Accounting for Convertible Debt Just Got Easier

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-06, which changes how companies account for convertible debt. This update aims to make the accounting simpler and improve consistency of earnings per share (EPS) calculations.

Explore how these recent updates can help make your financial reporting clearer and more straightforward.

Key changes introduced by ASU 2020-06

Elimination of beneficial conversion feature and cash conversion models

ASU 2020-06 eliminates the beneficial conversion feature and cash conversion accounting models. Now, convertible debt will be treated as a single instrument unless specific conditions require separation.

Amendment of derivatives scope exception guidance

The update significantly amends the derivatives scope exception guidance for contracts in an entity’s own equity by removing certain conditions required for equity classification under ASC 815-40-25.

Enhanced disclosure requirements

ASU 2020-06 expands the disclosures of convertible instruments, providing more transparency and consistency in financial reporting.

Significant impacts of ASU 2020-06

Simplification of accounting processes

By eliminating the beneficial conversion feature and cash conversion models, ASU 2020-06 simplifies the accounting for convertible instruments. This reduces the complexity and potential for errors in financial reporting.

Improved consistency in EPS calculations

The FASB’s update aims to make EPS calculations consistent by clarifying the treatment of convertible instruments so EPS figures are more comparable across different entities.

Increased transparency and disclosure

The enhanced disclosure requirements under ASU 2020-06 provide stakeholders with more detailed information about an entity’s convertible instruments. This increased transparency may help investors and analysts make better-informed decisions.

Consultation and engagement with specialists

Given the complexity of ASU 2020-06 changes, entities should engage knowledgeable professionals early in the process. Consultants can help you evaluate the terms of convertible debt arrangements and identify the appropriate accounting treatment.

Convertible debt before and after ASU 2020-06

Before ASU 2020-06

Consider a company that issues $1 million of convertible debt with a beneficial conversion feature. Under the previous accounting standards, the company would need to separate the debt into its liability and equity components. The beneficial conversion feature would be recognized as an equity component, and the remaining amount would be recorded as a liability. This process involves complex calculations and multiple journal entries.

Calculation example before ASU 2020-06

• Identify the beneficial conversion feature (BCF)
  • Assume the conversion price is $10 per share, and the market price at issuance is $12 per share
  • The BCF is calculated as: (market price - conversion price) x number of shares
  • BCF = ($12 - $10) x 100,000 shares = $200,000
• Allocate the proceeds
  • Allocate $200,000 to equity (BCF)
  • The remaining $800,000 is allocated to the liability component
• Journal entries
  • Debit cash $1,000,000
  • Credit convertible debt liability $800,000
  • Credit equity (BCF) $200,000

After ASU 2020-06

Under ASU 2020-06, the same $1 million of convertible debt would be accounted for as a single instrument. There is no need to separate the debt into liability and equity components. The entire amount would be recorded as a liability, simplifying the accounting process and reducing the potential for errors.

Calculation example after ASU 2020-06:

• Record the convertible debt as a single instrument
  • The entire $1 million is recorded as a liability
• Journal entries
  • Debit cash $1 million
  • Credit convertible debt liability $1 million

Impact of interest rates on convertible debt

In the current high-interest rate environment, convertible debt often offers a lower cash interest alternative compared to traditional debt instruments. This makes it an attractive option for companies looking to manage their cost of capital effectively.

Example

Consider a company needing to refinance an upcoming debt maturity. In the high-interest rate environment, traditional debt instruments may have interest rates of around 8 – 10%. However, by issuing convertible debt, the company can secure a lower interest rate, say around 3 – 4%.

Impact on financial statements

• Interest expense
  • $1 million of traditional debt issued at an 8% interest rate results in an annual interest expense of $80,000
  • $1 million of convertible debt issued at a 3% interest rate results in an annual interest expense of $30,000
• EPS impact
  • The lower interest expense from convertible debt improves the company's net income, which in turn positively impacts the EPS
• Cash flow
  • The lower interest payments associated with convertible debt improve the company's cash flow, providing more flexibility for other investments or operational needs

Embedded derivatives and bifurcation

Convertible instruments still subjected to separation models are:

1. Those with embedded conversion features that:
   1. Are not clearly and closely related to the host contract
   2. Meet the definition of a derivative
   3. Do not qualify for a scope exception from derivative accounting
2. Convertible debt instruments issued with substantial premiums recorded as paid-in capital

How CLA can help with convertible debt accounting

Our technical accounting advisory professionals can help your organization comply with the new standards and navigate these changes effectively. We also offer full- or part-time outsourced professionals to support your accounting needs. Whether you need staff for daily transactions, a consulting controller to scale operations, or a consulting CFO for financial guidance, we can help.

Contact us

Improve accuracy in your financial reporting and accounting. Complete the form below to connect with CLA.