4.3 Step 2: Evaluate the Settlement Provisions

4.3.1 Effect of Settlement Terms on the Classification of an Equity-Linked Instrument

If, after performing step 1 of the guidance in ASC 815-40-15-7 (see Section 4.2), an entity concludes that an equity-linked instrument’s contingent exercise provisions (if any) would not preclude a conclusion that the instrument is indexed to the entity’s own stock, the entity must perform step 2 of such guidance to evaluate the instrument’s settlement terms. Under step 2, an equity-linked instrument is considered indexed to the entity’s own stock if either of the following two conditions is met:

The instrument is a “fixed-for-fixed” forward or option on equity shares.
The instrument is not fixed for fixed, but the only variables that could affect the instrument’s settlement amount are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares.

An equity-linked instrument that does not meet either of these conditions does not qualify as equity. Conversely, if the instrument is considered indexed to the entity’s own stock under both step 1 and step 2, it could qualify for classification as equity if it also meets the equity classification criteria in ASC 815-40-25 (see Chapter 5).

4.3.2 The Concept of a Fixed-for-Fixed Forward or Option on Equity Shares

ASC 815-40

15-7C Unless paragraph 815-40-15-7A precludes it, an instrument (or embedded feature) shall be considered indexed to an entity’s own stock if its settlement amount will equal the difference between the following:

The fair value of a fixed number of the entity’s equity shares
A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.

For example, an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed price or for a fixed stated principal amount of a bond issued by the entity shall be considered indexed to the entity’s own stock.

An equity-linked instrument is considered a fixed-for-fixed forward or option on the entity’s equity shares if the instrument’s settlement amount will always equal the difference between (1) the “fair value of a fixed number of the entity’s equity shares” and (2) a fixed monetary amount denominated in the issuing entity’s functional currency.

Example 4-3

Fixed-for-Fixed Option

Entity X issues freestanding warrants that allow the holder to purchase a fixed number of 1,000 shares of X’s common stock for a fixed amount of $10 per share. There are no exercise contingencies and no potential adjustments to the exercise price or number of common shares underlying the warrants. As a result, the warrants are indexed to X’s stock because they are considered a fixed-for-fixed option on equity shares. That is, the holder will receive a fixed number of X’s shares for a fixed price.

The difference between the fair value of the equity shares underlying a contract and a contract’s strike price is sometimes referred to as the contract’s intrinsic value. If the fair value of each share on the exercise date is $15, the intrinsic value is $5 per share ($15 – $10) and the settlement amount is $5,000 (1,000 shares × $5 per share).

For an equity-linked instrument to qualify as fixed for fixed, it does not need to involve a gross physical exchange of the full stated amount of cash for the full stated number of shares. An instrument that involves a net settlement (e.g., a net number of shares equal in fair value to the settlement amount) could also qualify as fixed for fixed provided that the settlement amount equals the difference between the fair value of a fixed number of the entity’s equity shares and a fixed amount of cash. In addition, an instrument indexed to the fair value of the equity shares of a consolidated subsidiary can qualify as a fixed-for-fixed forward or option on equity shares provided that the subsidiary is a substantive entity (see Section 2.6.1).

Under ASC 815-40-25-27, an equity-linked instrument must explicitly limit the number of shares to be delivered in a share settlement to be classified in stockholders’ equity (see Section 5.3.4). The existence of a “share cap” in the contract’s terms solely to meet this condition would not preclude a conclusion that a contract is a fixed-for-fixed forward or option on equity shares.

Some equity-linked instruments have more than one potential settlement amount that is contingent on the occurrence or nonoccurrence of a specified event (e.g., whether an operational target is met). Such instruments are not considered fixed for fixed even if each of those potential settlement amounts would have been considered fixed for fixed when assessed separately.

Example 4-4

More Than One Potential Settlement Amount

Entity X issues a freestanding warrant that allows the holder to purchase a fixed number of shares of X’s common stock (900 shares) for a fixed amount of $10 per share if the entity’s revenue is less than $500 million. If the entity’s revenue equals or exceeds $500 million, the holder has the right to purchase a different, fixed number of shares (1,000 shares) for a fixed amount of $10 per share. There are no exercise contingencies or other potential adjustments to the exercise price or number of common shares underlying the warrant. Entity X determines that the warrant represents only one freestanding financial instrument. The warrant is therefore not considered fixed for fixed because the number of shares that will be delivered under the contract differs depending on whether the revenue target is met (i.e., the settlement amount varies on the basis of revenue).

If the contract instead had specified that it was exercisable only if the entity’s revenue equaled or exceeded $10 million for 1,000 shares at $10 per share, it would have been considered fixed for fixed. That contract would have contained an exercise contingency based on revenue that would have been evaluated under step 1, but the settlement amount would not have varied on the basis of revenue.

As discussed in Section 2.2, an entity applies the indexation and equity classification guidance in ASC 815-40 in determining whether an embedded derivative (e.g., an equity conversion option embedded in convertible debt) qualifies for the scope exception to the derivative accounting guidance in ASC 815-10-15-74(a). An equity conversion option that gives the holder the right to convert a fixed stated principal amount of a bond issued by the entity and denominated in the entity’s functional currency into a fixed number of the entity’s own equity shares is considered a fixed-for-fixed option on equity shares if there are no potential adjustments to the settlement terms.

Similarly, a conversion option embedded in a preferred stock instrument that gives the counterparty a right to buy a fixed number of the entity’s equity shares for a fixed stated amount of the preferred stock instrument issued by the entity would be considered a fixed-for-fixed option on equity shares when (1) the preferred stock host is considered a debt host contract in the evaluation of embedded derivatives and (2) there are no potential adjustments to the settlement terms. If the host contract in a convertible preferred stock instrument is considered an equity instrument, the embedded equity conversion option will be clearly and closely related to its host contract. Such an option is not separated from its host contract under ASC 815-15 irrespective of whether it would have qualified for the scope exception to the derivative accounting guidance in ASC 815-10-15-74(a). Therefore, the option is not assessed under the indexation and equity classification guidance in ASC 815-40 (see Section 2.2.2).

Under ASC 480-10-S99-3A and other SEC guidance, SEC 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 evaluating whether an embedded feature (e.g., a written put option embedded in the entity’s preferred stock) meets the scope exception for certain contracts on own equity in ASC 815-10-15-74(a), an entity treats temporary equity as equity even though it is presented outside of permanent equity (ASC 815-10-15-76). See further discussion in Section 2.2.2.

4.3.3 Provisions That Adjust the Settlement Amount

ASC 815-40

15-7D An instrument’s strike price or the number of shares used to calculate the settlement amount are not fixed if its terms provide for any potential adjustment, regardless of the probability of such adjustment(s) or whether such adjustments are in the entity’s control. If the instrument’s strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument (or embedded feature) shall still be considered indexed to an entity’s own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares (provided that paragraph 815-40-15-7A does not preclude such a conclusion).

15-7E A fixed-for-fixed forward or option on equity shares has a settlement amount that is equal to the difference between the price of a fixed number of equity shares and a fixed strike price. The fair value inputs of a fixed-for-fixed forward or option on equity shares may include the entity’s stock price and additional variables, including all of the following:

Strike price of the instrument
Term of the instrument
Expected dividends or other dilutive activities
Stock borrow cost
Interest rates
Stock price volatility
The entity’s credit spread
The ability to maintain a standard hedge position in the underlying shares.

