3.1 Identifying and Evaluating Contractual Terms

In determining the appropriate accounting for an equity-linked instrument, the entity should devote adequate time to reading the underlying legal documents. Terms that could be significant to the accounting analysis (e.g., contingent net cash settlement requirements or provisions that adjust the settlement amount) may be buried deep within the contract’s fine print. To properly apply the applicable accounting requirements, the entity needs to evaluate all the contractual terms, the legal and regulatory framework, and the relevant facts and circumstances.

In forming a view on the appropriate accounting for a contract, an entity cannot necessarily rely on the name given to the transaction (e.g., “equity derivative” or “accelerated share repurchase program”) or how it is described in summary term sheets, slide-show presentations, and marketing materials. Products with similar economics sometimes go by different names in the marketplace (e.g., products marketed by different investment banks), while products subject to different accounting may go by the same or similar names (e.g., a warrant on own equity can be designed in a variety of ways). Furthermore, the names given to contractual provisions in legal documents, such as conversion features or share settlement provisions, do not necessarily reflect their economics or how they would be identified and analyzed for accounting purposes; for example, certain redemption provisions may permit conversion features to be net settled (see Section 5.2.4.1). Minor variations in the way contractual terms are defined can have major accounting implications.

An individual contract may consist of multiple legal documents (e.g., a trade confirmation that refers to a master agreement and side letters), all of which an entity should consider in identifying the contract’s terms. In addition, when identifying the terms of a contract on its own shares, the entity should consider whether the terms of the underlying shares could affect the accounting analysis of the contract. In identifying the terms of such underlying shares, the entity should consider all relevant documents, including the entity’s certificate of incorporation and any shareholder agreement or side letter that affects the entity’s rights and obligations vis-à-vis a holder of those shares. For example, if an entity issues a warrant on its own shares and the entity is party to a shareholder agreement that includes a provision that allows the holder to put the warrant or the underlying shares to the issuing entity upon a change of control or other deemed liquidation event, that “put” provision would affect the warrant’s classification (i.e., the warrant would be classified as a liability) even though the provision is not contained within the warrant agreement itself.

For example, a trade confirmation may (1) incorporate ISDA equity derivatives definitions and (2) supplement, form a part of, and be subject to an agreement in the form of the ISDA master agreement that sets out general terms between the parties. Further, the confirmation may identify adjustments, settlement methods, early termination provisions, and other terms that must be evaluated within the context of an ISDA master agreement and ISDA’s equity derivatives definitions and specify that the terms of the confirmation govern in the event of any inconsistency between the documents. In this case, the application of the indexation and equity classification guidance in ASC 815-40 depends on the elections and modifications an entity has made and how they are defined within the documents. Adjustment or cancellation provisions or netting arrangements may preclude equity classification unless the contracting parties agree to override them in the transaction confirmation (see Section 5.2.2).

In remarks at the 2007 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Ashley Carpenter said: