New accounting standards you should know, Part 3: Making complex debt and equity less…complex

For anybody in the accounting world, one thing is clear: accounting standards never stay the same. In this multi-part series, “New accounting standards you should know,” I’ll catch you up on the latest accounting standard updates. Previously, we talked about the current expected credit loss model (CECL) under ASC 326. Today, let’s look at simplifications for complex debt and equity.

At this point in the series, you have likely read our previous articles on the new accounting standards of ASC 606, ASC 842, and CECL, all of which can have a major impact on the accounting for a business depending on the industry. In fact, you may be wondering if the Financial Accounting Standards Board (FASB) is just messing with us by releasing so many changes. But before you completely lose it, I have good news; not all of these updates are designed to make your work more difficult. In fact, some are meant to simplify complex areas, like the topic of this week’s article.

One of the most complex areas of technical accounting is around the debt and equity instruments issued by a company to finance its operations, commonly used for early-stage and rapid-growth companies. There are many types of forms of financing: common stock vs. preferred stock vs. term loans vs. warrants vs… you get the idea. And each type of financing brings its own terms and nuances, which vary for each company and can swing the accounting evaluation in a major way.

In this already-complex topic, one of the even-more-complex areas is for instruments that include an option to convert into shares of a company’s stock – the most common types of these instruments are convertible debt and convertible preferred stock. The technical accounting goal is to determine whether that conversion option needs to be separated from the instrument and accounted for separately. And I wasn’t joking about complex: up to this point, preferred stock with a conversion option requires going through two separate evaluation models, while convertible debt requires three. Each of those models brings a very confusing and subjective assessment and if you get just one step wrong, and you can completely mess up the accounting treatment. Sound like fun?

Yeah, the latest members of the FASB didn’t think so either. In August 2020, they released Accounting Standards Update (“ASU”) 2020-06, with the primary goal of eliminating a few of these evaluation models for convertible instruments:

• The first eliminated evaluation model is whether a “beneficial conversion feature” exists; put simply, whether an investor or lender of the instrument could immediately convert at a better value than the stock’s market price. This dreaded “BCF” model affected both convertible debt and convertible preferred stock, and could require complex valuation of a company’s own stock.

• The second eliminated evaluation model is whether a “cash conversion feature” exists, or if a conversion could be at least partially paid out in cash. Similar to the BCF model, it requires complex valuation of convertible debt both with, and hypothetically without, its conversion feature.

These evaluation models can result in significant effort and cost; they will not be missed. While the new ASU does replace these two models with one additional evaluation for convertible debt (if the debt is issued at a significant premium), it is far easier to evaluate compared to the former two.

Unfortunately, ASU 2020-06 does not remove what may be the toughest evaluation model for both convertible debt and convertible preferred stock, which is whether a conversion option would be accounted for as a derivative. However, it does reduce some of the requirements to qualify for the key scope exception of contracts indexed in a company’s own equity. In English? This makes it easier to argue that a conversion feature does not need to be broken out as a derivative. If you think debt/equity is complex, you don’t want to know how tricky derivative accounting can be, so in this case, the new ASU is welcome.

ASU 2020-06 brings a lot of benefits, so we at Zeroed-In suggest adopting it as soon as you can. It is effective for public companies with fiscal years beginning after December 15, 2021 (calendar year 2022), and for nonpublic companies with fiscal years beginning after December 15, 2023 (calendar year 2024). That is still quite a way off for nonpublic companies, so early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020 (calendar year 2021). So, you get to enjoy all the fun of the old guidance for any financing transactions prior to then.

On our next Zeroed-Insight, we'll share some important tweaks to your business combination accounting under ASC 805.