Expand
Resize
Add to favorites
Convertible instruments
One of the more significant changes resulting from ASU 2020-06 is the simplification of the convertible debt accounting framework through the elimination of many of the current models used to account for convertible debt and convertible preferred stock. The Board concluded that eliminating certain models would simplify the accounting for convertible instruments and improve the relevance of information provided to financial statement users.
Currently, under the convertible security accounting framework, there are multiple accounting models for convertible debt issued with different initial (and in some cases subsequent) recognition and measurement requirements. These are:
  • the fair value option,
  • the bifurcated derivative model,
  • the cash conversion model,
  • the beneficial conversion feature model,
  • the substantial premium model, and
  • the “traditional” convertible security model.
Several of these models apply to equity classified convertible preferred.
The ASU eliminates the cash conversion and the beneficial conversion feature models. It retains the other models and the ability to elect the fair value option for instruments eligible under ASC 825. With the elimination of the cash conversion and beneficial conversion feature models, more instruments will be eligible for the fair value option.
As a result of these changes, more convertible instruments will be reported as a single unit of account on the balance sheet. The elimination of the cash conversion and beneficial conversion feature models will result in fewer instruments for which proceeds need to be allocated between liability and equity accounting units, thereby resulting in fewer liabilities recorded with a discount, which will result in less interest expense through accretion.
The changes will result in a significant change in financial reporting. During the FASB’s extensive deliberations, they received feedback that the overall accounting framework and the accounting models were complex to interpret and apply. In addition, financial statement users indicated that they did not value information about non-cash interest expense and that for analysis purposes, they recombine these instruments and apply their own assumptions.
The models eliminated
Cash conversion model
The current cash conversion model is applied to issued convertible debt instruments when (1) the conversion option is not required to be separately accounted for as a bifurcated derivative under ASC 815 and (2) the conversion feature permits or requires the instrument to be settled, in whole or in part, in a combination of cash or stock. The two most popular forms of convertible debt issued by public companies today subject to this guidance are frequently referred to as “Instrument C” and “Instrument X.”
Instrument C refers to an instrument that when converted, the principal amount of the debt must be settled in cash, while the conversion spread can be settled in cash or shares at the issuer’s option. Instrument X refers to an instrument that upon conversion, the issuer may settle the instrument in cash or shares in any combination at the issuer’s option.
The cash conversion model requires the separation of 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. The amount allocated to the liability component is based on the fair value of a similar debt instrument excluding the embedded conversion option. The residual amount of proceeds are allocated to the equity component. The liability component is reported as a liability and the equity component is reported within equity (typically additional paid-in capital). The design of this accounting model is that the reporting entity would report an interest cost that is comparable to that which would have been incurred had the company issued debt without a conversion option.
Beneficial conversion feature model
Similar to the cash conversion model, the beneficial conversion feature (BCF) model is also a separation model. The BCF model applies to convertible debt and convertible preferred stock with non-detachable conversion features that are “in the money” at the commitment date (which is 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 received equal to the intrinsic value of the conversion feature to equity (typically additional paid-in capital) with the remaining proceeds recognized as a liability. Similar to the cash conversion model, this allocation of the intrinsic value to equity creates a discount on the debt or preferred stock.
New convertible debt framework
Under the new convertible debt framework:
  • a reporting entity will first decide whether to elect the fair value option under ASC 825-10. Note: convertible debt issued with a substantial premium may be ineligible for the fair value option;
  • if the fair value option is not elected, the reporting entity must assess whether the conversion feature requires bifurcation pursuant to ASC 815;
  • if bifurcation is not required, the reporting entity must evaluate whether the convertible debt was issued with a substantial premium;
  • if the fair value option is not elected, the conversion option is not required to be bifurcated, and the convertible debt was not issued with a substantial premium, the convertible debt will be accounted for as a single unit of account under the “traditional convertible security” model.
Figure 1 is a decision tree for applying the new convertible debt framework.
Figure 1
The new convertible debt framework
View image
Accounting models retained
ASC 815: Bifurcated derivative model
It will still be necessary for a reporting entity to evaluate whether the conversion feature meets the definition of a derivative. If so, it is required to be bifurcated under ASC 815 consistent with the requirements of current GAAP. However, the evaluation as to whether the conversion feature qualifies for the “own stock” derivative scope exception was amended by ASU 2020-06, as described in the Contracts in own equity section. If the conversion feature is bifurcated, the conversion option is initially recognized at fair value. The remaining proceeds are allocated to the debt host and reported as a liability. Subsequent changes in the fair value of the conversion option are recognized currently in earnings.
ASC 470-20: Substantial premium model
ASU 2020-06 does not change the accounting for convertible debt issued with a substantial premium. If convertible debt (that does not have a conversion option required to be bifurcated under ASC 815) is issued at a substantial premium, there is a presumption that such premium represents paid-in capital. In these cases, the convertible debt is reported by establishing a liability at its principal or par amount and the excess proceeds are reported as additional paid-in capital.
Traditional convertible debt model
Convertible debt not issued with a substantial premium or with an embedded conversion feature not required to be bifurcated under ASC 815 is accounted for as a liability and no portion of the proceeds from the issuance is attributed to the conversion feature. However, if the convertible debt was issued in conjunction with other unstated rights or privileges in addition to the convertible debt instrument, a portion of the initial proceeds would be allocated to those rights or privileges in accordance with other applicable GAAP.
Interest expense would be calculated using the effective interest method. However, without an initial allocation of proceeds to the conversion option, the debt will likely have a lower discount. This means applying the new framework will likely result in less reported interest expense.
When a convertible debt instrument that is accounted for as a liability in its entirety is converted into shares, cash, or any combination of shares and cash, pursuant to its original conversion terms:
  • the carrying amount of the convertible debt instrument, including any unamortized premium, discount, or issuance costs, are reduced by the cash transferred to the holders, if any,
  • the remainder is recognized in the capital accounts to reflect the shares issued, and
  • no extinguishment gain or loss is recognized.
This is a significant change from the current guidance for convertible debt with a cash conversion feature and for convertible debt or convertible preferred stock with a beneficial conversion feature. Under the current models for conversion of these instruments (pursuant to the original conversion terms), there is often an extinguishment gain or loss, or a deemed dividend to be recorded.
New convertible preferred stock framework
Certain issuers of preferred stock will be significantly impacted by ASU 2020-06, particularly those that have issued preferred stock with a beneficial conversion feature and those that have issued preferred stock that contains a down round feature. A down round feature reduces the conversion price of convertible preferred stock if the issuer sells shares of its stock for an amount less than the conversion price.
Just as with convertible debt, the beneficial conversion feature model of accounting for preferred stock has been eliminated.
Figure 2 is a decision tree for applying the new convertible preferred stock framework.
Figure 2
The new convertible preferred stock framework
View image
ASU 2017-11, Earnings per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 460), Derivatives and Hedging (Topic 815), (I) Accounting for Certain Financial Instruments with Down Round Features (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, amended ASC 815-40 to exclude down round features from the consideration of whether an instrument, including a conversion option in convertible preferred stock, is considered indexed to an entity’s own stock. In addition, ASU 2017-11 excluded convertible preferred stock from its provisions that require a reporting entity to record the value of the effect of a down round when it is triggered. Convertible preferred stock was excluded because a down round feature is also considered a contingent beneficial conversion feature, which would require accounting recognition under that model.
Since ASU 2020-06 eliminates the beneficial conversion feature model for both convertible preferred stock and convertible debt, the Board decided that convertible preferred stock should now be subject to the measurement provisions introduced by ASU 2017-11. As a result, when triggered, the value of the effect of the down round feature being triggered must be recognized as a charge to retained earnings (and earnings available to common shareholders for EPS purposes).
For an equity-classified convertible preferred stock instrument (assuming the conversion feature has not been bifurcated under ASC 815), the value of the effect of a down round feature is the difference between the following amounts determined immediately after the down round feature is triggered:
  1. The fair value of the convertible preferred stock (without the down round feature) with a strike (conversion) price corresponding to the previously stated strike price (that is, before the strike price reduction)
  2. The fair value of the convertible preferred stock (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
Convertible debt is still exempt from the measurement provisions introduced by ASU 2017-11 requiring a reporting entity to record the value of the effect of a down round feature when it is triggered. The Board decided to exclude convertible debt from these provisions because ASC 825 requires the issuer of convertible debt to disclose the fair value of the convertible debt at the convertible debt instrument level. The Board reasoned that this information was sufficient for users to perform their analysis.
Convertible instruments issued as compensation awards
ASU 2020-06 amends the guidance in ASC 718, Compensation - Stock Compensation, related to convertible instruments issued as share-based payment awards in exchange for goods or services. Currently, awards in the form of convertible instruments are initially accounted for under ASC 718 through the vesting date, with their fair value at the grant date recognized as compensation cost over the vesting period. Upon vesting, the award would become subject to other guidance (such as ASC 470 or ASC 815), including potential measurement of a beneficial conversion feature as of the vesting date or bifurcation of an embedded derivative.
Upon adoption of ASU 2020-06, share-based payment awards in the form of convertible instruments will remain subject to the recognition and measurement guidance of ASC 718 throughout the life of the instrument (and will not be reassessed under other applicable GAAP), unless the terms of the award are modified after the grantee vests in the award and is no longer providing goods or services (or is no longer an employee or customer).
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide