February 15, 2019 — FASB Decides to Relax Equity Classification Conditions
Deloitte Accounting Journal
February 15, 2019
FASB Decides to Relax Equity Classification Conditions
At its meeting on February 13, 2019, the FASB made several important decisions as part of its project on distinguishing liabilities from equity (including convertible debt).
Contracts on an Entity’s Own Equity
ASC 815-401 addresses whether an equity-linked contract (such as a warrant, option, or forward on an entity’s own equity shares) qualifies as equity in the entity’s financial statements. That guidance also applies in the determination of whether a contract or embedded feature (e.g., an equity conversion feature embedded in convertible debt) is exempt from derivative accounting under ASC 815. Under existing guidance in ASC 815-40, only a contract or embedded feature that is considered indexed to an entity’s own equity (e.g., the only variables that could affect the settlement amount are inputs to the fair value of a fixed-for-fixed forward or an option on an entity’s equity shares) and meets certain other conditions (e.g., the entity could not be forced to net cash settle the contract) qualifies as equity. At this week’s meeting, the Board tentatively decided to relax some of those conditions.
More specifically, the Board tentatively decided that existing guidance in ASC 815-40-15 related to the determination of whether a contract would be considered indexed to an entity’s own equity should continue to apply (see Chapter 4 of Deloitte’s A Roadmap to Accounting for Contracts on an Entity’s Own Equity). However, potential adjustments to the settlement amount that have only a remote likelihood of occurring would no longer preclude equity classification. Accordingly, a contract that previously did not qualify as equity because it contained an adjustment to the settlement amount that prevented it from meeting the indexation criteria in ASC 815-40-15 (e.g., a contingent adjustment indexed to an extraneous variable) might qualify as equity if only a remote likelihood existed that the adjustment would be triggered.
The FASB staff noted that contracts that would qualify as equity under the FASB’s proposed approach might be required to be classified as temporary equity by the SEC unless the SEC were to revise its requirements, since the SEC’s permanent equity conditions are stricter than the FASB’s proposed approach (see Chapter 9 of Deloitte’s A Roadmap to Distinguishing Liabilities From Equity).
In addition, the Board decided that an entity should be required to reassess a contract’s classification only upon the occurrence of a triggering event. Accordingly, an entity would no longer be required to reassess whether a contract qualifies as equity as of each balance sheet date (see Section 5.4 of Deloitte’s A Roadmap to Accounting for Contracts on an Entity’s Own Equity).
The FASB also tentatively decided to make limited improvements to the disclosure guidance related to contracts on an entity’s own equity. See the tentative Board decisions for further information.
The FASB staff stated that the Board had tentatively decided on June 6, 2018, that any convertible debt that does not contain a bifurcated embedded derivative should be accounted for as a single unit of account; that is, convertible debt with cash conversion features or beneficial conversion features would no longer require separation into liability and equity components under ASC 470-20.2
At this week’s meeting, the Board tentatively decided that the if-converted method should apply to the calculation of diluted earnings per share (EPS) for all convertible instruments. The treasury-stock method would no longer be available for convertible debt with cash conversion features, such as Instrument X (see Section 220.127.116.11 of Deloitte’s A Roadmap to the Presentation and Disclosure of Earnings per Share). Further, the Board tentatively agreed to remove the ability to overcome the presumption of share settlement in the calculation of EPS for contracts that may be settled in either cash or shares (see Section 18.104.22.168 of Deloitte’s A Roadmap to the Presentation and Disclosure of Earnings per Share).
The FASB also tentatively decided to amend the disclosure requirements related to convertible debt and convertible preferred shares. See the tentative Board decisions for further information.
The Board will discuss sweep issues and transition at a future meeting. The Board’s next step in performing due process would be to issue a proposed Accounting Standards Update for public comment, although the timing of such a document has not yet been determined.