Determinations and adjustments related to the settlement amount (including the determination of the ability to maintain a standard hedge position) shall be commercially reasonable.

15-7F An instrument (or embedded feature) shall not be considered indexed to the entity’s own stock if its settlement amount is affected by variables that are extraneous to the pricing of a fixed-for-fixed option or forward contract on equity shares. An instrument (or embedded feature) shall not be considered indexed to the entity’s own stock if either:

The instrument’s settlement calculation incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares.
The instrument contains a feature (such as a leverage factor) that increases exposure to the additional variables listed in the preceding paragraph in a manner that is inconsistent with a fixed-for-fixed forward or option on equity shares.

Equity-linked instruments commonly include provisions that result in adjustments to the exercise price or to the number of shares for which the instrument can be settled. Such adjustments may be specified directly in the contract (e.g., antidilution provisions) or incorporated into the contract by reference to adjustments defined in standard documentation for equity derivatives (e.g., ISDA terms related to hedge disruption or loss of stock borrow).

Examples 2 through 21 in ASC 815-40-55 (listed in Appendix A of this Roadmap) illustrate the application of the guidance in ASC 815-40-15-7. Seventeen of the examples address how to apply step 2 of such guidance to instruments that contain settlement adjustments. Those examples involve adjustments related to the following:

The entity’s stock price (Examples 8, 13, 15, 16, and 19; see Sections 4.3.5.1, 4.3.7.9, and 4.3.7.10).
Dividends (Examples 12 and 17; see Sections 4.3.5.3 and 4.3.7.1).
Dilutive events (Example 17; see Section 4.3.7.1).
Down-round protection (Example 9; see Section 4.3.7.2).
Table with axes of stock price and time (Example 19; see Sections 4.3.7.9 and 4.3.7.10).
Interest rates (Examples 13 and 14; see Section 4.3.5.2).
Merger announcement (Example 6; see Section 4.3.7.5).
Cost of stock borrow (Example 12; see Section 4.3.5.4).
Sales revenue (Example 7; see Section 4.3.5.7).
Price of gold (Example 5; see Section 4.3.5.6).
Foreign currency (Examples 11, 18, and 20; see Section 4.3.8).
Stock option exercise behavior (Example 21; see Section 4.3.5.9).
Contingent redemption for a fixed monetary amount (Example 10; see Section 4.3.7.12).

An equity-linked instrument that permits adjustments to the settlement amount is not considered indexed to the entity’s stock unless the only variables that could affect the instrument’s settlement amount (i.e., the exercise price or forward price or the number of shares used to calculate the settlement amount) are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on the entity’s equity shares or adjustments are made in accordance with a down-round feature (see Section 4.3.7.2). If each potential adjustment to the settlement terms is consistent with the inputs used in the pricing of a fixed-for-fixed forward or option on equity shares (e.g., stock price and strike price), the instrument is considered indexed to the entity’s own stock. Accordingly, an entity must evaluate whether any adjustments to the settlement amount that are specified in the contract meet this requirement.

There are two types of inputs:

An explicit input is an underlying (other than the occurrence or nonoccurrence of a specified event) that could affect the settlement amount of the instrument (i.e., the exercise price or forward price, or the number of equity shares used to calculate the settlement amount). Examples of explicit inputs include a specific interest rate, security price, commodity price, foreign exchange rate, inflation rate, credit rating, prepayment index, or other index or indexes of specified prices or rates.
An implicit input is an assumption about the occurrence or nonoccurrence of a specified event that could affect the settlement amount of an equity-linked instrument (i.e., the exercise price or forward price or the number of equity shares used to calculate the settlement amount). For example, there may be an implicit assumption in the pricing of an equity-linked instrument that no dilutive event affecting the underlying equity securities will occur (e.g., stock split). Other examples of implicit inputs include the occurrence or nonoccurrence of the following events:
- An IPO or a subsequent offering of securities by the issuer.
- A tender offer for the securities of the issuer.
- A change of control or merger involving the issuer.
- Bankruptcy or insolvency of the issuer.
- The incurrence of transaction costs to dispose of equity securities received upon settlement of an equity-linked option.

4.3.4 Evaluating Explicit Inputs

In the determination of the price (or fair value) of an equity-linked financial instrument, standard pricing models (e.g., the Black-Scholes-Merton option pricing model) require certain explicit inputs. Such inputs may include the exercise (or forward) price of the instrument, the term of the instrument, expected dividends, interest rates, and stock price volatility.

To evaluate whether adjustments to the settlement provisions that are based on an explicit input preclude a freestanding equity-linked instrument (or an embedded feature) from being considered indexed to an entity’s own stock, an entity considers the three questions below, assessing each explicit input separately. These considerations are relevant regardless of whether the explicit input (1) affects the exercise price or forward price of the instrument or the number of equity shares used to calculate the settlement amount or (2) results in an immediate settlement of the instrument at an adjusted settlement amount. If an adjustment that is based on an explicit input indicates that the instrument is not indexed to the entity’s own stock, the instrument does not qualify as equity.

Is the explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

For the instrument to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.

If the settlement terms are adjusted in response to changes in an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, those do not necessarily preclude the instrument from being considered indexed to the entity’s stock. If, however, the settlement amount varies in response to changes in explicit inputs other than those used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (i.e., extraneous variables), the instrument is not considered indexed to the entity’s stock. In this case, the instrument must be classified as an asset or a liability.

The table below includes examples of explicit inputs that may or may not preclude equity classification if an adjustment is made to the settlement amount in response to a change in the explicit input.

Permissible (Equity Classification Not Precluded)	Not Permissible (Equity Classification Precluded)
The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1). The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1). The exercise (or forward) price of the instrument. The term of the instrument. Expected dividends on the instrument (see Section 4.3.5.3). Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4). Risk-free interest rates (e.g., the federal funds rate or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.10, and 4.3.5.11). Stock price volatility. (see Section 4.3.5.5). The entity’s credit spread (generally only for convertible instruments).	Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.7). The authorized and unissued common shares of the issuer. The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event). A commodity price (see Section 4.3.5.6). A foreign currency index or rate (see Section 4.3.8). An inflation rate. Stock option exercise behavior (see Section 4.3.5.9). Reimbursement of the holder’s tax obligations (see Section 4.3.5.13).

Permissible (Equity Classification Not Precluded)

Not Permissible (Equity Classification Precluded)

The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1).
The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1).
The exercise (or forward) price of the instrument.
The term of the instrument.
Expected dividends on the instrument (see Section 4.3.5.3).
Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4).
Risk-free interest rates (e.g., the federal funds rate or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.10, and 4.3.5.11).
Stock price volatility. (see Section 4.3.5.5).
The entity’s credit spread (generally only for convertible instruments).

Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.7).
The authorized and unissued common shares of the issuer.
The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event).
A commodity price (see Section 4.3.5.6).
A foreign currency index or rate (see Section 4.3.8).
An inflation rate.
Stock option exercise behavior (see Section 4.3.5.9).
Reimbursement of the holder’s tax obligations (see Section 4.3.5.13).

Could a change in the explicit input (other than the entity’s stock price) affect the settlement amount in a manner inconsistent with how a change in the input would affect the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.

