Chapter 2 — Scope
Chapter 2 — Scope
2.1 Instruments Potentially Indexed to, and Potentially Settled in, the Entity’s Own Equity
ASC 815-40
15-1 The guidance in this Subtopic applies to all entities.
15-2 The guidance in this
Subtopic applies to freestanding contracts that are
potentially indexed to, and potentially settled in, an
entity’s own stock.
15-2A
The scope of this Subtopic includes security price
guarantees or other financial instruments indexed to, or
otherwise based on, the price of the entity’s stock that are
issued in connection with a business combination and that
are accounted for as contingent consideration.
15-4 The guidance in this Subtopic
applies to derivatives embedded in contracts in analyzing the
embedded feature under paragraphs 815-15-25-1(c) and
815-15-25-14 as though it were a freestanding instrument (as
further discussed in paragraphs 815-40-25-39 through
25-40).
ASC 815-40 applies to both public business
entities (including SEC registrants) and private companies. The guidance focuses on
freestanding contracts (see Section 3.2) that
have the following characteristics (ASC 815-40-15-2):
Characteristic | ASC Reference | Roadmap Discussion |
---|---|---|
Potentially indexed to an entity’s own stock | ASC 815-40-15 provides guidance on determining whether an equity-linked
instrument is considered indexed to an entity’s own
stock. | |
Potentially settled in an entity’s own stock | ASC 815-40-25 provides guidance on whether an entity has the ability to settle
an equity-linked instrument in its own stock or could be
forced to net cash settle it. |
Unless a specific scope exception applies, therefore, the following types of
instruments would be within the scope of ASC 815-40:
-
A freestanding call option written by the entity that gives the holder a right to purchase equity shares of the entity.
-
A freestanding call option that gives the entity a right to repurchase outstanding shares.
-
A freestanding warrant issued by the entity to a shareholder giving it the right to subscribe to additional equity shares of the entity.
-
A freestanding put option that gives the entity the right to sell shares to the writer of the option.
-
A freestanding forward contract that commits the entity to issue additional equity shares or the resale of treasury shares.
-
Contracts issued as contingent consideration in a business combination that are indexed to, or otherwise based on, the price of the entity’s stock.
As noted in ASC 815-40-15-4, the indexation and equity classification guidance
in ASC 815-40 also applies to some embedded features that have all the
characteristics of a derivative instrument in an entity’s determination of whether
such features are exempt from bifurcation under ASC 815-15 (see Section 2.2).
ASC 815-40 does not directly apply to outstanding equity shares (e.g., common or
preferred equity securities). Nevertheless, some equity shares contain embedded
features that may require evaluation under the indexation and equity classification
guidance in ASC 815-40 (e.g., an equity conversion option in a convertible preferred
stock contract, provided the option has the characteristics of a derivative
instrument and is not clearly and closely related to the host contract; see Section 2.2).
ASC 815-40 does not apply to the counterparty of an equity-linked financial
instrument. From the counterparty’s perspective, the contract is not on its own
equity. For example, if an entity writes a call option on its own equity to a third
party, the holder of that call option would not apply ASC 815-40 to the contract
because from the counterparty’s perspective, the contract is indexed to another
entity’s equity. (See also ASC 815-10-15-75.) Because ASC 815-40 does not apply to
the counterparty of an equity-linked financial instrument, an “entity” in this
Roadmap refers to the reporting entity whose stock is the underlying instrument in
the contract.
2.2 Derivative Instruments
2.2.1 Interaction With the Derivative Accounting Requirements
ASC 815-40
15-4 The guidance in this Subtopic applies to
derivatives embedded in contracts in analyzing the embedded feature under
paragraphs 815-15-25-1(c) and 815-15-25-14 as though it were a freestanding
instrument (as further discussed in paragraphs 815-40-25-39 through
25-40).
15-5 The guidance in this paragraph through paragraph
815-40-15-8 applies to any freestanding financial instrument or embedded
feature that has all the characteristics of a derivative instrument (see the
guidance beginning in paragraph 815-10-15-83). That guidance applies for the
purpose of determining whether that instrument or embedded feature qualifies
for the first part of the scope exception in paragraph 815-10-15-74(a). That
guidance does not address the second part of the scope exception in paragraph
815-10-15-74(a), which is addressed in Section 815-40-25. The guidance also
applies to any freestanding financial instrument that is potentially settled
in an entity’s own stock, regardless of whether the instrument has all the
characteristics of a derivative instrument for purposes of determining whether
the instrument is within the scope of this Subtopic.
15-9 For guidance on the interaction of this Subtopic and Subtopic 815-10, see paragraphs 815-10-15-74 through 15-78. For guidance on the interaction of this Subtopic and Subtopic 815-15, see paragraph 815-15-25-15.
ASC 815-10
15-74 Notwithstanding the conditions of paragraphs
815-10-15-13 through 15-139, the reporting entity shall not consider the
following contracts to be derivative instruments for purposes of this
Subtopic:
- Contracts issued or held by that reporting entity that
are both:
- Indexed to its own stock (see Section 815-40-15)
- Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25). . . .
15-75 The scope exceptions in paragraph 815-10-15-74
do not apply to either of the following:
-
The counterparty in those contracts. For example, the scope exception in (b) in the preceding paragraph related to share-based compensation arrangements does not apply to equity instruments (including stock options) received by nonemployees as compensation for goods and services.
-
A contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock. That contract can be a derivative instrument for the issuer under paragraphs 815-10-15-13 through 15-139, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Subtopic. For example, a forward contract that is indexed to both an entity’s own stock and currency exchange rates does not qualify for the exception in (a) in the preceding paragraph with respect to that entity’s accounting because the forward contract is indexed in part to something other than that entity’s own stock (namely, currency exchange rates).
15-75A For purposes of evaluating
whether a financial instrument meets the scope exception in paragraph
815-10-15-74(a)(1), a down round feature shall be excluded from the
consideration of whether the instrument is indexed to the entity’s own
stock.
15-76 Temporary equity
is considered stockholders' equity for purposes of the scope exception in
paragraph 815-10-15-74(a) even if it is required to be displayed outside of
the permanent equity section.
15-83 A derivative instrument is a financial instrument or other contract with all of the following characteristics:
- Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both.
-
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Some freestanding equity-linked instruments have the characteristics of a
derivative instrument under ASC 815-10-15-83. In accordance with ASC 815, such instruments
must be accounted for as derivatives at fair value, with changes in fair value reported in
earnings, unless they meet a scope exception in ASC 815.1 Under ASC 815-10-15-74(a), certain contracts on an entity’s own equity are exempt
from derivative accounting. In assessing whether an equity-linked instrument qualifies for
this scope exception, an entity applies the indexation and equity classification guidance
in ASC 815-40. A contract that qualifies as equity under the indexation and equity
classification guidance in ASC 815-40 would meet that scope exception and therefore would
be exempt from the derivative accounting requirements in ASC 815.
A freestanding equity-linked instrument that does not meet the definition of a
derivative instrument is outside the scope of ASC 815 but is nevertheless within the scope
of ASC 815-40. For example, a freestanding warrant that requires physical settlement in
private-company stock may not meet the net settlement characteristic in the definition of
a derivative instrument. The issuer of a warrant that does not meet the definition of a
derivative instrument would assess it under ASC 815-40 but not under ASC 815. If the
instrument does not meet the indexation and equity classification guidance in ASC 815-40,
it must be classified as an asset or liability and recognized at fair value, with changes
in fair value reported in earnings. This accounting is required even though the instrument
does not have all the characteristics of a derivative instrument in ASC 815-10-15-83.
Connecting the Dots
Because ASC 815-40 must be applied to all freestanding equity-linked
instruments, the classification and measurement of such instruments is the same
irrespective of whether they meet the characteristics of a derivative instrument in
ASC 815-10-15-83. However, if an equity-linked instrument does not qualify for equity
classification, the disclosures in ASC 815 apply only if the instrument meets the
definition of a derivative instrument.
2.2.2 Hybrid Instruments and Embedded Features
ASC 815-15
25-1 An embedded derivative shall be separated from
the host contract and accounted for as a derivative instrument pursuant to
Subtopic 815-10 if and only if all of the following criteria are met:
-
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
-
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
-
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
ASC 815-40
15-4 The guidance in
this Subtopic applies to derivatives embedded in contracts in analyzing the
embedded feature under paragraphs 815-15-25-1(c) and 815-15-25-14 as though it
were a freestanding instrument (as further discussed in paragraphs
815-40-25-39 through 25-40).
An entity may issue a hybrid nonderivative instrument that contains an embedded
equity-linked instrument (e.g., convertible securities or redeemable equity securities).
Although the guidance in ASC 815-40 does not directly address hybrid financial
instruments, its requirements related to indexation and equity classification may apply in
the determination of whether the embedded feature must be bifurcated under ASC
815-15-25-1. Bifurcation of an embedded feature is required if the three conditions in ASC
815-15-25-1 are met. If the first two conditions in ASC 815-15-25-1 are met, the entity
must determine whether the embedded feature qualifies as a derivative instrument on a
stand-alone basis (i.e., under ASC 815-15-25-1(c)).
An embedded feature that does not contain all the characteristics of a
derivative instrument in ASC 815-10-15-83 does not meet the third condition in ASC
815-15-25-1; therefore, bifurcation of the feature is not required, and the entity does
not need to evaluate the embedded feature under the indexation and equity classification
guidance in ASC 815-40. However, if the embedded feature does meet all the characteristics
of a derivative instrument in ASC 815-10-15-83, the entity must evaluate whether the
feature is eligible for the scope exception in ASC 815-10-15-74(a).2 To do so, the entity applies the indexation and equity classification guidance in
ASC 815-40. An embedded feature that does not qualify as equity under ASC 815-40 and meets
the three bifurcation conditions in ASC 815-15-25-1 is removed from its host contract and
accounted for separately as a derivative instrument. If the feature meets the indexation
and equity classification requirements, however, it is not bifurcated because the
exception in ASC 815-10-15-74(a) applies.
Connecting the Dots
ASC 815-40 only applies to an embedded feature in the determination
of whether it qualifies for the scope exception in ASC 815-10-15-74(a). The
recognition, measurement, and disclosure guidance in ASC 815-40 does not apply to an
embedded feature irrespective of whether the feature has all the characteristics of a
derivative instrument in ASC 815.3 Instead, the embedded feature is subject to the recognition, measurement, and
disclosure guidance in ASC 470-20, ASC 505-10, and ASC 815.
Under ASC 480-10-S99-3A and other SEC guidance, registrants are required to classify
certain redeemable equity securities in temporary equity outside of permanent equity. (For
a comprehensive discussion of the application of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.) In the evaluation of
whether an item meets the scope exception for an entity’s own equity in ASC
815-10-15-74(a), temporary equity is considered equity (ASC 815-10-15-76).
Connecting the Dots
ASC 815-10-15-76 indicates that in the evaluation of whether an item meets the scope
exception in ASC 815-10-15-74(a) for an entity’s own equity, temporary equity is
considered equity. This guidance is relevant to the evaluation of embedded derivatives
in a hybrid contract; however, it is not relevant to the evaluation of a freestanding
equity-linked instrument. As noted in the example below, the guidance in ASC
815-10-15-76 is relevant to the evaluation of a put option embedded in a share because
the share (host contract) would be classified in temporary equity as a result of the
embedded equity-linked instrument. However, this guidance does not permit a
freestanding option on a redeemable equity security (i.e., an equity security that is
redeemable for cash) to meet the equity classification requirements in ASC 815-40-25.
Rather, such an equity-linked instrument would be considered a net-cash-settled
instrument that does not qualify for equity classification under ASC 815-40-25.
Example 2-1
Scope Exception — Temporary Equity
An SEC registrant issues
shares that contain an embedded written put option that permits the holder to
put the shares back to the registrant in exchange for a cash payment. In
accordance with ASC 480-10-S99-3A, the registrant may be required to classify
the shares in temporary equity. When evaluating whether the embedded put option
qualifies for the scope exception in ASC 815-10-15-74(a) under the equity
classification guidance in ASC 815-40 (e.g., in assessing whether the contract
permits the issuer to settle in shares), the registrant would consider the
shares to be equity shares even though they are presented outside of permanent
equity.A feature that is commonly subject to evaluation under ASC 815-40 is an equity conversion
option embedded in a debt instrument. If it meets all the characteristics of a derivative
instrument in ASC 815-10-15-83, such feature must be bifurcated under ASC 815-15 unless
either of the following apply:
- The convertible debt instrument is recognized at fair value, with changes in fair value reported in earnings (e.g., the issuer has elected the fair value option in ASC 825-10).
-
The embedded conversion option meets the indexation and equity classification guidance in ASC 815-40. (Note that features embedded in certain convertible debt instruments are exempt from some of the equity classification conditions in ASC 815-40-25 [see Section 5.5].)
Example 2-2
Embedded Derivatives
An entity has issued a debt security that gives the counterparty the right to
convert the security into the entity’s common stock. The equity conversion
feature (1) meets all the characteristics of a derivative in ASC 815-10-15-83
(e.g., because the stock is publicly traded and the number of shares received
upon conversion can be rapidly absorbed by the market) and (2) otherwise meets
the conditions for separation as an embedded derivative in ASC 815-15-25-1
(e.g., it is not clearly and closely related to its host debt contract, and
the debt is not being remeasured at fair value with changes in fair value
recognized in earnings). The entity would assess the conversion feature under
the indexation and equity classification guidance in ASC 815-40 to determine
whether the scope exception to the derivative accounting guidance in ASC
815-10-15-74(a) applies. If the conversion feature qualifies as equity under
ASC 815-40, it would be exempt from derivative accounting. If it does not
qualify as equity under ASC 815-40, it would be bifurcated as a derivative
instrument under ASC 815-15 unless another scope exception applies.
Connecting the Dots
For further discussion of the issuer’s accounting for equity conversion features
embedded in debt instruments, see Deloitte’s Roadmap Issuer’s Accounting for Debt.
Footnotes
1
While ASC 815 requires certain changes in the fair value of
derivative instruments designated in qualifying cash flow hedges to be recognized in
other comprehensive income, ASC 815-20-25-15(h) does not permit an entity to designate
a transaction involving the entity’s own equity instruments as a hedged item in a cash
flow hedge.
2
This evaluation would be unnecessary if the embedded feature met
another exception to the derivative accounting guidance in ASC 815-10 or ASC 815-15.
However, in practice, embedded equity-linked instruments generally only potentially
qualify for the scope exception in ASC 815-10-15-74(a).
3
ASC 815-40 does, however, apply to the evaluation of whether an
embedded feature that meets the definition of a derivative instrument qualifies
for the scope exception in ASC 815-10-15-74(a) (see ASC 815-40-15-4).
2.3 Certain Repurchase Obligations and Variable-Share Contracts
ASC 815-40
15-3 The guidance in this Subtopic does not apply to any of the following: . . .
e. Financial instruments that are within the scope of Topic 480 (see paragraph 815-40-15-12).
15-12 Paragraph
480-10-15-5 explains that Topic 480 does not apply to a
feature embedded in a financial instrument that is not a
derivative instrument in its entirety (for example, a
written put option embedded in a nonderivative host
contract) in analyzing the embedded feature as though it
were a separate instrument as required by paragraph
815-15-25-1(c). Therefore, this Subtopic applies in
evaluating those embedded features under Subtopic
815-15.
Financial instruments that must be accounted for as liabilities or assets under
ASC 480 are outside the scope of ASC 815-40. Therefore, an entity does not apply ASC
815-40 to an equity-linked instrument unless it has first determined that ASC 480 is
not applicable.
ASC 480 applies to three types of freestanding financial instruments that
contain obligations of the issuer (see Chapter
4 of Deloitte’s Roadmap Distinguishing
Liabilities From Equity as well as Sections 2.3.1 and 2.3.2
below). The scope of ASC 480 is limited to freestanding financial instruments and
does not include embedded features (e.g., an embedded written put option in an
equity share issued by the entity). The applicability of ASC 815-40 to embedded
features is discussed in Section
2.2.2.
2.3.1 Obligations to Repurchase Shares by Transferring Assets
ASC 480-10
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
As discussed in more detail in Chapter 5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity, contracts other than outstanding shares that require
— or could require — the issuer to repurchase its equity shares (or are indexed
to such an obligation) by transferring assets are accounted for as liabilities
(or potentially as assets) under ASC 480. For example, a forward purchase
contract on an entity’s own equity shares or a written put option on the
entity’s own equity shares is classified as a liability if the issuer could be
required to physically settle the contract by delivering cash in exchange for
the issuer’s equity shares. Similarly, a forward purchase or written put option
contract that permits the counterparty to net cash settle the contract would be
classified as an asset or a liability. These requirements apply even if the
purchase obligation is contingent on the occurrence or nonoccurrence of an event
(unless it is solely within the entity’s control) or upon the counterparty’s
exercise of an option.
ASC 480 applies to contracts that require or could require delivery of the
entity’s redeemable equity securities (e.g., warrants, written call options, and
forward sales) if the entity could ultimately be forced to redeem those
securities by transferring assets. This is the case even if the redeemable
equity securities would be classified within equity (including temporary equity)
when issued. For example, if an entity issues a warrant that permits the holder
to purchase the entity’s equity shares, that warrant is classified as a
liability if the underlying equity shares contain a redemption requirement that
is not solely within the entity’s control (e.g., an investor put option embedded
in preferred stock). Although the warrant is required to be classified as a
liability, the redeemable equity securities may qualify for classification as
equity or temporary equity once issued. Similarly, a written call option or a
forward sale contract on redeemable equity securities would be classified as a
liability under ASC 480 if the entity could be required to transfer assets even
if the obligation to transfer assets is embedded in the shares underlying the
option or forward.
If, under the redemption feature, the entity could be required to transfer
assets, a contract on redeemable stock is classified as a liability under ASC
480 regardless of the timing of the potential redemption requirement (e.g.,
immediately after exercise of a warrant or at some date in the future) or the
redemption price (e.g., fair value or a fixed price). In addition, such a
contract is classified as a liability even if the redemption feature is
conditional on a defined contingency (such as a change of control, a reduction
in the issuer’s credit rating, a conversion, or a failure to have a registration
statement declared effective by the SEC by a designated date), unless the
contingency is solely within the control of the issuer.
If an entity could not be required to transfer assets under a freestanding contract on redeemable equity securities, the contract may be within the scope of ASC 815-40. For example, the following types of contracts on redeemable equity securities would potentially be within the scope of ASC 815-40 unless another scope exception applies:
- A purchased call option that permits the entity to repurchase redeemable equity securities, at its option (because the entity has no obligation to repurchase the redeemable equity securities).
- A purchased put option that permits the entity to issue (sell) redeemable equity securities, at its option (because the entity has no obligation to issue redeemable equity securities).
2.3.1.1 Put Warrants
ASC 815-40
55-16 Put warrants are
frequently issued concurrently with debt securities
of the entity, are detachable from the debt, and may
be exercisable only under specified conditions. The
put feature of the instrument may expire under
varying circumstances, for example, with the passage
of time or if the entity has a public stock
offering. Under Subtopic 470-20, a portion of the
proceeds from the issuance of debt with detachable
warrants must be allocated to those warrants.
55-17 Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to do any of the following:
- Exercise the warrant feature to acquire the common stock of the entity at a specified price
- Exercise the put option feature to put the instrument back to the entity for a cash payment
- Exercise both the warrant feature to acquire the common stock and the put option feature to put that stock back to the entity for a cash payment.
55-18 Because the contract
gives the counterparty the choice of cash settlement
or settlement in shares, entities should report the
proceeds from the issuance of put warrants as
liabilities and subsequently measure the put
warrants at fair value with changes in fair value
reported in earnings as required by Topic 480. That
is, a put warrant that embodies an obligation to
repurchase the issuer’s equity shares, or is indexed
to such an obligation, and that requires or may
require a transfer of assets is within the scope of
that Topic and therefore is to be recognized as a
liability.
A put warrant is an example of an instrument that is required to be classified
as a liability under ASC 480. Even though the warrant gives the counterparty
an option to purchase the entity’s stock, the warrant is classified as a
liability in its entirety under ASC 480 if the entity could be forced to
repurchase the warrant for cash or other assets because it represents an
obligation that is indexed to an obligation to repurchase the entity’s
equity shares, and the entity may be required to transfer cash or other
assets (see Section
5.1 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Alternatively, the counterparty may have the
right to put the stock it received upon exercise of the warrant back to the
entity for cash. In that case, the warrant embodies an obligation to
repurchase equity shares for cash (see Section 5.2.1 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity). Because put warrants fall
within the scope of ASC 480, they are outside the scope of ASC 815-40.
2.3.2 Contracts to Issue a Variable Number of Shares
ASC 480-10
25-14 A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).
See paragraph 480-10-55-21 for related implementation guidance.
Sometimes entities use their own shares as “currency” to settle an obligation in
which the number of shares delivered depends on the value of the obligation. If
a financial instrument embodies an obligation that the entity must or may settle
in shares, the entity could be required to classify the contract as a liability
(or, potentially, an asset) even if the instrument does not contain an
obligation to transfer cash or other assets. As discussed in more detail in
Chapter 6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity, ASC 480
identifies three circumstances in which a share-settleable contract would be
classified as a liability. A contract that embodies an obligation that the
issuer must or may settle in a variable number of equity-classified shares is
classified as a liability if, at inception, the obligation’s monetary value is
based solely or predominantly on:
-
A fixed monetary amount known at inception.
-
Variations in something other than the issuer’s equity shares.
-
Variations inversely related to changes in the fair value of the entity’s equity shares.
This guidance applies not only to contracts that require share settlement but also to contracts that the issuer may elect to settle in either assets or a variable number of shares. For financial instruments other than outstanding shares, this guidance applies irrespective of whether the obligation is conditional or unconditional.
The following are examples of contracts that would be accounted for as liabilities or assets under this guidance:
- A net-share-settled forward repurchase contract whose value is inversely related to the entity’s stock price (e.g., because the forward price is fixed).
- A net-share-settled written put option whose value is inversely related to the entity’s stock price (e.g., because the strike price is fixed).
- A contract to issue a variable number of equity shares whose value is based solely or predominantly on variations in something other than the entity’s equity shares (e.g., the S&P 500 Index).
- A prepaid variable share forward on the entity’s stock that obligates the entity to deliver shares with a monetary value that is predominantly a fixed monetary amount known at inception.
- Stock-settled debt.
2.3.3 Application of ASC 480 to Freestanding Written Puts and Forward Purchase Contracts
ASC 480-10
55-63 The following table
addresses classification of freestanding written put options
and forward purchase contracts within the scope of this
Subtopic.
If a forward contract requires physical settlement by repurchase of
a fixed number of the issuer’s equity shares for cash, it is classified as a
liability under ASC 480-10-25-8 and accounted for in accordance with ASC 480-10-30-3
and ASC 480-10-35-3 in a manner similar to a treasury stock repurchase with borrowed
funds (see Section
5.3.1 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Other forward purchase contracts and written put options
that require or may require the issuer to settle its obligation under the contract
by transferring assets are classified as assets or liabilities under ASC 480-10-25-8
and accounted for at fair value under ASC 480-10-30-7, ASC 480-10-35-1, ASC
480-10-35-4A, or ASC 480-10-35-5 (see Sections 5.1 and 5.3.2 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Such contracts include those that require net cash
settlement, permit the issuer to choose between net cash or physical settlement (but
not net share settlement), and give the counterparty a settlement choice if at least
one of the options is physical settlement or net cash settlement. Forward purchase
contracts and written put options that require or permit the issuer to settle its
obligation under the contract net in shares are classified as assets or liabilities
under ASC 480-10-25-14(c) and accounted for at fair value in accordance with ASC
480-10-30-7 as well as ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5 (see
Sections 6.1.4 and
6.3 of Deloitte’s
Roadmap Distinguishing
Liabilities From Equity).
2.4 Share-Based Payments
ASC 815-40 — Glossary
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
Also called share-based compensation arrangements.
ASC 815-40
15-3 The guidance in this Subtopic
does not apply to any of the following: . . .
b. Contracts that are issued to compensate grantees
in a share-based payment arrangement within the
scope of Topic 718 . . . .
15-5A The guidance in this
paragraph through paragraph 815-40-15-8 does not apply to
share-based payment awards within the scope of Topic 718 for
purposes of determining whether instruments are classified
as liability awards or equity awards under that Topic.
Equity-linked financial instruments issued to investors for
purposes of establishing a market-based measure of the
grant-date fair value of employee stock options are not
within the scope of Topic 718 themselves. Consequently, the
guidance in this paragraph through paragraph 815-40-15-8
applies to such market-based share-based payment stock
option valuation instruments for purposes of making the
determinations described in paragraph 815-40-15-5.
ASC 718-10
15-5 The guidance in this Topic
does not apply to transactions involving share-based payment
awards granted to a lender or an investor that provides
financing to the issuer. However, see paragraphs
815-40-35-14 through 35-15, 815-40-35-18, 815-40-55-49, and
815-40-55-52 for guidance on an issuer’s accounting for
modifications or exchanges of written call options to
compensate grantees. . . .
Awards May Become
Subject to Other Guidance
35-9 Paragraphs 718-10-35-10
through 35-14 are intended to apply to those instruments
issued in share-based payment transactions with employees
and nonemployees accounted for under this Topic . . . .
35-10 A freestanding financial
instrument or a convertible security issued to a grantee
that is subject to initial recognition and measurement
guidance within this Topic shall continue to be subject to
the recognition and measurement provisions of this Topic
throughout the life of the instrument, unless its terms are
modified after any of the following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
35-10A Only for
purposes of paragraph 718-10-35-10, a modification does not
include a change to the terms of an award if that change is
made solely to reflect an equity restructuring provided that
both of the following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of that
instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12 Once the classification of an
instrument is determined, the recognition and measurement
provisions of this Topic shall be applied until the
instrument ceases to be subject to the requirements
discussed in paragraph 718-10-35-10. Topic 480 or other
applicable GAAP, such as Topic 815, applies to a
freestanding financial instrument that was issued under a
share-based payment arrangement but that is no longer
subject to this Topic. This guidance is not intended to
suggest that all freestanding financial instruments shall be
accounted for as liabilities pursuant to Topic 480, but
rather that freestanding financial instruments issued in
share-based payment transactions may become subject to that
Topic or other applicable GAAP depending on their
substantive characteristics and when certain criteria are
met.
35-14 An entity may modify
(including cancel and replace) or settle a fully vested,
freestanding financial instrument after it becomes subject
to Topic 480 or other applicable GAAP. Such a modification
or settlement shall be accounted for under the provisions of
this Topic unless it applies equally to all financial
instruments of the same class regardless of the holder of
the financial instrument. Following the modification, the
instrument continues to be accounted for under that Topic or
other applicable GAAP. A modification or settlement of a
class of financial instrument that is designed exclusively
for and held only by grantees (or their beneficiaries) may
stem from the employment or vendor relationship depending on
the terms of the modification or settlement. Thus, such a
modification or settlement may be subject to the
requirements of this Topic. See paragraph 718-10-35-10 for a
discussion of changes to awards made solely to reflect an
equity restructuring.
ASC 815-40 does not apply to a share-based payment arrangement that
is within the scope of ASC 718. For example, it does not apply to a share-based
payment award granted to (1) an employee as compensation for rendering service, (2)
a nonemployee as compensation for the acquisition of goods or services by the
entity, or (3) a customer in conjunction with the entity’s sale of goods or services
that are within the scope of ASC 606. The entity would instead apply ASC 718 to
determine (1) whether the share-based payment arrangement should be classified as
equity or as a liability and (2) the appropriate accounting. However, ASC 815-40
does apply to equity-linked freestanding financial instruments that are issued to
nonemployee investors to establish a market-based measure of the grant-date fair
value of stock options because such arrangements are not within the scope of ASC 718
(see ASC 815-40-15-5A).
ASC 815-40 may also apply to an instrument that was originally
issued to a grantee in a share-based payment arrangement subject to ASC 718 if the
terms of the instrument are subsequently modified. If the terms of a share-based
payment award originally subject to ASC 718 are modified and the holder is no longer
an employee, or, for awards granted to nonemployees, a vested award is modified and
the grantee is no longer providing goods or services or is no longer a customer, ASC
718 ceases to apply unless the modification is made solely to reflect an equity
restructuring and the two conditions in ASC 718-10-35-10A are met. If an instrument
originally issued to a grantee in a share-based payment arrangement subject to ASC
718 becomes subject to ASC 480 or ASC 815-40, the classification of the instrument
may change.
ASC 718-10-15-5 exempts from the scope of ASC 718 transactions
involving equity instruments granted to a lender or an investor that provides
financing to the issuer. For example, if an entity obtains a loan in exchange for
issuing a contract on its own equity, that contract would not be within the scope of
ASC 718, but it would be evaluated under ASC 815-40 and any other applicable
guidance (including ASC 480).
2.5 Business Combinations
2.5.1 Contingent Consideration
ASC 815-40
15-2A The
scope of this Subtopic includes security price
guarantees or other financial instruments indexed
to, or otherwise based on, the price of the
entity’s stock that are issued in connection with
a business combination and that are accounted for
as contingent consideration.
ASC Master Glossary
Contingent Consideration
Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
In business combinations, the parties may agree to the contingent issuance of
additional shares in the future or to a contingent
return of shares. Contingent consideration is part
of the total consideration transferred for the
acquiree and therefore must be measured and
recognized at fair value as of the acquisition
date. Such arrangements permit the parties to
proceed with a business combination without
agreeing on the final purchase price. For example,
the acquirer may agree to deliver a specified
number of its own equity shares if the earnings of
the acquired entity exceed a specified target in
the year following the combination. Other examples
of events that may trigger contingent
consideration payments include reaching a
specified stock price or reaching a milestone on a
research and development project.
There is no scope exception in ASC 815-40 for equity-linked financial
instruments that represent contingent consideration in a business
combination. Accordingly, the acquirer determines whether contingent
consideration should be classified as equity or as an asset or a
liability in accordance with ASC 815-40 and any other applicable
guidance (including ASC 480).
ASC 805-30-35-1 discusses how to recognize changes in fair value of contingent consideration other than measurement-period adjustments. Contingent consideration classified as equity is not remeasured, and its settlement is recognized in equity. Contingent consideration classified as an asset or a liability is remeasured to fair value in each reporting period, with changes in fair value recognized in earnings unless the consideration qualifies for recognition in other comprehensive income under the hedge accounting guidance in ASC 815.
Under ASC 805, adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date are recognized as adjustments to goodwill. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information was based on events that occurred after the acquisition date. For example, earnings targets that are met, changes in share prices, and FDA approvals are all changes that occur after the acquisition date. Changes in fair value resulting from these items are recognized in earnings and not as adjustments to goodwill.
2.5.2 Lock-Up Options
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.
ASC Master Glossary
Lock-Up Options
Contingently exercisable options to purchase equity securities of another party to a business combination, at favorable prices, to encourage successful completion of that combination. If the merger is consummated as proposed, the options expire unexercised. If, however, a specified event occurs that interferes with the planned business combination, the options become exercisable.
Unless a scope exception applies, contracts that are only contingently
exercisable (e.g., equity-linked financial
instruments that become issuable or exercisable
upon an initial public offering [IPO] or other
contingent event) are not exempt from ASC 815-40.
One scope exception applies to lock-up options in
business combinations. ASC 815-40-15-6 specifies
that such options are “not . . . considered issued
for accounting purposes unless and until [they]
become exercisable.” Effectively, this means that
no accounting recognition is given to such options
before they become exercisable.
As defined in the ASC master glossary, lock-up options are limited to certain
contingent options exchanged by parties to a contemplated business
combination. The purpose of such options is to promote the completion
of the business combination between the parties. The options are meant
to “lock up” the acquiree and prevent it from being sold to other
potential buyers. For instance, lock-up options might give the
potential acquirer in a business combination the right to purchase
additional equity of the target company at a favorable price in the
event a third party purchases a large interest in the target company.
In this case, the options are designed to discourage third parties
from buying a large interest in the target company. If the business
combination proceeds as planned, however, the options never become
exercisable.
In addition, lock-up options are not specifically limited to those arrangements
for which no consideration is exchanged or firmly
committed. Further, the guidance on lock-up
options applies not only to freestanding financial
instruments but also to embedded features (e.g., a
lock-up option in a loan commitment).
2.5.3 Share-Settleable Earn-Out Arrangements
A special-purpose acquisition company (SPAC) is a newly formed company
that raises cash in an IPO and uses that cash or the equity of the SPAC, or both, to fund
the acquisition of a target. After a SPAC IPO, the SPAC’s management looks to complete an
acquisition of a target within the period specified in its governing documents (e.g., 24
months). In many cases, the SPAC and target may need to secure additional financing to
facilitate the transaction. For example, they may consider funding through a private
investment in public equity, which will generally close contemporaneously with the
consummation of the transaction. If an acquisition cannot be completed within the required
time frame, the cash raised by the SPAC in the IPO must be returned to the investors and
the SPAC is dissolved (unless the SPAC extends its timeline via a proxy process).
As part of the merger negotiations, the SPAC and target may agree to
enter into what is often referred to as an “earn-out” arrangement. Share-settleable
earn-out arrangements may be established with the target’s shareholders, the SPAC’s
sponsors, or both. Generally, share-settleable earn-out arrangements have the following
characteristics:
- The combined company is required to issue additional shares of common stock if, during a specified period after the merger date, its stock price equals or exceeds a stated amount or amounts.
- Some or all of the shares not previously issued will become issuable upon the occurrence of a specific event (e.g., a change of control of the combined company).
- The settlement must occur in shares (i.e., the combined company or holder cannot elect cash settlement).
Example 2-3
SPAC Earn-Out Arrangement
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will be issued to the target’s
shareholders for each of the following share price levels achieved over the
next five years:
- Level 1 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $10 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $10 per share.
- Level 2 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $15 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $15 per share.
- Level 3 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $20 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $20 per share.
- Level 4 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $25 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $25 per share.
If Level 4 is achieved, an aggregate of 4 million common
shares of the combined company (i.e., 1 million shares for each level) will be
issued pro rata to the target’s shareholders on the basis of their
pretransaction ownership interests.
For share-settleable earn-out arrangements such as those in the example
above, the accounting treatment of the shares awarded depends on the arrangements’ terms.
In cases in which these types of earn-out arrangements are entered into with the SPAC’s
sponsor, the shares are generally issued before the transaction; however, at the time of
the SPAC transaction, they become subject to either transfer restrictions or forfeiture on
the basis of one or more share price levels or the occurrence of a specific event (e.g., a
change of control). Such shares may or may not be held in escrow. In either case, if the
holder of the shares is subject to losing those shares (i.e., they would be forfeited if
one or more conditions are not met), for accounting purposes, those arrangements are
treated in the same manner as share-settleable earn-out arrangements that involve the
conditional issuance of shares (i.e., they are treated as equity-linked instruments as
opposed to outstanding shares). If, however, the owner legally owns the shares and is
subject only to transfer restrictions that lapse upon the earlier of (1) meeting one or
more specific conditions or (2) a stated date, such shares are considered to be
outstanding shares of stock subject to transferability restrictions rather than
equity-linked instruments. In other words, share-settleable earn-out arrangements that
contain vesting-type conditions are treated as equity-linked instruments (regardless of
whether the related shares have been issued), whereas earn-out arrangements that subject
the holder only to transfer restrictions are treated as outstanding shares.
Share-settleable earn-out arrangements that represent equity-linked
instruments are classified as either liabilities or equity instruments on the basis of ASC
815-40 unless such arrangements are within the scope of ASC 480 or ASC 718.4 Contracts that are classified in equity under ASC 815-40 are not remeasured.
However, contracts classified as liabilities must be subsequently remeasured at fair
value, with changes in fair value recognized in earnings.
To be classified as an equity instrument under ASC 815-40, a
share-settleable earn-out arrangement must meet the indexation and equity classification
requirements in ASC 815-40. The application of ASC 815-40 to these arrangements can be
very complex. Before beginning the analysis, entities must ensure that they have a
complete understanding of all the relevant terms. For example, in some cases, the main
provisions are included in a separate section of the merger agreement, but there could be
other agreements or “side letters” that modify or expand upon such terms. In addition, the
terms of such arrangements may be affected by definitions that are difficult to interpret.
Entities may need to consult with their legal advisers to obtain an understanding of such
definitions.
Several considerations, including those related to the following, are
relevant in the determination of how ASC 815-40 applies to an equity-linked instrument
such as a share-settleable earn-out arrangement.
- The unit of account — The arrangement may be a single unit of account, or it may contain multiple units of account, depending on whether (1) the arrangement as a whole represents a freestanding financial contract or (2) there are multiple freestanding financial contracts within the overall arrangement. (See Section 3.2 for further discussion of the unit of account.)
- Whether the equity-linked instrument is indexed to the combined company’s stock under ASC 815-40-15 — Only share-settleable earn-out arrangements that are indexed to the issuing entity’s stock may be classified in equity. (See Sections 4.2.3.2 and 4.3.7.4 for further discussion of indexation requirements.)
- Whether the equity-linked instrument satisfies the conditions for equity classification under ASC 815-40-25 — Only share-settleable earn-out arrangements for which the entity controls settlement in shares may be classified in equity. (See Chapter 5 for further discussion of these classification requirements.)
- Whether the earn-out arrangement gives the holder nonforfeitable rights to dividends irrespective of the arrangement’s classification as an equity or liability instrument — If this is the case, the instrument is a participating security regardless of whether the combined company actually declares or pays dividends. (See Deloitte’s Roadmap Earnings per Share for discussion of participating securities and the two-class method of calculating EPS.)
Footnotes
4
Generally, a share-settleable earn-out arrangement would be subject
to ASC 718 if the holder must provide service to the combined company after the merger
date and one or more share-price levels are reached or other conditions are met.
Therefore, entities should consider whether the counterparty to the arrangement must
provide services to the combined company to earn the award.
2.6 Consolidation and the Equity Method
2.6.1 Contracts on the Stock of Consolidated Subsidiaries
ASC 810-10
45-17A An equity-classified
instrument (including an embedded feature that is
separately recorded in equity under applicable GAAP)
within the scope of the guidance in paragraph
815-40-15-5C shall be presented as a component of
noncontrolling interest in the consolidated financial
statements whether the instrument was entered into by
the parent or the subsidiary. However, if such an
equity-classified instrument was entered into by the
parent and expires unexercised, the carrying amount of
the instrument shall be reclassified from the
noncontrolling interest to the controlling interest.
ASC 815-40
15-5C Freestanding financial
instruments (and embedded features) for which the payoff
to the counterparty is based, in whole or in part, on
the stock of a consolidated subsidiary are not precluded
from being considered indexed to the entity’s own stock
in the consolidated financial statements of the parent
if the subsidiary is a substantive entity. If the
subsidiary is not a substantive entity, the instrument
or embedded feature shall not be considered indexed to
the entity’s own stock. If the subsidiary is considered
to be a substantive entity, the guidance beginning in
paragraph 815-40-15-5 shall be applied to determine
whether the freestanding financial instrument (or an
embedded feature) is indexed to the entity’s own stock
and shall be considered in conjunction with other
applicable GAAP (for example, this Subtopic) in
determining the classification of the freestanding
financial instrument (or an embedded feature) in the
financial statements of the entity. The guidance in this
paragraph applies to those instruments (and embedded
features) in the consolidated financial statements of
the parent, whether the instrument was entered into by
the parent or the subsidiary. The guidance in this
paragraph does not affect the accounting for instruments
(or embedded features) that would not otherwise qualify
for the scope exception in paragraph 815-10-15-74(a).
For example, freestanding instruments that are
classified as liabilities (or assets) under Topic 480
and put and call options embedded in a noncontrolling
interest that is accounted for as a financing
arrangement under Topic 480 are not affected by this
guidance. For guidance on presentation of an
equity-classified instrument (including an embedded
feature that is separately recorded in equity under
applicable GAAP) within the scope of the guidance in
this paragraph, see paragraph 810-10-45-17A.
In consolidated financial statements, contracts potentially indexed to, and
potentially settled in, the equity shares of a consolidated subsidiary are analyzed in a
manner similar to contracts on the parent entity’s own stock unless the subsidiary is not
a substantive entity. Thus, a contract on subsidiary stock could be within the scope of
ASC 815-40 and qualify for equity classification in the consolidated financial statements
even though it is not on the parent entity’s own stock. This is the case irrespective of
whether the parent or the subsidiary entered into the contract. An equity-classified
contract on the stock of a consolidated subsidiary is presented as a component of
noncontrolling interest in the consolidated financial statements.
If the subsidiary is not a substantive entity, a contract on that subsidiary’s
stock is outside the scope of ASC 815-40 and does not qualify for equity classification
regardless of whether the contract otherwise meets the conditions for equity
classification in ASC 815-40. However, since ASC 815-40 does not define “substantive
entity,” judgment must be used in the determination of whether an entity is substantive.
For example, a shell entity that holds commodities or stocks might not be a substantive
entity.
2.6.2 Contracts on the Stock of a Parent or Other Entity That Is Not Consolidated
In the subsidiary’s separate financial statements, the equity of its parent
would not be considered part of the subsidiary’s equity. Therefore, a contract potentially
indexed to, and potentially settled in, the parent’s stock would be outside the scope of
ASC 815-40 and could not be classified within equity in the subsidiary’s separate
financial statements. For the same reason, a contract on the stock of an affiliated entity
that is not consolidated by the reporting entity (e.g., a sister company within a group)
would be outside the scope of ASC 815-40. Such a contract would not qualify as equity in
the reporting entity’s financial statements, although it might qualify as equity in the
reporting entity’s parent’s financial statements if the parent consolidates the affiliated
entity. See Section 5.2.7 for
further discussion about the analysis under ASC 815-40-25 of contracts indexed to an
entity’s own equity that can be settled in the shares of another entity within a
consolidated group.
Connecting the Dots
The discussion above focuses on a subsidiary’s accounting for an equity-linked
instrument that is indexed to the stock of its parent or to the stock of an affiliate
that is not consolidated by the subsidiary. As noted previously, in the application of
ASC 815-40, the stock of a subsidiary’s parent or its affiliate is not considered
equity of the subsidiary; therefore, an equity-linked instrument on the stock of the
subsidiary’s parent or its affiliate may not be classified in equity. However, this
does not mean that a subsidiary should classify an ownership interest in the stock of
its parent or its affiliate as an asset. Rather, it is presumed that such ownership is
established to facilitate a treasury stock transaction on behalf of the subsidiary’s
parent or its affiliate and that the ownership interest should therefore be classified
in equity within the subsidiary’s separate financial statements. See further
discussion in Section 4.3.2.1 of Deloitte’s
Roadmap Noncontrolling Interests.
2.6.3 Contracts on the Stock of an Equity Method Investee
Equity shares issued by an equity method investee are not considered part of the
entity’s own equity. Therefore, contracts potentially indexed to, and potentially settled
in, the equity shares of an equity method investee would be outside the scope of ASC
815-40.
2.6.4 Certain Option Combinations Involving Noncontrolling Interests
ASC 815-40
15-3 The guidance in this Subtopic does not apply to any of the following: . . .
d. A written put option and a purchased call option embedded in the shares of a noncontrolling
interest of a consolidated subsidiary if the
arrangement is accounted for as a financing under
the guidance beginning in paragraph 480-10-55-53 .
. . .
ASC 480-10
55-53 A controlling majority owner (parent) holds 80 percent of a subsidiary’s equity shares. The remaining 20 percent (the noncontrolling interest) is owned by an unrelated entity (the noncontrolling interest holder). Simultaneous with the acquisition of the noncontrolling interest, the noncontrolling interest holder and the parent enter into a derivative instrument that is indexed to the subsidiary’s equity shares. The terms of the derivative instrument may be any of the following: . . .
b. The parent has a call option to buy the other 20 percent at a fixed price at a stated future date, and the
noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those
same terms, that is, the fixed price of the call is equal to the fixed price of the put option. (Derivative 2) . . .
55-55 Depending on how Derivative 2 was issued, one
of three different accounting methods applies. If Derivative 2 was issued as a
single freestanding instrument, under this Subtopic it would be accounted for
in its entirety as a liability (or an asset in some circumstances), initially
and subsequently measured at fair value. If the written put option and the
purchased call option in Derivative 2 were issued as freestanding instruments,
the written put option would be accounted for under this Subtopic as a
liability measured at fair value, and the purchased call option would be
accounted for under Subtopic 815-40. Under both of those situations, the
noncontrolling interest is accounted for separately from the derivative
instrument under applicable guidance. However, if the written put option and
purchased call option are embedded in the shares (noncontrolling interest) and
the shares are not otherwise classified as liabilities under the guidance in
this Subtopic, the instrument shall be accounted for as discussed in paragraph
480-10-55-59 with the parent consolidating 100 percent of the subsidiary.
55-57 In applying paragraphs 480-10-25-4 through 25-14 to determine classification, a freestanding financial instrument within this Subtopic’s scope is precluded from being combined with another freestanding financial instrument, unless combination is required under the provisions of Topic 815; therefore, unless under the particular facts and circumstances that Topic provides otherwise, freestanding derivative instruments in the scope of this Subtopic would not be combined with the noncontrolling interest.
55-58 This guidance is limited to circumstances in which the parent owns a majority of the subsidiary’s outstanding common stock and consolidates that subsidiary at inception of the derivative instrument. This guidance is limited to the specific derivative instruments described.
Written Put Option and Purchased Call Option Embedded in Noncontrolling Interest
55-59 If the derivative instrument in Derivative 2 is
embedded in the shares (noncontrolling interest) and the shares are not
otherwise classified as liabilities under the guidance in this Subtopic, the
combination of options should be viewed on a combined basis with the
noncontrolling interest and accounted for as a financing of the parent’s
purchase of the noncontrolling interest.
55-60 Under that approach, the parent would consolidate 100 percent of the subsidiary and would attribute the stated yield earned under the combined derivative instrument and noncontrolling interest position to interest expense (that is, the financing would be accreted to the strike price of the forward or option over the period until settlement). No gain or loss would be recognized on the sale of the noncontrolling interest by the parent to the noncontrolling interest holder at the inception of the derivative instrument.
55-61 The risks and rewards
of owning the noncontrolling interest have been retained
by the parent during the period of the derivative
instrument, notwithstanding the legal ownership of the
noncontrolling interest by the counterparty. Combining
the two transactions in this circumstance reflects the
substance of the transactions; that the counterparty is
financing the noncontrolling interest. Upon such
combination, the resulting instrument is not a
derivative instrument subject to Subtopic 815-10.
55-62 This accounting applies even if the exercise prices of the put and call options are not equal, as long as those exercise prices are not significantly different.
ASC 480-10-55-53 through 55-62 require certain embedded option combinations
involving a noncontrolling interest of a consolidated subsidiary to be accounted for on a
combined basis with the noncontrolling interest as a financing of the parent’s purchase of
the noncontrolling interest. Such option combinations are exempt from the scope of ASC
815-40. This accounting treatment applies when:
-
The parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary.
-
The remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest) are held by a third party.
-
Simultaneously with the acquisition of the noncontrolling interest, the parent and the holder of the noncontrolling interest enter into the following option combination:
-
The parent has a call option to purchase the noncontrolling interest at a fixed price on a stated future date.
-
The noncontrolling interest holder has a put option to sell the noncontrolling interest to the parent under the same terms. (ASC 480-10-55-62 suggests that the exercise prices do not need to be equal as long as they are not significantly different.)
-
-
The options are embedded in the shares representing the noncontrolling interest (i.e., they are not considered freestanding instruments).
-
The noncontrolling interest shares do not meet the definition of a mandatorily redeemable financial instrument (see Chapter 4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).
This guidance applies irrespective of whether the noncontrolling interest is in
the form of common stock or preferred stock. Further, the guidance applies even if the
relative ownership interests of the parent and the holder of the noncontrolling interest
differ from the levels assumed in the fact pattern described in ASC 480 (i.e., 80 percent
and 20 percent), provided that the parent owns a majority of the subsidiary’s outstanding
common stock and consolidates the subsidiary at the inception of the arrangement (ASC
480-10-55-58). The guidance does not apply, however, if the option strike prices are based
on a formula (e.g., EBITDA) that is not simply an indexation to interest rates rather than
being fixed or if the options are contingent on the satisfaction of certain conditions
(for further discussion, see Section
7.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).
If a parent and the holder of a noncontrolling interest enter into put and call
options on the noncontrolling interest and either the option combination or each option is
considered to be a freestanding financial instrument (see Section 3.2.1) that is separate from the
noncontrolling interest, the noncontrolling interest and the options would not be
accounted for on a combined basis as a financing of the parent’s purchase of the
noncontrolling interest. Instead, the accounting for the options depends on whether they
represent a single freestanding financial instrument (in which case the option combination
is accounted for as an asset or a liability under ASC 480-10-25-8) or two separate
freestanding financial instruments (in which case the put option is accounted for as a
liability under ASC 480-10-25-8, and the call option is evaluated under ASC 815-40).
Either way, the accounting differs from that specified for noncontrolling interests with
embedded options in ASC 480-10-55-59 through 55-62, because the noncontrolling interest
would be reflected in equity by the parent.
2.7 Guarantee Contracts
ASC 815-40
15-10 Topic 460 provides an exception from its initial recognition and initial measurement requirements, but not its disclosure provisions, for a guarantee for which the guarantor’s obligation would be reported as an equity item (rather than a liability) under generally accepted accounting principles (GAAP).
15-11 If
a contract under this Subtopic is required to be accounted
for as a liability under this Subtopic and also meets the
definition of a guarantee under Topic 460 (for example, a
physically settled written put option), both this Subtopic
and that Topic are consistent with respect to requiring the
issuer to account for the contract at fair value at the
initial measurement date. In that situation, the guarantee
would also be subject to the disclosure requirements of
Topic 460.
A contract potentially indexed to, and potentially settled in, an entity’s own
stock might fall within the scope of both ASC
815-40 and ASC 460. ASC 460-10-15-4 states that
with certain exceptions, ASC 460 applies to the
following types of guarantee contracts:
-
Contracts that contingently require a guarantor to make payments [including cash, financial instruments, other assets, shares of its stock, or provision of services] to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. . . .
-
Contracts that contingently require a guarantor to make payments . . . to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). . . .
-
Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
-
Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
ASC 460-10-25-1(d) and ASC 460-10-30-1 exempt from the scope of the recognition
and initial measurement guidance on guarantee contracts in ASC 460 “[a] guarantee
for which the guarantor’s obligation would be reported as an equity item” (e.g.,
under ASC 815-40) rather than as a liability. However, the disclosure requirements
for guarantees in ASC 460 would apply to such contracts unless they are eligible for
a scope exception in ASC 460-10-15-7 (e.g., guarantees of an entity’s own future
performance are excluded from the scope of ASC 460).
Example 2-4
Guarantee Contracts
Assume:
- An entity writes a call option that gives the holder the right to purchase equity securities of the option issuer in exchange for payment of cash by the holder.
- The entity knows that the holder of the call option is purchasing the option to cover a short position in the entity’s equity securities.
In this example, the entity may conclude that the contract is within the scope of ASC 460 on the basis of ASC 460-10-15-4(a) since the issuer is required to transfer an equity security to the option holder as a result of the changes in a liability of the option holder (the underlying short position).
However, if the issuer has no factual basis on which to conclude that the holder
of the call option is purchasing the option to cover a short
position in the asset, the written call option is not within
the scope of ASC 460 since the issuer does not have the
information necessary to conclude that the option holder has
an underlying short position.
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.
2.9 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
ASC 470-20
05-12A An entity for which the cost to an investment banking firm (investment bank) or third-party investors
(investors) of borrowing its shares is prohibitive (for example, due to a lack of liquidity or extensive open
short positions in the shares) may enter into share-lending arrangements that are executed separately but
in connection with a convertible debt offering. Although the convertible debt instrument is ultimately sold to
investors, the share-lending arrangement is an agreement between the entity (share lender) and an investment
bank (share borrower) and is intended to facilitate the ability of the investors to hedge the conversion option in
the entity’s convertible debt.
05-12B The terms of a share-lending arrangement require the entity to issue shares (loaned shares) to
the investment bank in exchange for a nominal loan processing fee. Although the loaned shares are legally
outstanding, the nominal loan processing fee is typically equal to the par value of the common stock, which is
significantly less than the fair value of the loaned shares or the share-lending arrangement. Generally, upon
maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to
the entity for no additional consideration.
05-12C Other terms of a share-lending arrangement typically require the investment bank to reimburse the
entity for any dividends paid on the loaned shares. Typically, the arrangement precludes the investment bank
from voting on any matters submitted to a vote of the entity’s shareholders to the extent the investment bank
is the owner of the shares.
ASC 470-20 provides recognition, measurement, EPS, and disclosure guidance
related to an issuer’s accounting for equity-classified share-lending arrangements
that are executed in contemplation of a convertible debt issuance. This guidance is
designed for arrangements that have the following terms and characteristics:
-
The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
-
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
-
The counterparty will return the loaned shares to the issuer by the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
-
The arrangement qualifies as equity under GAAP.
-
The arrangement was executed in contemplation of a convertible debt issuance or other financing.
In evaluating whether the contract qualifies as equity under GAAP, the issuer
should consider the requirements in ASC 480 and ASC 815-40 (see Sections 4.3.5.12, 5.2.3.6, and 6.1.6).
Own-share lending arrangements usually derive their fair value from the difference between the
contractual processing fee and a market-based rate that would typically be charged for lending such
shares, adjusted as necessary to reflect the nonperformance risk of the share borrower. The terms of a
share-lending arrangement issued in contemplation of a convertible debt issuance typically require an
entity to issue its common shares to a counterparty (e.g., the bank) in exchange for a nominal processing
fee. The processing fee is significantly less than the fair value of the shares and is typically less than a
market fee that would be charged in a share-lending arrangement that is not issued in contemplation
of a convertible debt issuance. The issuer may accept less than a market rate on the arrangement to
promote the issuance of the convertible debt.
Example 2-9
Own-Share Lending Arrangement
Issuer A is in the process of issuing convertible debt. Before certain prospective investors agree to buy the
convertible debt, however, they would like to ensure that they are able to economically hedge their exposure
to A’s share price risk associated with the conversion option embedded in the debt. Accordingly, they seek
to enter into derivative contracts on the underlying shares (such as options, forwards, or total return swaps)
with Bank B that offset the “long” position in A’s share price risk that would result from an investment in the
convertible debt. To economically hedge its exposure from writing such derivatives, B in turn seeks to borrow
the underlying shares. By borrowing the shares, B can sell them short in the market to offset its “long” position
in A’s share price risk that would be created by its derivative contracts with the investors.
Because a sufficient amount of underlying shares is not readily available to market participants (or the price
is too high), B borrows the underlying shares by entering into a share-lending arrangement directly with A.
The terms of the share lending arrangement require B to pay a nominal processing fee to A (e.g., the par
value of the shares) that is significantly less than the agreement’s fair value. Issuer A is motivated to enter
into the agreement because the pricing and successful completion of the convertible debt offering depend
on the investors’ ability to enter into derivative contracts to hedge their equity price exposure, which in turn
depend on B’s ability to borrow the shares from A. During the period that the shares are on “loan,” they are
legally outstanding and the holder is legally entitled to dividends paid on them, although it must reimburse
A for any dividends paid on the loaned shares. Upon conversion or maturity of the convertible debt, B must
physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is
contractually entitled to a cash payment equal to the fair value of the loaned shares.