASC 825-10. The impact of electing the fair value option would be reflected through a cumulative effect adjustment to the opening retained earnings balance as of the beginning of the first reporting period a reporting entity adopted ASU 2020-06.

The new guidance requires reporting entities to assume share settlement, when an instrument can be settled in cash or shares at the reporting entity’s option, for purposes of computing diluted EPS.

10.3.1 Transition for convertible instruments

The ASU simplifies the accounting for convertible instruments by eliminating the cash conversion and the beneficial conversion feature (BCF) accounting models for convertible debt and convertible preferred stock.

10.3.1.1 Transition for convertible debt with cash conversion

The cash conversion model before the adoption of ASU 2020-06 is applicable to a convertible debt instrument when (1) the conversion option is not required to be separately accounted for as a bifurcated derivative pursuant to ASC 815-15, and (2) the instrument by its stated terms may be settled in cash (or other assets) upon conversion, in whole or in part. The objective of this model is to report an interest cost that is comparable to that which would have been incurred had the reporting entity issued debt without a conversion option. This is achieved by separating the equity component (conversion option) from the liability component, thereby creating a discount on the debt, which is then amortized through interest expense over the expected life of the instrument. See FG 6.6A for further information on convertible debt with a cash conversion feature before adoption of ASU 2020-06.

The elimination of the cash conversion sub-sections of ASC 470-20 results in these instruments being recorded as a single liability. As a result, the discount created by recognition of a component of the convertible debt in equity is eliminated and interest expense is reduced. As discussed in Question FG 10-1, the change in interest expense may also impact capitalized interest. Adjustments to previously recorded interest expense may also impact book/tax differences and deferred tax balances.

Example FG 10-1 illustrates the accounting as of the transition date for a convertible debt instrument with a cash conversion feature.

EXAMPLE FG 10-1
Transition of convertible debt with cash conversion feature upon adoption of ASU 2020-06

FG Corp, a calendar year-end public company, adopts ASU 2020-06 on January 1, 20X4. At the adoption date, FG Corp has convertible debt outstanding, which was issued on January 1, 20X1. Information about this debt is summarized in the following table.


Convertible debt issuance date	January 1, 20X1
FG Corp’s stock price at issuance date	$85
Principal amount	$1,000
Coupon rate	2% paid annually on December 31
Years to maturity	7 years
Issuer call option	2 years and thereafter
Investor put option	5 years and thereafter
Conversion price	$100
Conversion terms	Investors can convert in any quarter following a quarter in which FG Corp’s stock price traded at or above $110 for at least 45 days
Conversion settlement	Upon conversion, the investor will receive the principal amount (i.e., $1,000) in cash and net shares equal to value, if any, due to the conversion option being in the money

This example ignores the effects of debt issuance costs, accrued interest, and income taxes for simplicity.

How should FG Corp transition the convertible debt outstanding at the ASU 2020-06 adoption date under (1) the modified retrospective method, and (2) the full retrospective method?

Analysis

Before adoption of ASU 2020-06

At convertible debt issuance date (January 1, 20X1)

At the issuance date (i.e., January 1, 20X1), FG Corp concludes that the convertible debt is within the scope of the cash conversion guidance in ASC 470-20 and should be separated into its debt and equity components.

FG Corp determines that a nonconvertible debt instrument with the same terms would have an expected life of five years because its debt instrument is puttable by investors at the beginning of year six. Based on its analysis of 5-year nonconvertible debt with similar terms issued by companies with similar credit quality, FG Corp determines the coupon rate for a nonconvertible debt instrument with the same terms to be 8.02%. Using a present value calculation, FG Corp determines the initial carrying value of the debt as $760. The residual amount of proceeds allocated to the equity component is therefore $240 (the difference between the $1,000 proceeds and $760 debt liability).

The debt balance at the beginning and end of each year, along with the annual amortization of the discount on the debt using the effective interest method, is shown in the following table.

	20X1	20X2	20X3	20X4	20X5	Total
Debt balance at beginning of period ⁽¹⁾	$760	$801	$845	$893	$944
Amortization of discount on debt ⁽²⁾	41	44	48	51	56	240
Debt balance at end of period ⁽¹⁾	$801	$845	$893	$944	$1,000
⁽¹⁾The present value of the remaining $20 annual coupon payments ($1,000 * 2% = $20) plus present value of $1,000 principal payment at the end of the fifth year using 8.02% annual discount rate. ⁽²⁾Debt balance at the end of the year minus debt balance at the beginning of the year.

FG Corp records the following journal entry on January 1, 20X1 to recognize the receipt of cash proceeds from the issuance of the convertible debt instrument and its separation into liability and residual equity components.

Dr. Cash	$1,000
Dr. Convertible debt discount	$240
Cr. Convertible debt		$1,000
Cr. Additional paid-in capital (conversion option)		$240

During the first year (20X1)

FG Corp records the following journal entry to recognize the amortization of the debt discount and payment of interest.

Dr. Interest expense	$61
Cr. Cash		$20
Cr. Convertible debt discount		$41

During the second year (20X2)

FG Corp records the following journal entry to recognize the amortization of the debt discount and payment of interest.

Dr. Interest expense	$64
Cr. Cash		$20
Cr. Convertible debt discount		$44

During the third year (20X3)

FG Corp records the following journal entry to recognize the amortization of the debt discount and payment of interest.

Dr. Interest expense	$68
Cr. Cash		$20
Cr. Convertible debt discount		$48

The following table summarizes FG Corp’s balance sheet and income statement as of and for the years ended December 31, 20X1, 20X2, and 20X3 (assume the convertible debt is FG Corp’s only contract).

Before ASU 2020-06

		20X1	20X2	20X3
Balance sheets
Cash		$$980	$$960	$>$940
	Total assets	980	960	940
Convertible debt		1,000	1,000	1,000
Convertible debt discount		(199)	(155)	(107)
	Total liabilities	801 ⁽¹⁾	845 ⁽¹⁾	893 ⁽¹⁾
Additional paid-in capital (conversion option)		240	240	240
Retained earnings		(61) ⁽²⁾	(125) ⁽²⁾	(193) ⁽²⁾
	Total stockholders’ equity	179	115	47
	Total liabilities and stockholders’ equity	980	960	940
Income statements
Interest expense		61	64	68
Net loss		($61)	($64)	($68)
⁽¹⁾Convertible debt balance (see the amortization table above for details). ⁽²⁾Retained earnings at the beginning of the year plus interest expense recognized for the year.

Upon adoption of ASU 2020-06 on January 1, 20X4

Under the ASU, due to the elimination of the cash conversion accounting model, FG Corp determined that it should account for the convertible debt as a liability in its entirety (i.e., there is no separation of the conversion feature and all proceeds are allocated to the convertible debt instrument as a single unit of account).

If the ASU had been applied to the debt from the issuance date onwards, FG Corp would have recorded the following journal entry.

At convertible debt issuance date (January 1, 20X1)

FG Corp recognizes the cash proceeds from the issuance of convertible debt with a cash conversion option.

Dr. Cash	$1,000
Cr. Convertible debt		$1,000

During 20X1, 20X2, and 20X3

Annually, FG Corp recognizes the interest payments made during 20X1, 20X2 and 20X3.

Dr. Interest expense	$20
Cr. Cash		$20

At ASU 2020-06 adoption date on January 1, 20X4

(1) Modified retrospective transition method

If FG Corp elects the modified retrospective transition method, it should record the following transition adjustment journal entry at the adoption date (i.e., January 1, 20X4).

Dr. Additional paid-in capital (conversion option)	$240 ⁽¹⁾
Cr. Convertible debt discount		$107 ⁽²⁾
Cr. Retained earnings		$133 ⁽³⁾
⁽¹⁾ To derecognize the portion of the proceeds that was separated from the liability component and allocated to equity due to the cash conversion feature. ⁽²⁾ To derecognize the remaining convertible debt discount balance as of January 1, 20X4 ($240 discount on debt minus $133 cumulative amortization of the discount on debt in each of 20X1, 20X2 and 20X3). ⁽³⁾ To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X4, representing the reversal of the sum of the interest expense in 20X1 ($41), 20X2 ($44) and 20X3 ($48) due to amortization of convertible debt discount under prior GAAP.

The comparative financial statements for 20X2 and 20X3 remain unchanged in the 20X4 financial statements.

(2) Full retrospective transition method

If FG Corp elects the full retrospective transition method, it should record the following transition adjustment journal entry as of the beginning of the first comparative period presented in the 20X4 financial statements (i.e., January 1, 20X2).

Dr. Additional paid-in capital (conversion option)	$240 ⁽¹⁾
Cr. Convertible debt discount		$199 ⁽²⁾
Cr. Retained earnings		$41 ⁽³⁾
⁽¹⁾ To derecognize the portion of the proceeds that was separated from the liability component and allocated to equity due to the cash conversion feature. ⁽²⁾ To derecognize the remaining convertible debt discount balance as of January 1, 20X2. ⁽³⁾ To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X2, representing the reversal of the interest expense in 20X1 due to amortization of convertible debt discount under prior GAAP.