An adjustment in response to a change in an explicit input does not necessarily need to reflect the whole effect that the variable would have had on the fair value of a fixed-for-fixed forward or option on equity shares. If, however, an equity-linked instrument contains a feature (such as a leverage factor) that results in greater exposure to an input (other than the entity’s stock price) than the exposure to the input in the pricing (fair value measurement) of a fixed-for-fixed or option on equity shares, the instrument is considered not indexed to the entity’s stock and must be classified as an asset or a liability. Similarly, if a change in an explicit input (other than a change based solely on the entity’s stock price) affects the settlement amount of the instrument in a manner inconsistent with the effect that the underlying would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (e.g., the underlying affects the settlement amount inversely), the instrument is considered not indexed to the entity’s own equity.
Thus, there are two common situations in which a change in an explicit input (other than the entity’s stock price) affects the settlement amount in a manner inconsistent with the effect that a change in the input would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares:
- The underlying is leveraged (e.g., the interest rate input in a forward equity share contract is based on two times the change in the federal funds rate).
- The underlying affects the settlement amount inversely (e.g., the interest rate input into the pricing of a written call option is adjusted upward for a decrease in interest rates).
Could a change in the explicit input (other than the entity’s stock price) result in a settlement at a fixed monetary amount?

For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.

If a change in the input (other than a change based solely on the entity’s stock price) could result in a settlement amount equal to a fixed monetary amount, the instrument is considered not indexed to the entity’s stock. This is because the effect of the change in the underlying would result in a settlement amount that is inconsistent with such effect on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. For example, an equity-linked instrument that allows the holder to purchase 1,000 shares of an entity’s common stock for $10 per share, but that will be settled for $5 per share upon a specified change in an interest rate, is not indexed to the entity’s stock.

4.3.5 Explicit Inputs: Application Issues and Examples

4.3.5.1 Adjustments Based on the Entity’s Stock Price

The entity’s stock price is an explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. Similarly, the stock price of a consolidated subsidiary is a permissible input as long as the subsidiary is a substantive entity (see Section 2.6.1).

Examples 8, 13, 15, and 16 in ASC 815-40-55 illustrate that the following types of adjustments related to the entity’s stock price would not necessarily preclude a conclusion that the equity-linked instrument is considered indexed to the entity’s own stock:

A cap on the stock price (Examples 8 and 15).
A floor on the stock price (Example 15).
The use of a weighted-average stock price over a period instead of the current stock price (Example 13).
Variability in the number of shares used to determine the settlement amount depending on the entity’s stock price (Example 16). (Note that for such an instrument, an entity should consider whether ASC 480 would apply instead of ASC 815-40 [see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity].)

ASC 815-40

Example 8: Variability Involving Stock Price Cap

55-32 Entity A purchases net-settled call options that permit it to buy 100 shares of its common stock for $10 per share. However, the maximum appreciation on the call options is capped when Entity A’s stock price reaches $15 per share (that is, the counterparty’s maximum obligation is $500 [($15 − $10) × 100 shares]). The call options have 10-year terms and are exercisable at any time. The call options are considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price when Entity A’s stock price is between the $10 stated exercise price and the $15 price cap. However, whenever Entity A’s stock price exceeds $15, the strike price of the call options increases and decreases in amounts equal to the corresponding increases and decreases in Entity A’s stock price, such that the intrinsic value of each call option always equals $5. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed option contract, the call options are considered indexed to the entity’s own stock.

Example 13: Variability Involving Average Stock Price

55-38 Entity A enters into a net-settleable forward contract to sell 100 shares of its common stock in 1 year for an amount equal to $10 per share plus interest calculated at a variable interest rate (Federal Funds rate plus a fixed spread). The share price used to determine the settlement amount is based on the volume-weighted average daily market price of Entity A’s common stock for the 30-day period before the settlement date. The forward contract is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. However, the only variables that cause the settlement amount to differ from a fixed-for-fixed settlement amount are the 30-day volume-weighted average daily market price of Entity A’s common stock and an interest rate index. The pricing inputs of a fixed-for-fixed forward contract include the entity’s stock price and interest rates. Additionally, the floating interest rate feature does not introduce a leverage factor or otherwise increase the effects of interest rate changes on the instrument’s fair value.

Example 15: Variability Involving Stock Price Cap and Floor

55-40 Entity A enters into a net-settled forward contract to sell 100 shares of its common stock in 1 year for $1,000. However, the maximum amount payable to the counterparty at maturity is capped when Entity A’s stock price is greater than or equal to $15 per share (that is, Entity A’s maximum obligation is $500 [($15 − $10) × 100 shares]). Additionally, the maximum amount receivable from the counterparty at maturity is capped when Entity A’s stock price is less than or equal to $5 per share (that is, the counterparty’s maximum obligation is $500 [($5 − $10) × 100 shares]). The forward contract is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($1,000) when Entity A’s stock price is between $5 and $15. However, whenever Entity A’s stock price is greater than or equal to $15 at maturity, the amount payable to the counterparty always equals $500. Additionally, whenever Entity A’s stock price is less than or equal to $5 at maturity, the amount receivable from the counterparty always equals $500. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed forward contract, the instrument is considered indexed to the entity’s own stock.

Example 16: Variability Involving Cap on Shares Issued

55-41 Entity A enters into a forward contract to sell a variable number of its common shares in 1 year for $1,000. If Entity A’s stock price is equal to or less than $10 at maturity, Entity A will issue 100 shares of its common stock to the counterparty. If Entity A’s stock price is greater than $10 but equal to or less than $12 at maturity, Entity A will issue a variable number of its common shares worth $1,000. Finally, if the share price is greater than $12 at maturity, Entity A will issue 83.33 shares of its common stock. The forward contract is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed strike price ($1,000). Although the strike price to be received at settlement is fixed, the number of shares to be issued to the counterparty varies based on the entity’s stock price on the settlement date. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed forward contract on equity shares, the instrument is considered indexed to the entity’s own stock.

Similarly, an equity-linked instrument that is settled at the maximum (or minimum) stock price over a certain period (instead of the current stock price) would generally not preclude equity classification provided that the settlement is not also indexed to another variable such as the occurrence or nonoccurrence of a specified event. Further, a volume-weighted average price does not preclude equity classification even if it excludes trades that do not satisfy the requirements of Rule 10b-18 of the Securities Exchange Act of 1934.

A change-in-control provision may specify that the equity-linked instrument will become indexed to the equity shares of the acquirer in a business combination if all the entity’s stockholders receive stock of the acquiring entity. ASC 815-40 specifically states that such a clause does not preclude a conclusion that the instrument is indexed to the entity’s own stock (ASC 815-40-55-5; see Section 5.2.3.4).

Some warrants permit the holder to choose between share price inputs when the warrant is settled on a net share (or cashless) basis because the common shares underlying the warrant are not covered by an effective registration statement. The share price input elected by the holder is used to calculate the number of shares to be delivered upon settlement. Such an arrangement generally would not preclude the warrant from being considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7 as long as (1) the rights related to the ability to elect the share price input used upon a net share settlement do not depend on the warrant’s holder and (2) each such input represents a reasonable estimate of the issuer’s share price at the time of settlement.

Example 4-5

Warrant With Different Share Price Inputs Used in a Net Share Settlement

An entity issues a warrant that permits the holder to exercise the warrant on a cashless basis if at any time there is not an effective registration statement for the issuance of the underlying common shares. The calculation of the number of shares to be delivered if the holder exercises the warrant on a cashless basis depends on which share price input the holder elects. Any holder of the warrant has the right to elect one of the following share price inputs if it exercises the warrant during trading hours (the election is made upon the holder’s notice of exercise to the issuer):

The bid price at the time of execution of the notice of exercise.
The VWAP on the trading day immediately preceding the exercise date.
The VWAP as of the end of the trading day on the exercise date.

The entity determines that each of the share price inputs the holder may elect represents a reasonable share price input at the time of settlement (i.e., each share price input is consistent with the settlement of a fixed-for-fixed option on equity shares). Furthermore, the warrant’s election provisions do not give the holder the ability to control settlement on the basis of the maximum stock price of the issuer. For example, while the holder may be aware that the VWAP on the trading day immediately preceding the exercise date exceeds the bid price at the time of execution of the notice of exercise, the holder does not control whether the VWAP on the trading day immediately preceding the exercise date will exceed the VWAP as of the end of the trading day on the exercise date. Accordingly, the warrant agreement is not precluded from being considered indexed to the entity’s own stock under step 2 in ASC 815-40-15-7 because the holder can choose the share price input to use in calculating the number of shares delivered in a net share settlement.

If, however, the warrant’s election provisions indicated that the share price input was always based on the highest of three prices, the warrant would be precluded from being indexed to the issuer’s stock under step 2 in ASC 815-40-15-7 because (1) the settlement amount would exceed the settlement amount of a fixed-for-fixed option on equity shares and (2) the settlement of the warrant would depend on whether there is an effective registration for the underlying shares. In addition, if election provisions change or are eliminated upon a transfer by the holder to a third party, the variability in the share price input would depend on the warrant’s holder, which would also preclude the warrant from being indexed to the issuer’s stock (see Section 4.3.7.3).

4.3.5.2 Adjustments Based on the Risk-Free Market Interest Rate

The risk-free market interest rate (e.g., the federal funds rate or the U.S. Treasury rate) is an explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. For example, if a conversion option embedded in a debt security would be settled by the exchange of a fixed number of shares for a fixed principal amount plus interest accrued at a variable market rate, the conversion option would not be precluded from classification as equity.

Examples 13 and 14 in ASC 815-40-55 illustrate the application of step 2 in ASC 815-40-15-7 to variability in an equity-linked instrument’s settlement terms involving interest rates:

Example 13 (reproduced in the previous section) illustrates a forward contract for which variability in the settlement amount based on interest rates does not preclude equity classification. In the example, the forward price adjustment is based on the federal funds rate plus a fixed spread.
Example 14 below in ASC 815-40-55-39 illustrates a forward contract for which a change in interest rates affects the settlement amount in a manner inconsistent with the effect that a change in interest rates would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. In the example, the interest rate used to adjust the forward price is inversely related to LIBOR. Accordingly, that contract does not qualify for equity classification.

ASC 815-40

Example 14: Variability Involving Interest Rate Index

55-39 Entity A enters into a forward contract to sell 100 shares of its common stock in 1 year for an amount equal to $10 per share plus interest calculated at a variable interest rate that varies inversely with changes in the London Interbank Offered Rate (LIBOR) (similar to an “inverse floater,” as described in paragraphs 815-15-55-170 through 55-172). The forward contract is not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price varies inversely with changes in an interest rate index. The inverse floating interest rate feature increases the effects of interest rate changes on the instrument’s fair value (that is, the feature increases the instrument’s fair value exposure to interest rate changes) when compared to the exposure to interest rate changes of a fixed-for-fixed forward contract.

4.3.5.3 Adjustments Based on Dividends

The expected dividend on equity shares is an explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on those equity shares. Example 12 in ASC 815-40-55 illustrates that variability in an equity-linked instrument’s settlement terms based on dividends would not necessarily preclude equity classification.

ASC 815-40

Example 12: Variability Involving Dividend Distributions

55-37 Entity A enters into a forward contract to sell 100 shares of its common stock for $10 per share in 1 year. Historically, Entity A has paid a dividend of $0.10 per quarter on its common shares. Under the terms of the forward contract, if dividends per common share differ from $0.10 during any 3-month period, the strike price of the forward contract will be adjusted to offset the effect of the dividend differential (actual dividend versus $0.10) on the fair value of the instrument. Additionally, the terms of the forward contract provide for an adjustment to the strike price, using commercially reasonable means, to offset the effect of any increased cost of borrowing Entity A’s shares in the stock loan market on the fair value of the instrument. The forward contract is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The only circumstances in which the settlement amount will not equal the difference between the fair value of 100 shares and $1,000 ($10 per share) are if dividends per common share differ from $0.10 during any 3-month period or if there is an increased cost of borrowing Entity A’s shares in the stock loan market. The adjustments to the strike price resulting from those events are intended to offset their effects on the instrument’s fair value. In those circumstances, the only variables that could affect the settlement amount (dividends and stock borrow cost) would be inputs to the fair value of a fixed-for-fixed forward contract on equity shares.

Some ASR transactions have a settlement amount that is adjusted by the counterparty if the entity declares dividends with an ex-dividend date that is earlier than the expected ex-dividend date specified in the agreement. The adjustment is intended to compensate the counterparty for the lost time value of money as a result of the dividends’ being declared earlier than had been anticipated and thus earlier than had been priced into the instrument. Such an adjustment is similar to an adjustment for dividends, stock borrow costs (anticipated dividends factor into the cost to borrow a stock), and interest rates. Thus, the adjustment would not preclude the ASR transaction from being considered indexed to the entity’s common stock, because expected dividends, stock borrow costs, and interest rates are inputs into the pricing of a fixed-for-fixed forward on equity shares.

4.3.5.4 Adjustments Based on Cost of Stock Borrow

Like risk-free market interest rates, the cost of borrowing the entity’s shares in the stock loan market (“cost of stock borrow”) is an explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. The following is an example of an adjustment based on the cost of stock borrow:

If Counterparty determines, using its commercially reasonable judgment, that its actual cost of borrowing a number of Shares equal to the Base Shares to hedge its exposure to the Transaction exceeds a weighted-average rate equal to 50 basis points per annum, over any consecutive 30-day period, then, at Company’s election, either (A) Calculation Agent will reduce Forward Price to compensate Counterparty for the amount by which such cost exceeded a weighted-average rate equal to 50 basis points per annum during that period or (B) Borrow Cost Threshold will be reduced to 50 basis points per annum after that period.

Example 12 in ASC 815-40-55 (reproduced in the previous section) illustrates that variability in an equity-linked instrument’s settlement terms based on the cost of stock borrow would not necessarily preclude equity classification.

4.3.5.5 Adjustments Based on Stock Price Volatility

As noted in ASC 815-40-15-7E, volatility is an explicit input in a standard pricing model. Upon an early settlement, some option contracts on an entity’s own equity require the entity to calculate the settlement amount by applying a standard option pricing model (such as the Black-Scholes option pricing model) that uses market-based explicit inputs that are current as of the settlement date, except that the volatility input is prespecified (e.g., a fixed 20 percent volatility assumption). Such prespecified volatility assumptions will generally not be consistent with the volatility assumption in the pricing of a fixed-for-fixed option on equity shares. For example, the 2002 ISDA Equity Derivatives Definitions refer to the use of “implied volatility” (as opposed to, e.g., historical volatility) in the determination of the amount paid upon early settlement of an option contract. Implied volatility is expected to change over time. A prespecified volatility will not be consistent with implied volatility or another volatility assumption that a market participant would use to estimate the fair value of an option on equity shares. There is a limited exception, however, for a prespecified volatility assumption that would be used in a Black-Scholes option pricing model, or other appropriate option pricing model, to calculate the settlement amount upon an early settlement of an option contract. Such an assumption may not preclude the contract from being considered indexed to the entity’s own equity if the volatility input is prespecified solely to ensure that the settlement amount is determined in a manner consistent with the volatility assumption that was used in the initial pricing of the contract. In other words, the settlement amount is determined on the basis of an assumption that there was no change in this particular input. This view is consistent with the guidance in ASC 815-40-55-45 and 55-46, which suggests that an equity-linked instrument may be considered indexed to an entity’s own equity even if the settlement amount is determined on the basis of an assumption of no change in relevant pricing inputs other than stock price and time. However, before concluding that an early settlement amount that is calculated by using an option pricing model that incorporates a prespecified volatility assumption does not preclude an option contract from being indexed to an entity’s equity shares, an entity must consider the nature of the volatility assumption used in the initial pricing of the contract to determine whether the prespecified volatility assumption is actually consistent with the volatility assumption used in the initial pricing (i.e., that volatility changes actually do not affect the settlement amount of the contract). For example, if the prespecified volatility assumption used to calculate the option price upon an early settlement is the same volatility assumption used in the initial pricing, we would expect that the volatility assumption used reflects a constant annual volatility input. Further, a volatility input that is based on the greater of a fixed volatility assumption (e.g., a fixed 100 percent volatility assumption) and an estimate of current volatility at the time of settlement would preclude an option contract from being considered indexed to the entity’s own stock since such an input could result in a settlement amount that is greater than the settlement amount of a fixed-for-fixed option on the entity’s equity shares.

4.3.5.5.1 Side Letters That Modify Volatility Assumptions or Other Settlement Provisions

An issuer of convertible debt is often concerned about the dilution that could result from the conversion of the debt into the issuer’s equity shares. To reduce the potential for such dilution, issuers can economically offset the conversion option embedded in the debt by entering into transactions in which they have a right to receive equity shares when the debt is converted into equity shares. Such transactions are usually entered into with financial institutions that participate in the convertible debt offering. They include:

Call spread overlays — A call spread overlay consists of a purchased call option and a separate written warrant on the entity’s own equity. Generally, the purchased call option allows the issuer to receive from the option counterparty any shares (or other consideration) that it would issue upon conversion of the convertible debt. The initial strike price of the purchased call option (the “low” strike) equals the initial conversion price in the convertible debt. To offset part of the cost of the purchased call option, the entity writes a separate warrant with an initial strike price that is higher than the initial conversion price in the convertible debt (the “high” strike). On a combined basis, the net economic effect of the convertible debt and the call spread overlay is to increase the effective conversion price to the strike price of the written warrant (i.e., the high strike).
Capped calls — A capped call is a purchased call option with an embedded cap on the value of the shares (or other consideration) that the counterparty will deliver upon settlement. Economically, a capped call is similar to a call spread overlay. While a call spread overlay consists of two separate transactions (i.e., a purchased call option and a separate written warrant), a capped call is a single integrated transaction (i.e., a purchased call option with an embedded written warrant). The initial strike price of the capped call equals the initial conversion price, and the settlement is capped at an amount equivalent to what the “high” strike would have been in the warrant of a call spread overlay transaction.

In practice, entities that enter into call spread overlays or capped calls sometimes execute side letters with the counterparty to the contract, which replace some of the terms described in the primary contract. For example, it is common for side letters to modify how the contract’s settlement amount (e.g., “close-out amount” or “cancellation amount”) is computed upon an early settlement. Whereas the contract might appear to imply that the settlement amount will be calculated in accordance with the ISDA’s standard terms and definitions (e.g., by reference to an ISDA master agreement and ISDA Equity Derivatives Definitions), the effect of the side letter is to modify the calculation (e.g., by specifying that a different volatility input should be used or by including a so-called tax cap that is designed to ensure that a capped call and the related convertible debt can be integrated for tax purposes). Side letters may also modify the allocation of options among multiple counterparties in the event of a partial early settlement (e.g., in lieu of a pro rata early settlement of the options among the counterparties, only the options held by certain counterparties are settled early, or there are specified calculations that result in a non-pro-rata allocation of the options settled early among multiple counterparties). Accordingly, entities need to consider the potential impact of side letters when determining the accounting for a contract.

As discussed in Section 4.3.3, adjustments to the calculation of an equity-linked instrument’s settlement amount may affect whether the contract qualifies as equity or must be accounted for at fair value with changes in fair value recognized in earnings. For an equity-linked instrument to be considered indexed to an entity’s own equity under step 2 in ASC 815-40-15-7, any variable that could affect the settlement amount must be an input into the pricing of a fixed-for-fixed forward or option on equity shares and cannot be extraneous to the pricing of such an option or forward. Accordingly, to ascertain whether an equity-linked instrument qualifies as equity under ASC 815-40, an entity should evaluate each adjustment that may affect the instrument’s settlement amount (including adjustments specified in side letters, such as adjustments that differ from standard ISDA terms)3 to determine whether it precludes such a conclusion. Certain considerations related to the analysis of volatility inputs are discussed in Sections 4.3.5.5 and 4.3.7.14.

4.3.5.5.2 Example of Capped Call With Side Letter

The example below illustrates a side letter that modifies the volatility provisions of a capped call option entered into in conjunction with the issuance of convertible debt.

Example 4-6

Capped Call With Side Letter

On April 1, 2020, Issuer issued convertible debt that matures on April 1, 2027 (the “maturity date”). Each $1,000 of note principal is convertible into 25 shares of Issuer’s common stock — a conversion price of approximately $40 per share. The conversion price represents a 33 percent premium over Issuer’s common stock price (approximately $30). The debt can be converted at maturity or upon the occurrence of an event that constitutes a “fundamental change.”

Concurrently with the issuance, Issuer purchased a “capped call option” on its own common stock from a dealer (“Dealer”). The capped call option allows Issuer to participate in its common stock’s appreciation above $40, up to $60. The single freestanding financial instrument, from Issuer’s perspective, represents (1) a purchased call option on its own stock with a strike price of $40 (the “low strike”) purchased from Dealer and (2) a written call option on its own stock with a strike price of $60 (the “cap strike”) sold to Dealer.

The capped call option expires on the maturity date and is automatically exercised if the conversion option in the debt is exercised, or Issuer can terminate all or a portion of the option early if it repurchases all or a portion of its convertible debt (e.g., if Issuer repurchases debt with a face value of $1,000, it can terminate the capped call for 25 shares) (“repurchase termination”).

The terms of the ISDA Equity Derivatives Definitions and an ISDA master agreement apply to the capped call option. The terms of the ISDA master agreement, however, were modified through a side letter to change the settlement amount if the capped call option is (1) exercised in connection with a fundamental change or (2) terminated in connection with a repurchase termination. In those cases, in calculating the settlement amount, Dealer will determine the fair value of both option components of the capped call option (i.e., the purchased call option with a $40 strike and the written call option with a $60 strike) by using the same volatility input. That volatility input will be based on the volatility input applicable to the cap strike.

In the absence of the side letter, the settlement amount would be calculated on the basis of the fair value of each option component and the volatility input for each option component would be determined separately on the basis of the strike price of the component (i.e., on the basis of the low strike for the purchased call option and the cap strike for the written call option).

In the limited circumstances in which the capped call option will be settled before the maturity date, the side letter reduces the number of potentially subjective inputs that Dealer may need to estimate.

