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Convertible Instruments

Do the disclosure amendments in this proposed Update for convertible debt instruments in paragraphs 470-20-50-1A through 50-1I and for convertible preferred stock in paragraphs 505-10-50-12 through 50-18 provide decision-useful information? Should any of these disclosures be required for every annual and interim period for which a statement of financial position and a statement of financial performance are presented? Should any other disclosures for convertible instruments be required? Please explain why or why not.

Convertible Instruments

Under current GAAP, there are five accounting models for convertible debt instruments. Except for the traditional convertible debt model that recognizes a convertible debt instrument as a single debt instrument, the other four models, with their different measurement guidance, require that embedded conversion features be separated (using different separation approaches) from the host contract and classified as equity under Subtopic 470-20, DebtDebt with Conversion and Other 3 Options, or as liabilities under Subtopic 815-15, Derivatives and Hedging Embedded Derivatives. Convertible preferred stock also is required to be assessed under similar models.

Feedback from preparers and practitioners indicated that the accounting guidance for convertible instruments is unnecessarily complex and difficult to navigate, resulting in applying or interpreting the guidance incorrectly or inconsistently. Consequently, accounting for convertible instruments has been the subject of a significant number of restatements.

Feedback from users of financial statements indicated that most users do not find the current separation models for convertible instruments useful and relevant, because they generally view and analyze those instruments on a whole-instrument basis. Because a convertible debt instrument is going to be either repaid at maturity or converted to stock, users of financial statements asserted that separating the instrument into two components is confusing and creates a result in the financial statements that is inconsistent with their views. Many users also indicated that cash (coupon) interest expense is more relevant information for their analyses, rather than an imputed interest expense that results from the separation of conversion features required by GAAP. Overall, most users of financial statements stated that they would prefer a simple recognition, measurement, and presentation approach with sufficient disclosures for convertible instruments to have a simplified and consistent starting point across entities to perform their analyses.

In response to the feedback received, the Board decided to simplify the accounting for convertible instruments by removing the separation models in Subtopic 470-20 for convertible instruments. Under the amendments in this proposed Update, for convertible instruments with conversion features that are not required to be accounted for as derivatives under Topic 815, the embedded conversion features would no longer be separated from the host contract. Consequently, a convertible debt instrument would be accounted for as a single liability measured at its amortized cost and a convertible preferred stock would be accounted for as a single equity instrument measured at its historical cost as long as no other features require bifurcation and recognition as derivatives. By removing those separation models, the interest rate of convertible debt instruments typically would be closer to the coupon interest rate when applying the guidance in Topic 835, Interest.

The Board expects that the amendments in this proposed Update would provide financial statement users with a simpler and more consistent starting point to perform analyses across entities, consistent with feedback received from users. The Board also expects that the proposed amendments would improve the operability of the guidance and reduce, to a large extent, the complexities in the accounting for convertible instruments and the difficulties with the interpretation and application of the relevant guidance.

To further improve the decision usefulness and relevance of the information being provided to users of financial statements, the Board decided to increase information transparency by making the following disclosure amendments in this proposed Update for convertible instruments:

1. Add disclosure objective

2. Add information about events or conditions that occur during the reporting period that significantly affect the conversion conditions

3. Add information on which party controls the conversion rights

4. Align disclosure requirements for contingently convertible instruments with other convertible instruments

5. Require that existing fair value disclosures in Topic 825, Financial Instruments, be provided at the individual instrument level rather than in the aggregate.

Derivatives Scope Exception for Contracts in an Entitys Own Equity

Under current guidance in Subtopic 815-40, Derivatives and HedgingContracts in Entitys Own Equity, an entity must determine whether a contract qualifies for a scope exception from derivative accounting. This guidance must be applied to freestanding financial instruments and embedded features that have all the characteristics of a derivative instrument and freestanding financial instruments that potentially are settled in an entitys own stock, regardless of whether the instrument has all the characteristics of a derivative instrument. The analysis to determine whether a contract meets this scope exception includes two criteria: (1) the contract is indexed to an entitys own stock and (2) the contract is equity classified. If both of those criteria are not met, the contract must be recognized as an asset or a liability.