In addition, FG Corp should revise its 20X2 and 20X3 financial statements to reflect the effects of the changes under the ASU. The following table summarizes FG Corp’s balance sheet and income statement upon adoption of ASU 2020-06 under the full retrospective transition method.

After ASU 2020-06		January 1, 20X2	December 31, 20X2	December 31, 20X3
Balance sheets
Cash		$980	$960	$940
	Total assets	980	960	940
Convertible debt		1,000	1,000	1,000
	Total liabilities	1,000	1,000	1,000
Retained earnings		(20) ⁽¹⁾	(40) ⁽²⁾	(60) ⁽²⁾
	Total stockholders’ equity	(20)	(40)	(60)
	Total liabilities and stockholders’ equity	$980	960	940
Income statements
Interest expense			20	$20
Net loss			($20)	($20)
⁽¹⁾This amount is the interest expense recognized in FY 20X1. It is calculated as the difference between retained earnings balance as of December 31, 20X1, under prior GAAP ($61) and the cumulative adjustment to opening retained earnings as of January 1, 20X2 ($41). ⁽²⁾Retained earnings at the beginning of the year plus interest expense recognized for the year.

Based on the above, the reversal of interest expense previously recorded for amortization of debt discount in 20X2 and 20X3 would result in an increase in the net income (or decrease in net loss) for 20X2 and 20X3 by $44 and $48, respectively. The statement of changes in equity, statement of cash flows and EPS for the 20X2 and 20X3 comparative reporting periods should be restated accordingly.

10.3.1.2 Transition for convertible instruments with BCF

The beneficial conversion feature (BCF) accounting model before the adoption of ASU 2020-06 applies to convertible debt and convertible preferred stock with non-detachable conversion features that are “in the money” at the commitment date (typically, the issuance date) and are not separately accounted for under the derivatives guidance in ASC 815. Under this model, the beneficial conversion feature is recognized by allocating a portion of the proceeds equal to the intrinsic value of the conversion feature to equity (typically, additional paid-in capital) with the remaining proceeds recognized as a liability (if convertible debt) or as equity (if convertible preferred stock). The allocation of intrinsic value to equity creates a discount on the debt or preferred stock. See FG 6.7A (convertible debt) and FG 7.3.2.2A (convertible preferred stock) for further information on convertible instruments with a BCF before adoption of ASU 2020-06.

The elimination of the BCF accounting model results in these instruments being recorded as a single liability (if convertible debt) or a single preferred equity instrument (if preferred stock). As a result, the discount created by recognition of the BCF is eliminated which reduces the amount of interest expense (or the deemed dividend in the case of convertible preferred stock). In the case of convertible debt, adjustments to previously recorded interest expense may impact book/tax differences and deferred tax balances.

Example FG 10-2 illustrates the transition accounting for convertible preferred stock with a BCF.

EXAMPLE FG 10-2
Transition of convertible preferred stock with BCF upon adoption of ASU 2020-06

FG Corp, a calendar year-end public company, adopts ASU 2020-06 on January 1, 20X4. At the adoption date, FG Corp has convertible preferred stock with a BCF along with 100 detachable warrants to purchase common stock outstanding. Information about this instrument is summarized in the following table.


Convertible preferred stock with detachable warrants commitment date	January 1, 20X1 (this is also the issuance date)
Convertible preferred stock stated value	$1,000
Convertible preferred stock stated conversion price	$20
Number of detachable warrants	100 warrants for common stock at a strike price of $20/share
FG Corp’s stock price at issuance date	$18/share
Cash proceeds at issuance date	$1,000
Investor put option	After 5 years and thereafter
Conversion option	After 4 years and thereafter

This example ignores the effects of preferred stock issuance costs for simplicity.

What is the appropriate transition adjustment for the convertible preferred stock with a BCF under (1) the modified retrospective method, and (2) the full retrospective method?

Analysis

Before adoption of ASU 2020-06

At the convertible preferred stock issuance date (January 1, 20X1)

Warrant discount

FG Corp concludes that the convertible preferred stock and the detachable warrants meet the requirements for equity classification.

Since the warrants are classified as equity, FG Corp allocates the proceeds from the issuance of the preferred stock and warrants using the relative fair value method. The proceeds allocated to the convertible preferred stock and warrants are $700 and $300, respectively.

FG Corp makes a policy choice to accrete the $300 discount on convertible preferred stock (recorded as a deemed dividend) as a result of the relative fair value allocation over five years from the issuance date through the first put date (because the preferred stock is puttable by investors at the beginning of year six). FG Corp determines the effective interest rate is 7.39% which is the rate at which the present value of $1,000 at the end of five years equals the $700 proceeds allocated to the preferred stock at the issuance date.

