Why Private Equity and Venture Capital Firms Should Early Adopt This Debt Accounting Update
The Financial Accounting Standards Board (FASB) has been evaluating accounting standards for the past several years to identify the requirements that could be streamlined. One area that received recent attention involves accounting for convertible instruments and contracts in an entity’s own equity under ASC Topic 815, Debt.
Accounting Standards Update (ASU) 2020-06 addresses complexities for issuers of convertible debt and preferred stock. The update won’t go into effect for private entities until calendar year 2024 (public company filers generally adopt in 2022) but early adoption is permitted.
Private equity and venture capital (PE and VC) firms may want to consider the benefits of early adoption, particularly because the following accounting requirements may be easier (and as a result, reducing time and cost burden) to manage.
PE and VC firms with embedded cash and beneficial conversion features (BCF) can early adopt ASU 2020-06 to account for these conversions features as a single unit using the traditional convertible debt model. Previously, BCFs had to be evaluated for separate accounting and if recognized, a BCF typically resulted in higher non-cash interest charges over the life of the instrument.
ASU 2020-06 continues to require bifurcation for conversion features that meet the criteria for accounting under the substantial premium model or that meet the definition of a derivative.
If your organization has conversion features, it will be required to assess the amount and timing of future cash flows in those instruments as part of your disclosures. Public companies have additional fair value reporting requirements.
Contracts in an Entity’s Own Equity
If your firm has equity contracts, ASU 2020-06 will make reporting for them simpler by removing the requirement to assess whether your equity contracts permit settlement of unregistered shares. You would assess whether your equity contract contains a cash settlement requirement for when registered shares are unavailable. Those contracts with specific cash settlement provisions are not classified as equity; all others will be considered equity contracts.
Also eliminated are the assessments related to bankruptcy situations. Previously, entities would have been required to evaluate whether their equity contracts require collateral or provide the holder with rights that rank higher than a shareholder. Once adopted, entities would not have to report penalty payments related to late SEC filings.
Changes to Earnings per Share Guidance
For PE and VC firms that present Earnings per Share (EPS), ASU 2020-06 provides for improvements to EPS guidance for convertible instruments, including required use of the if-converted method in computation of diluted EPS when an entity has issued convertible instruments. In addition ASU 2020-06 includes the following:
- [WU1] Entities must include in their diluted EPS calculation the effect of instruments that may be settled in cash or shares based on the potential share settlement to maximize the potential dilution in diluted EPS
- Equity-classified convertible preferred stock that has a down round feature is accounted for under the recognition and measurement guidance in ASC Topic 260, due to removal of the beneficial conversion feature model from the convertible instrument guidance, discussed above.
- Clarification that the weighted-average share count from each quarter should be used when calculating year-to-date weighted-average share count.
If your PE or VC firm decides to early adopt, it is advisable to enlist the assistance of an experienced accounting provider. There are a few options to transition to the standard updates, including using a modified approach – applying changes to contracts or instruments as of the adoption year or full retrospective approach, to all reporting periods presented in the financial statement.
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Published on March 01, 2022