Under the scope and scope exceptions Section of Subtopic 815-40, the concept of indexation is defined as an application of a two-step process (referred to as the indexation criterion). In Step 1, an entity evaluates the feature for any contingent exercise provisions. Step 1 is not within the scope of the amendments in this proposed Update. In Step 2, an entity evaluates the features settlement provisions. The fixed-for-fixed principle underlying Step 2 (analysis of the features settlement provisions) means that an embedded feature or equity contract is considered indexed to an entitys own stock if its settlement amount will equal the difference between the fair value of a fixed number of the entitys equity shares and a fixed monetary amount. However, most contracts subject to this guidance contain adjustment provisions upon the occurrence of contingent events. As a result, a list of exceptions exists to supplement the principle. In performing this assessment under the indexation criterion, an entity is required to consider any potential settlement adjustment provisions, regardless of the likelihood of the contingent events occurring.

Under the recognition Section of Subtopic 815-40, an entity must determine whether a contract meets specific conditions to be classified as equity (referred to as the settlement criterion). Analyzing whether a contract meets the settlement criterion involves evaluating the contracts settlement optionality and conditions necessary for share settlement. The general concept behind the settlement criterion is that a contract that will settle in an entitys own equity shares meets the criterion, whereas a contract that may (or will) require settlement in cash does not. The guidance includes seven conditions for performing this assessment, and the current guidance explicitly precludes considering the likelihood that an event would trigger cash settlement.

The Board received feedback that stakeholders have difficulty applying the guidance for this exception to derivative accounting because of its lack of organization, as well as that the guidance is rules based, internally inconsistent, and often is asserted to result in form-over-substance-based accounting conclusions. For example, a remote feature may drive the accounting treatment of the contract.

The amendments in this proposed Update would revise the guidance in Subtopic 815-40, as follows:

1. Add a likelihood threshold to the existing indexation guidance. All other existing indexation guidance would remain. However, an entity would no longer be required to evaluate potential adjustments that have a remote likelihood of occurring.

2. Remove the following from the settlement guidance: a. Requirement to evaluate contingent events that could require net cash settlement but have a remote likelihood of occurring b. Condition about settlement in unregistered shares c. Condition about collateral d. Condition about shareholder rights.

3. Clarify the condition about failure to timely file in the settlement guidance that penalty payments do not preclude equity classification.

The amendments in this proposed Update would reduce or eliminate situations in which classification conclusions are driven by remote contingent events. This change would, in turn, improve the understandability of the guidance and the subsequent accounting conclusions for all stakeholders. The Board decided that the proposed amendments would provide immediate relief for private companies and small public companies that continue to have errors in their financial statements because of the form-based (or rules-based) accounting requirements.

The amendments in this proposed Update to the derivatives scope exception for contracts in an entitys own equity would change the population of contracts that currently are recognized as assets or liabilities. For a freestanding instrument, if the instrument qualifies for the derivatives scope exception under the proposed amendments, an entity would record the instrument in equity. For an embedded feature, if the feature qualifies for the derivatives scope exception under the 6 proposed amendments, an entity would no longer bifurcate the feature and account for it separately.

The Board also decided to change the frequency of reassessing whether the derivatives scope exception is met. Under current guidance, reassessment is required at each balance sheet date. The amendments in this proposed Update would reduce the frequency of reassessment by requiring it only upon the occurrence of a reassessment event (such as an adjustment to the instruments strike price or the number of shares used to calculate the settlement amount). The proposed amendments would amend the disclosure requirements about contingent events to compensate for the reduction in frequency of the reassessments. The proposed amendments also would improve the guidance about disclosures for contracts in an entitys own equity.