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downloadThe Financial Accounting Standards Board (FASB) issued an Accounting Standard Update (ASU 2020-06) on August 5, 2020 to simplify the accounting for convertible instruments and contracts in a company’s own equity. FASB also made changes to the earnings per share (EPS) calculation and disclosures for convertible instruments and contracts in an entity’s own equity. The changes are effective in 2022 for calendar-year Securities and Exchange Commission (SEC) public business entities, excluding smaller reporting companies as defined by the SEC. Smaller reporting companies are defined as either having public float below $250 million, regardless of the amount of revenue, or having less than $100 million in revenue and public float less than $700 million. The changes are effective in 2024 for all other entities. Early adoption is permitted in should see it : best accounting research services near me


Convertible Instruments

Many companies issue debt or preferred stock which allows the holders to convert them into common stock when certain conditions are met. Under existing accounting rules, there are five models for accounting for convertible debt or convertible preferred stock. Convertible instruments are usually convertible into a company’s common stock. The five models are:

The embedded derivative model

The cash conversion model

The beneficial conversion feature model

The substantial premium model; and

The traditional conversion model.


The first four models require the convertible instrument to be separated into two components: the host debt or preferred stock component and the conversion component. The conversion component can either be classified as an equity or as a derivative, and the derivative can either be an asset or a liability, depending on the features and the applicable rules.

The traditional model does not require separation of the convertible component from the host instrument, and the entire contract is accounted for as one unit. The different models result in some convertible instruments being accounted for as two units of account while others are accounted for as one should see it : affordable research accounting firm

These different models complicated the accounting for convertible instruments and resulted in differences in practice and numerous restatements over the years. Furthermore, many financial statement users viewed a convertible instrument as one unit of account and treated it as such in their analyses. FASB acceded to the drumbeat of complaints about the complexity of accounting for these instruments and amended the rules.


Contracts in an Entity’s Own Equity

Existing rules allow certain financial instruments to be excluded from complex derivative accounting if they meet two criteria:

The instrument is indexed to the entity’s own stock (the “indexation criterion”); and

The contract is classified as equity (the “settlement criterion”)

If both criteria are met, the instrument is classified as equity and avoids derivative accounting. Contracts that do not meet the criteria are accounted for as derivative assets or liabilities. Contracts settled in the entity’s own shares meet the settlement criterion, and contracts that may or will be settled in cash do not meet this criterion and are accounted for as derivatives. There are seven conditions that must be evaluated to determine whether cash settlement is possible. All seven conditions must be met for a contract to be classified as equity. If any of the conditions is not met, it is possible for the instrument to be cash settled and it would fail the settlement should see it : find accountant for company analysis

The seven conditions are as follows:

Settlement is permitted in unregistered shares

The entity has sufficient authorized and unissued shares available to settle the contract

The contract contains an explicit limit on the number of shares to be delivered in a settlement

There are no required cash payments to the counterparty

There are no cash settled top-off or make-whole provisions

No counterparty rights rank higher than shareholder rights

No collateral is required

Earnings per Share

Current guidance allows two methods for calculating EPS – the if-converted method and the treasury stock method. Under the if-converted method, convertible shares are assumed to be converted into common stock at the beginning of the reporting period or when issued, if later. The shares assumed to be issued are added to the denominator for the EPS calculation if they are more dilutive, and any interest and preferred dividends included in the income statement during the period are added to the numerator. The presumption that the contract will be settled in shares may be overcome if past experience or a stated policy provides a reasonable basis to believe that full or partial cash settlement will occur.


The treasury stock method assumes that proceeds from exercise of options and warrants would be used to purchase common stock at the average market price during the period.


Convertible Instruments

The new rules eliminated two of the four models that required separation of a convertible instrument into two accounting units. The models eliminated are the cash-conversion and the beneficial conversion models. Instruments that were separated under these models will now be accounted for as a single unit of account. The embedded derivative model and the substantial premium models remain in place, and convertible instruments will be separated if they meet the criteria for separation under either of these models. The traditional model remains in place for instruments that meet the criteria to be accounted for under this model.

A convertible debt instrument not required to be separated will be accounted for as a single liability at its amortized cost and a convertible preferred stock instrument will be accounted for as single equity instrument at its historical cost.

Contracts in Own Equity

The new rules simplified the settlement conditions that must be met for equity classification. The conditions requiring settlement in unregistered shares, no counterparty rights ranking higher than shareholder rights, and no collateral requirements were all removed. For the unregistered share condition, equity classification is still precluded if the contract explicitly states the entity must settle in cash if registered shares are unavailable. In addition, FASB modified condition four to exclude penalty payments from required cash payments to the should see it : tailored accounting analysis

Earnings per Share Calculation

FASB made several changes to the EPS calculation. The if-converted method is now the only method allowed to be used for EPS calculation for convertible instruments. The treasury method, which was allowed under the old rules, can no longer be used for convertible instruments.


FASB amended the guidance for the if-converted method by removing the ability to rebut the presumption that the contract will be settled in shares. Therefore, the effect of potential share settlement must be included in the diluted EPS calculation when an instrument may be settled in cash or shares.

The update also clarified that an average market price should be used to calculate the diluted EPS denominator when the exercise prices may change on the basis of an entity’s share price or when changes in the entity’s share price may affect the number of shares that may be used to settle a financial instrument.


It further clarified that an entity should use the weighted-average share count from each quarter when calculating the year-to-date weighted-average share count.

The ASU requires several new disclosures about convertible instruments, contracts in own equity, and EPS.

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