The amortization of the warrant discount is shown in the following table.

	20X1	20X2	20X3	20X4	20X5	Total
Preferred stock balance at beginning of period	$700 ⁽²⁾	$752	$808	$868	$932
Amortization of warrant discount (as deemed dividend) ⁽¹⁾	52	56	60	64	68	300
Preferred stock balance at end of period ⁽³⁾	$752	$808	$868	$932	$1,000
⁽¹⁾Preferred stock balance at the beginning of the period multiplied by the effective interest rate of 7.39%. ⁽²⁾Amount of proceeds allocated to preferred stock at the issuance date. ⁽³⁾Preferred stock balance at the beginning of the period plus deemed dividend due to amortization of the warrant discount.

Beneficial conversion feature

Based on a stated conversion price of $20, the preferred stock is convertible into 50 shares of FG Corp’s common stock ($1,000 stated value / $20 conversion price).

The effective conversion price is $14 calculated by dividing (1) the proceeds received for the convertible preferred stock ($700) by (2) the number of common shares into which the preferred stock is convertible (50 shares).

$700 / 50 shares = $14 conversion price

FG Corp determines the convertible preferred stock contains a BCF as its stock price of $18 on the issuance date is greater than the $14 effective conversion price. The BCF calculated is $200, representing the difference between the issuance date stock price ($18) and the effective conversion price ($14) multiplied by the number of shares into which the preferred stock is convertible (50 shares).

The amount of the proceeds allocated to preferred stock is therefore $500 (the difference between the $700 proceeds allocated to the preferred stock and $200 BCF equity component).

FG Corp makes a policy choice to accrete the BCF discount of $200 (i.e., record accretion as a deemed dividend) over four years from the issuance date through the first conversion date because the preferred stock is convertible by investors at the beginning of year five and is not puttable until the beginning of year six. FG Corp determines the effective interest rate is 8.78% which is the rate at which the present value of $700 at the end of four years equals the $500 proceeds allocated to the preferred stock at the issuance date.

The amortization of the BCF is shown in the following table.

	20X1	20X2	20X3	20X4	Total
Preferred stock balance at beginning of period	$500 ⁽²⁾	$544	$592	$644
Amortization of BCF (as deemed dividend) ⁽¹⁾	44	48	52	56	200
Preferred stock balance at end of period ⁽³⁾	$544	$592	$644	$700
⁽¹⁾Preferred stock balance at the beginning of the period multiplied by the effective interest rate of 8.78%. ⁽²⁾Amount of proceeds allocated to preferred stock. ⁽³⁾Preferred stock balance at the beginning of the period plus deemed dividend due to amortization of the BCF.

FG Corp records the following journal entry on January 1, 20X1 to recognize the receipt of cash proceeds from the issuance of convertible preferred stock with warrants and the separation of the instrument into preferred stock, warrants and the BCF.

Dr. Cash	$1,000
Dr. Discount on convertible preferred stock (relative fair value allocation)	$300
Dr. Discount on convertible preferred stock (BCF)	$200
Cr. Convertible preferred stock		$1,000
Cr. Additional paid-in capital (warrants)		$300
Cr. Additional paid-in capital (BCF)		$200

During the first year (20X1)

FG Corp records the following journal entry to recognize the amortization of the warrant and BCF discount as deemed dividends.

Dr. Retained earnings	$96
Cr. Discount on convertible preferred stock (relative fair value allocation)		$52
Cr. Discount on convertible preferred stock (BCF)		$44

During the second year (20X2)

FG Corp records the following journal entry to recognize the amortization of the warrant and BCF discount as deemed dividends.

Dr. Retained earnings	$104
Cr. Discount on convertible preferred stock (relative fair value allocation)		$56
Cr. Discount on convertible preferred stock (BCF)		$48

During the third year (20X3)

FG Corp records the following journal entry to recognize the amortization of the warrant and BCF discount as deemed dividends.

