2.8 Contingently Issuable Contracts

ASC 815-40

15-6 The guidance in this paragraph applies to both the issuer and the holder of the instrument. Outstanding instruments within the scope of the guidance in paragraphs 815-40-15-5 through 15-8 shall always be considered issued for accounting purposes, except as discussed in the next sentence. Lock-up options shall not be considered issued for accounting purposes unless and until the options become exercisable.

Unless a scope exception applies (such as the one for lock-up options [see Section 2.5.2]), contracts on an entity’s own equity that are only contingently issuable, exercisable, or settleable are not exempt from ASC 815-40. Thus, a freestanding equity-linked instrument that becomes issuable, exercisable, or settleable only upon the occurrence or nonoccurrence of a specified event (e.g., an IPO, a debt draw, or the meeting of a revenue target) is considered issued for accounting purposes and evaluated under ASC 815-40. ASC 815-40 applies even if the specified event is within the entity’s control. This is illustrated in the example in ASC 815-40-55-26, which implies that a warrant that is exercisable solely upon the occurrence of an IPO (which is an event that an entity typically has the ability to avoid) is within the scope of ASC 815-40. Further, ASC 815-40 applies even if no consideration is exchanged at inception.

A contingency that affects the exercisability or settlement of an equity-linked instrument influences its measurement but not the fact that the instrument is issued for accounting purposes. Since one party has agreed to give up an asset (e.g., cash), perform a service, or do some combination of both, the instrument must be considered issued for accounting purposes. That is, if a contract or any other enforceable arrangement is established as a result of one party’s performance, the instrument must be recognized for accounting purposes regardless of the nature of the contingencies that affect the exercisability or settlement of the instrument. All instruments that are considered issued for accounting purposes contain value since there would be no reason for two parties to enter into an arrangement that does not have value.

Freestanding equity-linked instruments that become issuable, exercisable, or settleable only upon the occurrence or nonoccurrence of a specified event are often executed in connection with the issuance of preferred stock, debt, or loan commitments. For example, in conjunction with the issuance of convertible preferred stock, entities often enter into agreements to issue additional shares of the preferred stock if certain milestones are met in the future. (Such transactions are often referred to as issuances of “tranche preferred stock.”) In addition, entities commonly issue warrants that are exercisable on the basis of the amount of debt draws made under a loan commitment. These types of freestanding equity-linked instruments are considered issued and outstanding for accounting purposes regardless of whether they are deemed legally issued before the specified event occurs or fails to occur. Entities must therefore apply the guidance in ASC 815-40 to determine whether to classify such instruments as liabilities or equity. The unit of account identified for an instrument may significantly affect its classification (see Section 3.2).

Although less common, there may be situations in which equity-linked instruments that become issuable, exercisable, or settleable only upon the occurrence or nonoccurrence of a specified event represent embedded features in a hybrid financial instrument. In these cases, the embedded features must be evaluated for bifurcation in accordance with ASC 815-15.

Example 2-5

Warrant That Vests on the Basis of Debt Draw

Company A executes a credit facility with Bank B, which permits, but does not require, A to borrow $15 million. As part of the agreement, A provides B with a warrant, which becomes exercisable (vested) only if A elects to draw on the credit facility. Once vested, the warrant permits B to purchase 1 million shares of A’s common stock. The warrant is viewed as outstanding under ASC 815-40 before the vesting condition has been met even though the contingency underlying the exercisability of the warrant is within the entity’s control. Accordingly, A should evaluate the warrant under ASC 815-40 to determine whether it should account for it as a liability or equity instrument even if A has not yet drawn on the credit facility. (Note that before A draws on the credit facility, this warrant would be outside the scope of ASC 480 even if the underlying shares were to include a deemed liquidation feature or other redemption provision outside of A’s control, provided that A has discretion to avoid a transfer of assets or equity shares by electing not to make any draw; see Section 2.2.1.3 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.)

Note that in this example, the warrant is considered a freestanding financial instrument, which is generally the case for these types of arrangements. If, however, the warrant was considered embedded in the loan commitment, the warrant would be bifurcated from the loan commitment host contract and recognized as a derivative liability unless it (1) does not meet the definition of a derivative or (2) qualifies for equity classification under ASC 815-40. An entity would not be able to apply the loan commitment scope exception to the warrant because this scope exception could only be applied to the host contract.

Example 2-6

Warrants That Vest on the Basis of Debt Draws

Company A executes a credit facility with Bank B, which permits, but does not require, A to borrow up to $10 million. As part of the agreement, A provides B with warrants, which become exercisable (vested) only if A elects to draw specified amounts on the credit facility. The warrants permit B to purchase the following number of shares:

200,000 shares for the first $2.5 million of debt drawn.
300,000 shares for the second $2.5 million of debt drawn.
500,000 shares for the remaining $5 million of debt drawn.

The warrants are viewed as outstanding under ASC 815-40 even if no amounts have been drawn. Accordingly, A should evaluate the warrants under ASC 815-40 to determine whether it should account for them as liabilities or equity instruments. Note that if the warrants are determined to be one unit of account (see Section 3.2), they would not be considered indexed to the entity’s own stock under ASC 815-40-15, because the amount of debt draws affects the settlement amount. Since this underlying is not an input into the pricing of a fixed-for-fixed option on equity shares (see Sections 4.2.2.3 and 4.3.3), the warrants would be accounted for as liabilities under ASC 815-40.

Note that in this example, the warrants are considered freestanding financial instruments, which is generally the case for these types of arrangements. If, however, the warrants were considered embedded in the loan commitment, the warrants would be bifurcated from the loan commitment host contract and recognized as derivative liabilities unless they do not meet the definition of a derivative. An entity would not be able to apply the loan commitment scope exception to the warrants because this scope exception could only be applied to the host contract.

Nevertheless, if an arrangement is not contractually binding or legally enforceable, it is not recognized. For example, an arrangement would generally not be recognized if both parties have an unconditional right to cancel it (i.e., to “walk away”) without any penalty or right to recover damages. An entity should consult its legal advisers for assistance in determining whether an arrangement is contractually binding or legally enforceable.

Example 2-7

Nonbinding Accelerated Share Repurchase Transaction

On June 15, 20X0, Company A entered into an accelerated share repurchase (ASR) agreement with Bank B that clearly defined all significant terms of the transaction (see Section 3.2.5 for a description of an ASR transaction). The agreement included a cancellation provision under which both A and B had the right to terminate the ASR at any time before the settlement of the initial treasury stock repurchase on July 1, 20X0 (the prepayment date), by written notice to the other party, without any penalty or recourse for the other party to recover damages. The ASR should be initially recognized on the prepayment date when the cancellation right expired and the contract became binding.

Example 2-8

Nonbinding Plan of Reorganization in Bankruptcy

An entity has filed for bankruptcy protection and has filed a proposed plan of reorganization that includes the issuance of shares and warrants to specified investors after approval by the bankruptcy court. The investors have made commitments to purchase the shares and warrants at specified prices. However, the bankruptcy court is under no legal obligation to accept the plan and has full discretion regarding whether to accept or reject it. In these circumstances, the entity would not recognize the capital commitments and warrants since they are not binding on the entity.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.