Recent FASB Simplifications to Convertible Bond Accounting

A frequent concern for companies is how to classify debt and equity. Convertible bonds, which have features of both, are especially confusing because of differences in accounting for seemingly similar instruments. In response to this, on August 5, 2020, FASB released an update under ASU 2020-06. The update aims to make it easier to understand and implement the current guidance on financial instruments that have liability and equity characteristics.

For convertible instruments, FASB eliminated the need to use multiple models to handle some common convertible features. They also simplified part of the classification analysis. However, separate accounting remains in place for two other unique circumstances, specifically:

• Embedded derivatives with conversion features that are not clearly or closely related to the host contract
• Convertible debt issued with substantial premiums that are recorded as paid-in capital

Additionally, FASB amended EPS guidance and other derivative scope exceptions that are currently causing some derivative contracts — ones with similar economic characteristics — to be treated as equity for accounting purposes.

In this blog post, we step through some of the key differences applicable to most convertible bond securities.

Convertible Instruments Classifications

Prior to the new guidance, accounting for convertible debt instruments under GAAP could involve five different models. Four require separation of the debt and equity components:

1. Embedded derivative (815-15). This model accounts for embedded derivatives with conversion features that are not clearly or closely related to the host contract. Conversion features are bifurcated as derivatives from the host contract and measured at fair value. This bifurcation is still required under ASU 2020-06.

2. Substantial premium (470-20). Under this model, the premiums are recorded as paid-in capital. Under ASU 2020-06, for a convertible debt instrument issued with a substantial premium, these premiums will continue to be separated from the debt instrument and recorded as an equity component.

3. Cash conversion (470-20). This model accounts for convertible debt instruments that may be settled partially or wholly in cash upon conversion, an extremely common feature. The host contract is measured at fair value as any other non-convertible debt instrument, and conversion features are recorded as equity components at residual value. This separation is no longer applicable under the ASU 2020-06.

4. Beneficial conversion feature (470-20). This model accounts for convertible debt instruments that are in the money at issuance, or become in the money at a later date upon the occurrence of certain contingent events. Conversion features are recorded as equity components at intrinsic value, and the host contract is recorded at the residual amount. This separation is no longer applicable under ASU 2020-06.

The remaining model requires no separation because the instrument as a whole is recognized as debt only:

5. Traditional convertible debt (470-20). Under this model, the convertible debt instrument as a whole is recorded as a single debt instrument measured at amortized cost. This remains applicable under ASU 2020-06.

Preparers of financial statements have often faced confusion over the models that require separate accounting. This leads to financial statements that are inconsistent with the results of analyses, as well as interest expense that excludes convertible note features and therefore can significantly differ from the note coupon rates.

To address this problem, FASB simplified the accounting treatment for convertible debt by removing these separation models from subtopic 470-20, Debt – Debt with Conversion and Other Options, for convertible instruments:

Consequently, a convertible debt instrument will be accounted for as a single liability measured at its amortized cost and 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. By removing those separation models, the interest rate of convertible debt instruments typically will be closer to the coupon interest rate when applying the guidance in Topic 835, Interest.

Disclosure Updates

FASB amended the standard convertible instrument disclosures so that it’s easier to understand the detailed disclosure requirements. Companies will need to add disclosure information about anything that causes conversion contingencies to significantly change over a reporting period. In addition, companies will have to disclose which party controls the conversion rights. Finally, they’ll need to disclose information for each convertible instrument individually instead of aggregating them.

FASB also changed the disclosure guidelines for contingently convertible instruments as well as for convertibles with substantial premiums. The idea was to make the accounting more consistent with standard convertibles. These types of securities are less common, so they aren’t covered in detail.

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

Under the current guidance in Subtopic 815-40, Derivatives and Hedging – Contracts in Entity’s Own Equity, companies had to determine whether a contract related to derivative instruments — such as those with embedded features, freestanding financial instruments, and instruments settled in entity’s own stock — qualified for a scope exclusion from derivative accounting and the related mark-to-markets. According to the FASB, this was resulting in form over substance conclusions based on some of the potential factors. The conversion feature in convertible debt, as well as the structure of warrants, are frequent subjects of this analysis.

Two analyses are required for this scope: The contract must be equity classified and also considered indexed to an entity’s own stock. At the same time, legal opinions are no longer required for settlement in unregistered shares, collateral, and shareholder rights. These three conditions often either required in-depth analysis or caused instruments to fail to meet this exception, even though they had no effect on the instrument’s economics. Excluding these components means more consistent identification of substantially similar instruments.

EPS

Historically, most companies have used the if-converted method for convertible debt. But if a company could support the assumptions that they could and would settle their convertible debt with cash versus stock, they could use the treasury stock method instead. Under the new guidance, this different treatment is eliminated. All convertible debt will require the if-converted method.

Other Notes

In addition to the factors noted above, the new guidance contains significant clarifications on the application of this accounting and the disclosure requirements, based on differences seen in reporting and less common features of various contracts.

One of the most anticipated pieces of this guidance was a remote-likelihood threshold for features that violated the indexation and classification guidance. In other words, a feature would not trigger derivative accounting just from being in a contract. Instead, it would have to have a reasonable probability of occurring. This has been pushed to a future project. Even so, if the probability of these features is remote, the value of these specific features is typically negligible since they’ll be triggered only rarely.

Effective Date

The amendments 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 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. FASB has specified that an entity should adopt the guidance as of the beginning of its annual fiscal year.

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