Dr. Retained earnings	$112
Cr. Discount on convertible preferred stock (relative fair value allocation)		$60
Cr. Discount on convertible preferred stock (BCF)		$52

The following table summarizes FG Corp’s balance sheet as of December 31, 20X1, 20X2, 20X3 (assume the convertible preferred stock with the BCF and 100 detachable warrants is FG Corp’s only contract):

				Year ended December 31
Before ASU 2020-06		20X1	20X2		20X3

Cash		$1,000	$1,000		$1,000
	Total assets	1,000	1,000		1,000
Convertible preferred stock		1,000	1,000		1,000
Discount on convertible preferred stock		(404) ⁽¹⁾	(300) ⁽¹⁾		(188) ⁽¹⁾
Additional paid-in capital (BCF + warrants)		500	500		500
Retained earnings		(96) ⁽²⁾	(200) ⁽²⁾		(312) ⁽²⁾
	Total stockholders’ equity	$1,000	$1,000		$1,000
⁽¹⁾Remaining balance of unamortized preferred stock discount attributable to warrants and BCF ($500 total discount minus the sum of cumulative amortization of BCF and warrants discount). See amortization tables above for discount on preferred stock due to warrants and BCF for details. ⁽²⁾Retained earnings at the beginning of the year plus deemed dividends due to amortization of discount recognized for the year.

Upon adoption of ASU 2020-06 on January 1, 20X4

The convertible preferred stock is accounted for as a single mezzanine classified instrument due to the elimination of the BCF accounting model. At the issuance date, $700 is allocated to the convertible preferred stock as a single unit of account.

Had the ASU been applied to the convertible preferred stock at the issuance date, FG Corp would have recorded the following journal entries.

At convertible preferred stock issuance date (January 1, 20X1)

Recognize the cash proceeds from the issuance of convertible preferred stock with detachable common stock warrants.

Dr. Cash	$1,000
Dr. Discount on convertible preferred stock (relative fair value allocation)	$300
Cr. Convertible preferred stock		$1,000
Cr. Additional paid-in capital (warrants)		$300

During 20X1, 20X2, and 20X3

Recognize the amortization of the warrant discount as a deemed dividend as follows:

During 20X1

Dr. Retained earnings	$52
Cr. Discount on convertible preferred stock		$52

During 20X2

Dr. Retained earnings	$56
Cr. Discount on convertible preferred stock		$56

During 20X3

Dr. Retained earnings	$60
Cr. Discount on convertible preferred stock		$60

At ASU 2020-06 adoption date on January 1, 20X4

(1) Modified retrospective method

If FG Corp elects the modified retrospective transition method, it should record the following transition adjustment journal entry at the adoption date (i.e., January 1, 20X4).

Dr. Additional paid-in capital (BCF)	$200 ⁽¹⁾
Cr. Discount on convertible preferred stock (BCF)		$56 ⁽²⁾
Cr. Retained earnings		$144 ⁽³⁾
⁽¹⁾To derecognize the portion of the proceeds that was allocated to the BCF. ⁽²⁾To derecognize the remaining discount attributable to the BCF as of January 1, 20X4 ($2o0 BCF minus $144 cumulative amortization of the BCF in 20X1, 20X2 and 20X3). ⁽³⁾To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X4 representing the reversal of the sum of the deemed dividends in 20X1 ($44), 20X2($48) and 20X3(52) due to the amortization of the BCF under prior GAAP.

The comparative financial statements for 20X2 and 20X3 remain unchanged in the 20X4 financial statements.

(2) Full retrospective method

If FG Corp elects the full retrospective transition method, it should record the following transition adjustment as of the beginning of the first comparative period presented in the 20X4 financial statements (i.e., January 1, 20X2).

Dr. Additional paid-in capital (BCF)	$200 ⁽¹⁾
Cr. Discount on convertible preferred stock (BCF)		$156 ⁽²⁾
Cr. Retained earnings		$44 ⁽³⁾
⁽¹⁾ To derecognize the portion of the proceeds that was allocated to the BCF. ⁽²⁾ To derecognize the remaining discount attributable to the BCF as of January 1, 20X2. ⁽³⁾ To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X2 representing the reversal of the deemed dividend in 20X1 due to the amortization of the BCF under prior GAAP.

In addition, FG Corp should revise its 20X2 and 20X3 financial statements to reflect the effects of the changes under the ASU. The following table summarizes FG Corp’s balance sheet upon adoption of ASU 2020-06 under the full retrospective transition method.

After ASU 2020-06		January 1, 20X2	December 31, 20X2	December 31, 20X3
Cash		$1,000	$1,000	$1,000
	Total assets	1,000	1,000	1,000
Convertible preferred stock		1,000	1,000	1,000
Discount on convertible preferred stock (warrants)		(248)	(192)	(132)
Additional paid-in capital (warrants)		300	300	300
Retained earnings		(52) ⁽¹⁾	(108) ⁽²⁾	(168) ⁽²⁾
	Total stockholders’ equity	$1,000	$1,000	$1,000
⁽¹⁾Difference between the retained earnings balance as of December 31, 20X1 under the prior GAAP ($96) and the cumulative adjustment to opening retained earnings as of January 1, 20X2 ($44). ⁽²⁾Retained earnings at the beginning of the year plus deemed dividend recognized for the year.

