ASU 2020-06 simplifies the guidance in U.S. GAAP on the issuer’s accounting for convertible debt instruments

HG, LLP — Tue, 25 Aug 2020 02:03:52 +0000

ASU 2020-06 simplifies the guidance in U.S. GAAP on the issuer’s accounting for convertible debt instruments

On August 5, 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity.

ASU 2020-06 removes from U.S. GAAP the separation models for (1) convertible debt with a cash conversion feature (CCF) and (2) convertible instruments with a beneficial conversion feature (BCF). As a result, after adopting the ASU’s guidance, entities will not separately present in equity an embedded conversion feature in such debt. Instead, they will account for a convertible debt instrument wholly as debt, and for convertible preferred stock wholly as preferred stock (i.e., as a single unit of account), unless (1) a convertible instrument contains features that require bifurcation as a derivative under ASC 815 or (2) a convertible debt instrument was issued at a substantial premium.

Under the current guidance of ASC 470-20 that applies the separate models for allocation of proceeds to convertible instruments, the nonconvertible debt component of the convertible debt with CCF is measured first at its fair value and the residual amount is allocated to equity. BCF is measured first at its intrinsic value and allocated to equity, and the residual amount is allocated to the host contract as liability. As such, applying the separation models in ASC 470-20 to convertible instruments with a BCF or CCF involves the recognition of a debt discount for the portion of proceeds allocated to equity. This debt discount is amortized to interest expense. Therefore, the elimination of these models will reduce reported interest expense and increase reported net income for entities that have issued a convertible instrument that was within the scope of those models before the adoption of ASU 2020-06.

The new guidance of ASU 2020-06 requires entities to provide expanded disclosures about “the terms and features of convertible instruments,” how the instruments have been reported in the entity’s financial statements, and information about events, conditions, and circumstances that can affect how to assess the amount or timing of an entity’s future cash flows related to those instruments.

Need help?

If you have further questions, please contact us through info@hg-llp.com or make an appointment below.

Fair value needed for convertible notes?

HG, LLP — Thu, 16 Jul 2020 12:29:45 +0000

Fair value needed for convertible notes?

The accounting treatment for a convertible debt instrument depends on the terms of the instrument. Some convertible debt instruments are settled upon conversion entirely in shares, some in a combination of cash and shares, and, less commonly, entirely in cash. The terms of the convertible debt instrument may mandate a settlement method or the reporting entity may have a choice.

Many convertible debt instruments contain a number of provisions, such as put and call options or contingent interest features, which should be assessed to determine whether the features should be accounted for separately.

The below framework will help a reporting entity determine which of the four accounting models it should follow when accounting for its convertible debt.

Source: PwC Guide to accounting for financing transactions: debt, equity and the instruments in between

The embedded features that must be bifurcated from the underlying debt host for accounting purposes may be subject to fair value measurement and mark-to-market adjustments each period, impacting reported earnings and requiring valuation experts to determine the valuation of such instrument.

ASC 815-15-25-1 requires that an embedded feature be evaluated for the following three criteria to determine if bifurcation and derivative treatment are appropriate:

1. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.

2. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.

3. A separate instrument with the same terms as the embedded derivative would be classified as a derivative instrument subject to derivative accounting pursuant to Section 815-10-15. For an embedded feature to qualify as an embedded derivative, it must first qualify as a derivative when evaluated as a freestanding instrument and not an embedded feature. To qualify as a derivative, the following three criteria must be met:

a) The feature must have an underlying and a notional and/or payment provision.

b) There must be no initial investment, with the exception of an investment that is less than the expected market value of the feature. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative).

c) The contract must allow for net settlement or provide a way to achieve the equivalent of net settlement (i.e. the use of a market mechanism or the delivery of an asset readily convertible to cash).

If the qualifications are not met, there is no need to bifurcate and separately account for the feature, and the debt should be recorded based either on the cash proceeds received, or on the allocated proceeds.

Beneficial conversion feature (BCF) on a convertible note

When the conversion price of a convertible instrument is below the fair value of the shares of the underlying stock, a beneficial conversion feature (BCF) exists. Determine whether the conversion feature is in the money at the commitment date. If the feature is in the money, there is a beneficial conversion and it will be necessary to “allocate the debt proceeds with an equity component receiving the intrinsic value of the beneficial conversion feature.”

An issuer’s beneficial conversion feature on a convertible instrument is equal to the difference between the company’s market price of common stock on the measurement date and the effective conversion price multiplied by the number of shares the holder is entitled to upon conversion.

If BCF is a contingent beneficial conversion upon the success of IPO, BCF would be recorded at the date of conversion. On the issuance of the convertible note, BCF is accounted as a liability in its entirety of the convertible note.

How to get help?

HG, LLP specializes in accounting and valuation for convertible debts. We’ll help you understand the basics of convertible debts and other complex securities such as warrants. Please contact us through www.hg-llp.com and make an appointment as below.