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.
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