Based on the above, the reversal of the deemed dividends recorded for the amortization of the BCF in 20X2 and 20X3 would result in an increase to the numerator in basic EPS for 20X2 and 20X3 of $48 and $52, respectively. The statements of changes in equity for 20X2 and 20X3 should be restated accordingly.

10.3.2 Transition for equity-linked instruments

Freestanding equity linked instruments must be analyzed pursuant to ASC 815-40 in order to determine whether they should be classified as equity, or an asset or liability . Similarly, embedded equity-linked features that are not clearly and closely related to their host instrument must be analyzed pursuant to ASC 815-40 in order to determine whether they must be bifurcated from their host and separately accounted for as liabilities. ASC 815-40-25 includes numerous conditions that must be met in order to conclude that these freestanding equity-linked instruments and equity-linked embedded features can be classified as equity. ASU 2020-06 eliminates three of these conditions in ASC 815-40-25-10A. The three conditions that no longer need to be considered are (1) whether settlement is required in registered shares, (2) whether counterparty rights rank higher than shareholder rights, and (3) whether collateral is required.

ASC 815-40-25-10

Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in paragraphs 815-40-25-8 through 25-9 and paragraphs 815- 40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:

Subparagraph superseded by Accounting Standards Update No. 2020-06.
Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement. Equity-linked instruments model 5-34
No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchanges Commission (SEC).
No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
Subparagraph superseded by Accounting Standards Update No. 2020-06.
Subparagraph superseded by Accounting Standards Update No. 2020-06.

ASC 815-40-25-10A

The following conditions are not required to be considered in an entity’s evaluation of net cash settlement (that is, if any one of these provisions is in a contract [or the contract is silent on these points], they should not preclude equity classification, except as described below):

Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.

10.3.2.1 Transition of certain equity-linked instruments

Prior to the adoption of ASU 2020-06, reporting entities may have classified a freestanding equity-linked instrument (or an embedded equity-linked feature) as a liability based on an evaluation of one of the three eliminated conditions mentioned in FG 10.3.2. For example, if a warrant required the delivery of registered shares upon exercise, a reporting entity would have been required to classify the warrant as a liability.

Upon adoption of ASU 2020-06, the three conditions described in ASC 815-40-25-10A would no longer require a freestanding contract or embedded feature be classified as a liability. As a result, the changes in fair value of the liability would no longer need to be recognized in the income statement, and a transition adjustment would be required for these instruments. Furthermore, for certain instruments with an embedded equity linked feature such as nonconvertible debt with warrants, the change in the classification of the warrants from a liability to equity would impact the discount on the debt and hence interest expense. The change in interest expense may also impact capitalized interest as discussed in Question FG 10-1. Changes in the income statement due to changes in fair value of the liability or interest expense previously recognized for financial reporting purposes may impact book/tax differences and deferred tax balances.

See FG 5.6.3 (post adoption of ASU 2020-06) and FG 5.6.3A (pre adoption of ASU 2020-06) for further information on the equity classification requirements for equity-linked instruments.

Example FG 10-3 illustrates the transition of a liability classified warrant that would be equity classified upon adoption of ASU 2020-06.

EXAMPLE FG 10-3
Transition of a liability classified warrant that would be equity classified upon adoption of ASU 2020-06

FG Corp, a calendar year-end public company, adopts ASU 2020-06 on January 1, 20X4. At the adoption date, FG Corp has preferred stock with detachable common stock warrants outstanding. Information about this instrument is summarized in the following table.


Preferred stock with detachable common stock warrants issuance date	January 1, 20X1
Preferred stock stated value	$1,000
Common stock detachable warrants	100 detachable warrants to buy common stock
Preferred stock features	No conversion feature; contains a contingent redemption feature that is not probable of becoming redeemable
Cash proceeds at issuance date	$1,000
Certain provisions	The warrant requires the delivery of registered shares
Fair value of preferred stock at issuance date	$710
Warrant fair value and change in fair value		20X1	20X2	20X3
	Fair value at beginning of period	$300	$340	$310
	Change in fair value	40	(30)	50
	Fair value at end of period	$340	$310	$360

This example ignores the effects of issuance costs and income taxes for simplicity.

What is the appropriate transition adjustment for the detachable common stock warrants outstanding at the ASU 2020-06 adoption date under (1) the modified retrospective method, and (2) the full retrospective method?

Analysis

Before adoption of ASU 2020-06

At instrument issuance date (January 1, 20X1)

FG Corp concludes the warrant does not meet the requirements for equity classification because the warrant requires the delivery of registered shares.

Since the warrants are classified as a liability, FG Corp first allocates some of the proceeds to the warrant based on its fair value at issuance date ($300) with the remaining proceeds ($700 = $1,000 - $300) allocated to the preferred stock.

FG Corp records the following journal entry on January 1, 20X1 to recognize the receipt of cash proceeds from the issuance of preferred stock with detachable common stock warrants.

Dr. Cash	$1,000
Dr. Discount on preferred stock (resulting from consideration allocated to warrants)	$300
Cr. Warrant liability		$300
Cr. Preferred stock		$1,000

During the first year (20X1)

FG Corp records the following journal entry to recognize a loss due to the increase in the fair value of the warrants.

Dr. Loss from warrant	$40
Cr. Warrant liability		$40

During the second year (20X2)

FG Corp records the following journal entry to recognize a gain due to the decrease in the fair value of the warrants.

Dr. Warrant liability	$30
Cr. Gain from warrant		$30

Fair value change during the third year (20X3)

FG Corp records the following journal entry to recognize a loss due to the increase in the fair value of the warrants.

Dr. Loss from warrant	$50
Cr. Warrant liability		$50

The following table summarizes FG Corp’s balance sheet and income statement as of and for the years ended December 31, 20X1, 20X2, 20X3, respectively (assume that the preferred stock with detachable common stock warrants is FG Corp’s only contract).

Before ASU 2020-06

		20X1	20X2	20X3
Balance sheets
Cash		$1,000	$1,000	$1,000
	Total assets	1,000	1,000	1,000
Warrant liability		340	310	360
	Total liabilities	340	310	360
Convertible preferred stock, net		700	700	700
Retained earnings		(40) ⁽¹⁾	(10) ⁽¹⁾	(60) ⁽¹⁾
	Total stockholders’ equity	660	690	640
	Total liabilities and stockholders’ equity	1,000	1,000	1,000
Income statements
Gain (loss) from warrant		(40)	30	(50)
Net income (loss)		($40)	$30	($50)
⁽¹⁾Retained earnings at the beginning of the year plus gain (loss) from change in fair value of the warrant recognized for the year.

Upon adoption of ASU 2020-06 on January 1, 20X4

Pursuant to ASC 815-40-25-10A(a), a provision requiring the delivery of registered shares does not preclude equity classification unless the contract explicitly states that the contract must be settled in cash if registered shares are not available. FG Corp’s contract does not explicitly state that the warrant must be settled in cash. As there are no other provisions in the warrant agreement that would require liability classification, FG Corp would have concluded that the warrants are equity classified under ASU 2020-06.

Had the ASU been applied to the warrants at the issuance date, FG Corp would have recorded the following journal entries.

At the issuance date (January 1, 20X1)

Since the warrants are classified as equity, FG Corp would have allocated the $1,000 proceeds from the issuance of the preferred stock and warrants using the relative fair value method based on the $710 fair value of the preferred stock and the $300 fair value of the warrants at the date of issuance. The allocation would have been as follows:

$1,000 × $710 / ($710 + $300) = $703 proceeds allocated to preferred stock

$1,000 × $300 / ($710 + $300) = $297 proceeds allocated to warrants

FG Corp would have recorded the following journal entry to recognize the receipt of cash proceeds from the issuance of the preferred stock with detachable common stock warrants.

Dr. Cash	$1,000
Dr. Discount on preferred stock (resulting from relative fair value allocation)	$297
Cr. Additional paid-in capital (warrants)		$297
Cr. Preferred stock		$1,000

During 20X1, 20X2 and 20X3

As the warrants would have been equity classified, FG Corp would not have recognized the change in fair value of the warrants through earnings during 20X1, 20X2 and 20X3.

At ASU 2020-06 adoption date on January 1, 20X4

(1) Modified retrospective method

If FG Corp elects the modified retrospective transition method, it should record the following transition adjustment at the adoption date (i.e., January 1, 20X4).

Dr. Warrant liability	$360 ⁽¹⁾
Cr. Discount on preferred stock		$3 ⁽²⁾
Cr. Additional paid-in capital (warrants)		$297 ⁽³⁾
Cr. Retained earnings		$60 ⁽⁴⁾
⁽¹⁾ To reclassify the warrant liability at January 1, 20X4 to equity. ⁽²⁾ To adjust the discount on the preferred stock based on the relative fair value method of allocation of proceeds ⁽³⁾ To reflect difference between the relative fair value allocation method as a result of the adoption compared to the residual allocation under prior accounting. ⁽⁴⁾ To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X4 representing the reversal of the cumulative income statement impact due to the change in the fair value of the warrants under prior GAAP.

The financial statements for 20X2 and 20X3 remain unchanged.

(2) Full retrospective method

If FG Corp elects the full retrospective transition method, it should record the following transition adjustment as of the beginning of the first comparative reporting period presented in the 20X4 financial statements (i.e., January 1, 20X2).

Dr. Warrant liability	$340 ⁽¹⁾
Cr. Discount on preferred stock		$3 ⁽²⁾
Cr. Additional paid-in capital (warrants)		$297 ⁽³⁾
Cr. Retained earnings		$40 ⁽⁴⁾
⁽¹⁾ To reclassify the warrant liability at January 1, 20X2 to equity. ⁽²⁾ To reflect the difference between the relative fair value allocation method as a result of the adoption compared to the residual allocation under prior accounting ⁽³⁾ To record the warrant in equity based on a relative fair value allocation. ⁽⁴⁾ To recognize the cumulative adjustment to opening retained earnings as of January 1, 20X2 representing the reversal of the cumulative income statement impact due to the change in the fair value of the warrant under prior GAAP.

In addition, FG Corp would revise its comparative 20X2 and 20X3 financial statements in its 20X4 financial statements to reflect the effects of the changes pursuant to ASU 2020-06. The following table summarizes FG Corp’s balance sheet and income statement upon adoption of ASU 2020-06 under the full retrospective transition method.

After ASU 2020-06		January 1, 20X2	December 31, 20X2	December 31, 20X3
Balance sheets
Cash		$1,000	$1,000	$1,000
	Total assets	1,000	1,000	1,000
Convertible preferred stock, net		703	703	703
Additional paid-in capital (warrants)		297	297	297
Retained earnings		0 ⁽¹⁾	0	0
	Total stockholders’ equity	1,000	1,000	1,000
	Total liabilities and stockholders’ equity	$1,000	1,000	1,000
Income statements
Net income (loss)			$0	$0
⁽¹⁾Difference between the retained earnings balance as of December 31, 20X1 under the prior GAAP ($40) and the cumulative adjustment to opening retained earnings as of January 1, 20X2 ($40).

Based on the above, the gain or loss due to a change in the fair value of the warrant in 20X2 and 20X3 would get reversed after adopting the ASU. The net income for 20X2 would decrease by $30, and the net income for 20X3 would increase by $50. The statements of changes in equity, statements of cash flows and EPS for 20X2 and 20X3 comparative reporting periods should be restated accordingly.

The basis for conclusions of the ASU summarizes the impact of the guidance to certain equity-linked instruments upon adoption of ASU 2020-06.

ASU 2020-06 BC129

The following table includes examples of how the transition method(s) should be applied in common scenarios:

Instrument Type and Current GAAP Classification	Effect of Guidance (If Scope Exception Currently Failed, but Passed under the Amendments)
Freestanding instrument is classified as a liability.	Reclassify to equity and adjust basis of instrument to what would have been the value at initial measurement.
Embedded feature is classified as a liability, and the host is classified as a liability.	Recombine instruments into a single liability instrument. Determine what the basis of that instrument would have been originally if the embedded feature had not been bifurcated. This would include a recalculation of the effective interest rate and any amortization of a discount (or premium).
Embedded feature is classified as a liability, and the host is classified as equity.	Recombine instruments into a single equity instrument and recalculate basis. Determine what the basis of that instrument would have been originally if the embedded feature had not been bifurcated.
Multiple embedded features are bifurcated from the host and classified as liabilities (host is classified as equity).	Recombine instruments into a single equity instrument (except for features not affected by this guidance) and recalculate basis. Determine what the basis of that instrument would have been originally if the embedded feature(s) had not been bifurcated.
Multiple embedded features are bifurcated from the host and classified as liabilities (host is classified as a liability).	Recombine instruments into a single liability instrument (except for features not affected by this guidance) and recalculate basis. Determine what the basis of that instrument would have been originally if those embedded features had not been bifurcated. This would include a recalculation of the effective interest rate and any amortization of a discount (or premium).

ASU 2020-06 BC129

The following table includes examples of how the transition method(s) should be applied in common scenarios:

Instrument Type and Current GAAP Classification	Effect of Guidance (If Scope Exception Currently Failed, but Passed under the Amendments)
Debt is issued with detachable warrants.	Recalculate Day 1 allocation between the debt and warrants. Reclassify the warrants to equity on the basis of original relative fair value. Recalculate the basis of the debt. This would include a recalculation of the effective interest rate and any amortization of a discount (or premium).

ASU 2020-06 BC130

The effects of the basis adjustments described in the table above would be recognized in accordance with the transition requirements in paragraph 815-40-65-1(b).

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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