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FASB

Companies to Get Narrower Convertible Debt Model in Upcoming Proposed Rules

The FASB plans to reduce the accounting model for convertible debt from five to one or two models. The change is part of the board’s work to simplify rules on distinguishing between liabilities and equity—an area where there has been a high volume of restatements.

The FASB plans to narrow the rules for convertible debt under a proposal it will issue “in the near term” for distinguishing liabilities from equity, the board’s Vice Chairman James Kroeker said during its March 15, 2019, webcast for CPE providers.

Convertible debt is a loan obtained by a company from venture capital or angel investors whereby both parties agree to convert the debt into equity at a specific date. Rules surrounding convertible debt are important to emerging and growing companies that seek alternative financing solutions. They create complex accounting issues, however, and have therefore become a major source of confusion and restatements.

“We’ll have an exposure draft out in the near term that I hope will reduce the complexity of applying the literature by narrowing the number of [convertible debt] models that you have for certain types of transactions,” Kroeker said.

There are currently five models to account for convertible debt today, which the board plans to narrow down to one or perhaps two models, Kroeker said. “I didn’t know there were five [models]—I thought there were three, so it’s an area of tremendous complexity in the accounting today,” he said.

The project, one of the board’s priorities for 2019, was added to its agenda in September 2017 to tackle the accounting for distinguishing between liabilities and equity.

The FASB’s main decision-making discussions started in February 2019. The board has so far tentatively voted to revise certain disclosures for convertible instruments, including adding disclosure objectives for convertible debt and for convertible preferred shares. Among other revisions, guidance in the FASB’s codification literature on convertible debt in Subtopic 470-20, Debt–Debt with Conversion and other Options, and guidance on convertible preferred shares in Topic 505, Equity, will be centralized, the board said. Moreover, the derivative scope exception in Section 815-40-15, Derivatives and Hedging–Contracts in Entity’s Own Equity, and the diluted earnings-per-share calculation will be improved, according to a summary of the board’s decisions.

Accounting for distinguishing liabilities from equity has had decades of standard-setting work–dating as far back as 1986 when it was added to the FASB’s technical agenda.

Since then, the board has issued various pieces of guidance, including Accounting Standards Update (ASU) 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Those rules, including portions that address financial instruments with “downround” features, resolve various issues that have been raised.

The outcry for revisions to the liabilities and equity topic has not waned. Accountants in 2017 told the FASB that current guidance is “overly complex, internally inconsistent, path dependent, form based and is a cause for frequent financial statement restatements.”

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