The flat volatility assumption upon early exercise or repurchase termination has been included in side letters for both tax-integrated and non-tax-integrated capped call options. In a tax-integrated structure, the side letter caps the settlement amount at the lesser of the (1) value of the capped call option determined by using the volatility input for the cap strike for both option components and (2) synthetic instrument-adjusted amount (i.e., the cap could exceed the fair value of the option determined in accordance with unmodified ISDA terms).

Note that this example discusses a side letter that requires the volatility inputs for the low strike and cap strike components of the capped call option to always be the same in the event of an early settlement. Other side letters may specify merely that the volatility input for the low strike could never be less than the volatility input for the cap strike. In the evaluation of these types of side letters, the counterparty that was intended (or expected) to benefit from them is not relevant. Rather, the evaluation focuses on whether a settlement could, regardless of likelihood, be for an amount that would deviate from a settlement amount that is based on the pricing inputs into a fixed-for-fixed option. If so, the contract would not be considered indexed to the issuer’s stock under step 2 of ASC 815-40-15-7 as a result of the side letter.

4.3.5.6 Adjustments Based on a Commodity Price

A commodity price (e.g., the price of a precious metal, crude oil, natural gas, or electricity) is not an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. Therefore, an equity-linked instrument that includes such indexation cannot be classified as equity. Example 5 in ASC 815-40-55 below illustrates this scenario.

ASC 815-40

Example 5: Variability Involving a Commodity Price

55-29 Entity A issues warrants that permit the holder to buy 100 shares of its common stock in exchange for one ounce of gold. The warrants have 10-year terms; however, they only become exercisable if Entity A completes an initial public offering. The warrants are not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The exercise contingency (that is, the initial public offering) is not an observable market or an observable index, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
Step 2. The settlement amount would not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price varies based on the price of one ounce of gold. The price of gold is not an input to the fair value of a fixed-for-fixed option on equity shares.

4.3.5.7 Adjustments Based on the Entity’s Revenue

An entity’s revenue is not an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on the entity’s shares. Therefore, an equity-linked instrument that includes an adjustment of the settlement amount based on the entity’s revenue cannot be classified as equity.

Note that the evaluation of underlyings that are based on revenue differs under steps 1 and 2 of the guidance in ASC 815-40-15-7:

The fact that an equity-linked instrument contains an exercise contingency based on the entity’s revenue does not preclude equity classification under step 1 (see Section 4.2). Thus, an equity-linked instrument that only becomes exercisable or settleable if revenue exceeds a certain target could be classified as equity provided it meets all the other conditions for equity classification. For example, a contingent consideration arrangement that specifies that the entity will deliver 100 shares if the acquired subsidiary’s revenue exceeds a specified level could qualify as equity (provided the subsidiary is a substantive entity).
An adjustment of the settlement amount based on the entity’s revenue precludes equity classification under step 2. Thus, an equity-linked instrument in which the strike price or the number of shares specified in the contract is adjusted based on the entity’s revenue cannot be classified as equity. For example, a contingent consideration arrangement that specifies that the entity will deliver 100 shares if revenue exceeds $10 million and 150 shares if revenue exceeds $20 million does not qualify as equity, because the settlement amount is adjusted based on revenue.

Example 7 in ASC 815-40-55 below illustrates the application of step 2 to an option contract with a strike price that varies depending on the entity’s revenue.

ASC 815-40

Example 7: Variability Involving Revenue Target

55-31 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for an initial price of $10 per share. The warrants have 10-year terms and are exercisable at any time. However, the terms of the warrants specify that the strike price is reduced by $0.50 after any year in which Entity A does not achieve revenues of at least $100 million. The warrants are not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount would not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price would be adjusted after any year in which Entity A does not achieve revenues of at least $100 million. The amount of an entity’s annual revenues is not an input to the fair value of a fixed-for-fixed option on equity shares.

Example 4-7

Adjustment Based on Revenue

An entity enters into a contingent consideration arrangement in conjunction with a business combination. The arrangement requires the entity to deliver a variable number of shares to the seller if investment management and advisory fees earned by the acquired entity exceed specified levels. The entity delivers no shares if fees are less than $50 million. The entity delivers 0 to 5,000 shares, determined by straight-line interpolation, if fees are from $50 million to $75 million. The entity delivers 5,000 shares if fees exceed $75 million.

This arrangement includes an exercise contingency (fees earned) that does not preclude the arrangement from being considered indexed to the entity’s own stock under step 1 in ASC 815-40-15-7. In the evaluation of step 2, however, the variability in the settlement amount based on fees earned indicates that the instrument is not indexed to the entity’s stock and that the instrument must be classified as an asset or a liability.

4.3.5.8 Adjustments Based on a Percentage of Equity

Some equity-linked instruments are settled on the basis of a percentage of equity. For example, a warrant may specify that the counterparty will receive a variable number of shares on the basis of a fixed percentage (e.g., 5 percent) of the fully diluted equity of the entity. Because the number of outstanding common shares does not represent an input in the valuation of a fixed-for-fixed forward or option on equity shares (except in antidilution adjustments; see Section 4.3.7.1), the equity-linked instrument is considered not indexed to the entity’s stock and must be classified as an asset or a liability.

Some convertible instruments include a feature that allows the holder to convert the instrument into the issuer’s equity shares at a conversion price that is calculated as a fixed dollar amount (also referred to as a “valuation cap”) divided by the number of outstanding shares of the issuer as of the date of conversion. Because the number of outstanding common shares does not represent an input in the valuation of a fixed-for-fixed forward or option on equity shares (except in antidilution adjustments; see Section 4.3.7.1) and the variability does not arise from a down-round feature, the conversion feature is considered not indexed to the entity’s stock.

Some equity-linked instruments contain a limit (cap) on the number of shares that the entity will deliver to the counterparty on the basis of a fixed percentage of the total number of the entity’s outstanding shares, voting power, or the entity’s fully diluted equity. Such a cap does not preclude equity classification if (1) it does not adjust the strike price or the number of shares underlying the instrument but instead results in a deferral of the settlement of the instrument in excess of the cap and (2) the instrument contains no requirement to cash settle the shares owed in excess of the cap (see Section 5.2.2). Note, however, that equity classification would be precluded if the cap was indexed to, or contingent on, an input that was not used in the pricing of a fixed-for-fixed forward or option on equity shares (e.g., shareholder approval). The equity-linked instrument may also fail to meet the equity classification conditions in ASC 815-40-25.

Example 4-8

Share Cap Contingent on Holder’s Beneficial Ownership

Company X has issued a warrant to issue common stock to Company Y. The warrant specifies that Y is not entitled to take delivery of any shares owed to it under the contract if, after such receipt, it would beneficially own more than 4.9 percent of the total number of X’s outstanding common shares on a fully diluted basis. This beneficial ownership cap was included in the warrant to avoid regulatory reporting requirements that would otherwise apply if Y owned 5 percent or more of X’s common stock. If any delivery of shares owed to Y is not made as a result of this provision, X’s obligation to deliver such excess shares is not extinguished. However, X has no obligation to settle the excess shares in cash but must instead deliver them if or when Y no longer beneficially owns more than 4.9 percent of the total number of outstanding common shares. Thus, Y can obtain the excess shares by selling any shares it holds before exercise and any shares it receives upon exercise. The warrant is not precluded from being considered indexed to the entity’s own equity under ASC 815-40-15 because the cap (1) represents a permissible exercise contingency (see Section 4.2.3) and (2) does not adjust the instrument’s settlement amount (see Section 4.2.2.3).

A beneficial ownership cap such as the one described above would not typically prevent an equity-linked instrument from being indexed to the issuer’s stock, provided that the holder has the ability to exercise the warrant in part so that the holder would always have the ability to realize the full economics of the instrument. However, if an equity-linked instrument contained a beneficial ownership cap, only allowed the holder to exercise or settle the instrument on a single date, and subjected the holder to variability on settlement depending on the stated cap (i.e., the holder would never receive the shares in excess of the cap), the instrument would not meet the conditions to be considered indexed to the issuer’s common stock because the settlement amount depends on the number of outstanding common shares of the issuer, which is not an input into the pricing of a fixed-for-fixed forward or option on equity shares.

Example 4-9

Share Cap Contingent on Shareholder Approval

Company X has issued a forward contract to issue common stock. The contract limits the number of shares that will be delivered upon settlement to 19.9 percent of the voting power or 19.9 percent of the total number of shares of common stock outstanding before the issuance. The purpose of the cap is to ensure compliance with certain stock exchange rules, which require shareholder approval for certain issuances of common stock equal to 20 percent or more of the shares of common stock or 20 percent or more of the voting power outstanding before the issuance. The contract specifies that X has no obligation to settle excess shares in cash and that the cap is automatically removed if X obtains shareholder approval to issue the excess shares. As long as the contract represents a single unit of account, it would not qualify as equity under ASC 815-40-15 because it contains an adjustment to the settlement amount that is based on shareholder approval, which is not an input into the pricing of a fixed-for-fixed forward or option on equity shares (see Section 4.3.6.2).

Example 4-10

SEPA

Company Y enters into a standby equity purchase agreement (SEPA) with Investor A under which Y has the right, but not the obligation, to issue up to 10 million common shares to A over the next 18 months at a purchase price equal to 97 percent of the VWAP of Y’s common stock over the three-trading-day period before Y elects to issue shares under the SEPA. Company Y can elect to sell shares to A in increments of 2,000,000; however, in all cases the contract limits the number of shares that A is required to purchase so that A would never own more than 19.99 percent of Y’s common stock after taking into account A’s current holdings of such stock. This exchange cap provision is eliminated if Y obtains approval from its shareholders for A to own more than 19.99 percent of Y’s common stock.

Because the number of shares issuable under the SEPA depends on whether Y’s shareholders approve the removal of the exchange cap provision, and such removal is not an input into the pricing of a fixed-for-fixed forward or option on equity shares (see Section 4.3.6.2), the SEPA is not indexed to Y’s stock under step 2 in ASC 815-40-15-7. For additional information about SEPAs, see Section 6.2.5).

4.3.5.9 Adjustments Based on Stock Option Exercise Behavior

Stock option exercise behavior is not an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on the entity’s shares. Therefore, an equity-linked instrument that requires adjustments to the settlement amount on the basis of this variable cannot be classified as equity. Example 21 in ASC 815-40-55 below illustrates this scenario.

ASC 815-40

Example 21: Variability Involving Securities Issued to Establish a Market-Based Measure of Grantee Stock Option Value

55-48 Entity A issues a security to investors for purposes of establishing a market-based measure of the grant-date fair value of a grant of stock options issued in a share-based payment transaction. Under the terms of that market-based stock option valuation instrument, Entity A is obligated to make variable quarterly payments to the investors that are a function of the net intrinsic value received by a pool of Entity A’s grantees, based on actual stock option exercises by those grantees each period. The market-based stock option valuation instrument has a 10-year term, consistent with the contractual term of the underlying stock options. The market-based stock option valuation instrument is not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The analysis of the exercise contingency (or contingencies) depends on the particular terms and features of the instrument. However, as indicated in Step 2 below, a market-based stock option valuation instrument would not be considered indexed to the entity’s own stock.
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed strike price. The instrument provides for variable quarterly payments to investors that are based on actual stock option exercises for the period. Because a variable that affects the instrument’s settlement amount is stock option exercise behavior, which is not an input to the fair value of a fixed-for-fixed option or forward contract on equity shares, the instrument is not considered indexed to the entity’s own stock.

Freestanding equity-linked financial instruments issued to nonemployee investors to establish a market-based measure of the grant-date fair value of stock options are within the scope of ASC 815-40 since they are not issued as compensation for goods or services. This is the case even though the instruments may refer to stock options that qualify for the scope exception for share-based payment arrangements.

4.3.5.10 Convertible Preferred Stock

When a convertible preferred stock instrument contains a host debt instrument, the evaluation of whether the embedded conversion option is considered indexed to the entity’s stock is performed in the same manner as the evaluation of whether an embedded conversion option in a debt instrument is considered indexed to the entity’s stock. ASC 815-40-15-7C indicates that “an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares . . . for a fixed stated principal amount of a bond issued by the entity” is considered a fixed-for-fixed option on equity shares. An issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed stated amount of a preferred stock instrument issued by the entity would also be considered a fixed-for-fixed option on equity shares when the preferred stock host is considered a debt instrument and there are no potential adjustments to the settlement terms.

In certain situations, the number of shares issued upon conversion of a convertible preferred stock instrument varies on the basis of the amount, if any, of accrued and unpaid dividends (i.e., the conversion formula specifies that, upon conversion, the investor will receive a number of equity shares that is equal to the liquidation value of the preferred stock plus accrued and unpaid dividends divided by a fixed conversion price). When the number of shares issuable upon conversion of a convertible preferred stock instrument is affected by accrued and unpaid dividends, the monetary amount exchanged upon conversion would not be considered fixed (i.e., the exchange does not involve a fixed amount of a preferred stock instrument of the issuer in return for a fixed number of equity shares). In such cases, the entity should evaluate whether the variables that could affect the settlement amount (i.e., the accrued and unpaid dividends) would be considered an input used in the pricing (fair value measurement) of a fixed-for-fixed option on equity shares.

If the convertible preferred stock contains a host debt instrument, and the dividend is specified as a fixed coupon on the liquidation value or a variable coupon that varies on the basis of an interest rate index, this type of conversion formula would generally not preclude the embedded conversion option from being considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7. This is because fixed and variable interest rates would factor into the pricing of a fixed-for-fixed option on equity shares (see Section 4.3.5.2). However, the entity should consider whether the conversion formula introduces leverage or results in a fixed monetary settlement amount of the convertible preferred stock instrument (see Section 4.3.4).

4.3.5.11 Convertible Zero-Coupon Bond

As used in ASC 815-40-15-7C, the term “fixed stated principal amount” refers to the principal amount of the bond at its maturity. Therefore, an exchange of the issuer’s zero-coupon bond for a fixed number of the entity’s shares would qualify as a fixed stated principal amount of a bond issued by the entity. If the embedded conversion option does not contain variability in the settlement terms as a result of other terms, it would be considered a fixed-for-fixed option on equity shares and would therefore be considered indexed to the entity’s stock. Otherwise, the issuer would need to evaluate other variability under step 2 in ASC 815-40-15-7 to conclude that the embedded conversion option was indexed to its stock.

Sometimes, the number of shares issued upon conversion of a convertible zero-coupon bond varies on the basis of the date of conversion (e.g., the conversion formula specifies that, upon conversion, the investor will receive a number of equity shares that is equal to the accreted value of the bond divided by a fixed conversion price). When the number of equity shares issuable upon conversion of a convertible zero-coupon bond is affected by accreted interest on the zero-coupon bond, the monetary amount exchanged upon conversion would not be considered fixed (i.e., the exchange does not involve a fixed amount of a debt instrument of the issuer in return for a fixed number of equity shares). In such cases, the entity should evaluate whether the variables that could affect the settlement amount (i.e., the accreted interest) would be considered an input used in the pricing (fair value measurement) of a fixed-for-fixed option on equity shares. Since interest rates are a variable in the pricing of a fixed-for-fixed option on equity shares (see Section 4.3.5.2), this type of conversion formula generally does not preclude the embedded conversion option from being considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7. The effective yield on a zero-coupon bond is generally determined on the basis of risk-free interest rates and the issuer’s credit spread. The influence of the issuer’s credit spread on the effective yield does not invalidate this conclusion since the issuer’s credit spread is considered an input into the pricing (fair value measurement) of a fixed-for-fixed option embedded in a convertible instrument. However, the entity should consider whether the conversion formula introduces leverage or results in a fixed monetary settlement amount of the zero-coupon convertible bond (see Section 4.3.4).

4.3.5.12 Own-Share Lending Arrangements

For a share-lending arrangement on the entity’s own shares to be considered indexed to its own equity under ASC 815-40, any variables affecting the settlement amount of the share-lending arrangement should be inputs to the fair value (pricing) of a fixed-for-fixed forward or option on the entity’s equity shares. The variables that typically affect the fair value of a share-lending arrangement include the contractual processing fee, the market rate of borrowing the entity’s shares during the arrangement’s term, and the share borrower’s nonperformance risk. Such variables do not preclude a conclusion that the instrument is indexed to the issuer’s own equity under ASC 815-40-15. If a share-lending arrangement contains other variables that affect the settlement amount, however, an entity should evaluate those variables to determine whether they preclude a conclusion that the instrument is indexed to the issuer’s own equity shares. For example, a share-lending arrangement in contemplation of a settlement amount that is indexed to the S&P 500 Index or the price of gold does not qualify for equity classification. ASC 470-20 provides recognition, measurement, EPS, and disclosure guidance related to an issuer’s accounting for equity-classified share-lending arrangements on its own shares for those that are executed in contemplation of a convertible debt issuance (see Section 2.9).

4.3.5.13 Reimbursement of the Holder’s Taxes

An equity-linked financial instrument may include a provision that requires the entity to reimburse the holder for any taxes it might incur upon settlement of the instrument, such as capital gains or withholding taxes that are attributable to the holder. Because holder-specific taxes are not an input into the pricing of a fixed-for-fixed forward or option on equity shares, such a provision precludes the instrument from being indexed to the entity’s stock under step 2 in ASC 815-40-15-7. The instrument would not be considered indexed to the entity’s stock even if there were no current tax requirements under which the entity would have to make an adjustment because the instrument would still be indexed to changes in tax laws, which is not an input into the pricing of a fixed-for-fixed forward or option on equity shares. The likelihood of changes in tax laws is not relevant to the assessment under step 2.

The above analysis differs from the evaluation of stamp duties, transfer taxes, or other governmental charges that are imposed on, and payable by, the issuer for the issuance of its equity shares. Such amounts may not preclude an equity-linked instrument from being indexed to the entity’s stock under step 2 because:

The taxes are imposed on the issuer as opposed to the holder since they apply to any issuance of shares by the issuer (i.e., the entity, and not the holder of the equity-linked instrument, is legally obligated to pay the taxes).
The entity’s obligation is limited to costs (if any) that would be unavoidable upon the entity’s issuance of equity shares.
The taxes arise from governmental regulations as opposed to the contractual terms of the equity-linked instrument.
The taxes are not based on the tax attributes of the holder of the instrument (i.e., the issuer’s obligation does not encompass any amounts related to capital gains taxes, withholding taxes, or other taxes or expenses that depend on holder-specific factors).
The entity expects to incur no or only minimal costs associated with meeting its obligation.

See further discussion in Section 5.2.3.7 of stamp duties, transfer taxes, and other governmental charges.

4.3.6 Evaluating Implicit Inputs

4.3.6.1 Overview

ASC 815-40

15-7G Standard pricing models for equity-linked financial instruments contain certain implicit assumptions. One such assumption is that the stock price exposure inherent in those instruments can be hedged by entering into an offsetting position in the underlying equity shares. For example, the Black-Scholes-Merton option-pricing model assumes that the underlying shares can be sold short without transaction costs and that stock price changes will be continuous. Accordingly, for purposes of applying Step 2, fair value inputs include adjustments to neutralize the effects of events that can cause stock price discontinuities. For example, a merger announcement may cause an immediate jump (up or down) in the price of shares underlying an equity-linked option contract. A holder of that instrument would not be able to continuously adjust its hedge position in the underlying shares due to the discontinuous stock price change. As a result, changes in the fair value of an equity-linked instrument and changes in the fair value of an offsetting hedge position in the underlying shares will differ, creating a gain or loss for the instrument holder as a result of the merger announcement. Therefore, inclusion of provisions that adjust the terms of the instrument to offset the net gain or loss resulting from a merger announcement or similar event do not preclude an equity-linked instrument (or embedded feature) from being considered indexed to an entity’s own stock.

In the pricing of an equity-linked instrument under standard valuation models (e.g., the Black-Scholes-Merton option pricing model), certain assumptions are implicit. Some instruments permit adjustments to the settlement terms when such implicit assumptions are invalidated. For example, the pricing of a contract may assume that no dilutive event will occur. If such an event occurs (e.g., a dilutive event) and is inconsistent with an implicit assumption in the valuation model (e.g., no dilutive events will occur), an adjustment to the contract’s settlement terms (e.g., an antidilution adjustment) does not necessarily preclude the contract from being considered indexed to the entity’s stock. However, if the settlement provisions are adjusted because of the occurrence or nonoccurrence of a specified event that does not invalidate an implicit assumption in a standard valuation model (e.g., the issuance of additional equity shares at a price equal to their fair value), the instrument is considered not indexed to the entity’s stock.

Below are examples of implicit assumptions that may be contained in a standard valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares. A neutralizing adjustment to the settlement amount in response to the invalidation of such an assumption would not preclude a conclusion that the instrument is indexed to the entity’s own equity:

The investor is able to maintain a standard hedge position in the equity shares underlying the instrument (e.g., the shares underlying a forward or option on equity shares can be sold short without transaction costs) — When an investor incurs transaction costs to sell shares short, has a loss of stock borrow, or is unable to maintain a standard hedge position (i.e., a hedging disruption event occurs, as further discussed below), an implicit assumption in standard valuation models is invalidated. Therefore, an adjustment to the settlement amount does not necessarily preclude the instrument from being considered indexed to the entity’s stock.
Stock price changes will be continual — Stock price discontinuities invalidate an implicit assumption to the extent that they result in a hedging disruption event. Occurrences that may cause a stock price discontinuity resulting in a hedging disruption event include:
- A merger event or change of control involving an issuer (see Section 4.3.7.5).
- A tender offer for an issuer’s shares.
- A termination of trading of an issuer’s shares (e.g., a delisting).
- A governmental or political event.
- A natural disaster.
Dilutive events will not occur (or, if they occur, the terms of the instruments will be adjusted solely to offset the effects of the dilutive events) — In standard valuation models, it is assumed that dilutive events will not occur (see Section 4.3.7.1). Dilutive events may include:
- A stock split, subdivision, combination, reclassification, or recapitalization.
- A stock dividend or distribution by an issuer.
- A rights offering by an issuer.
- An offering of additional common stock or equity-linked securities by an issuer at a price that is less than fair value (i.e., the current quoted market price for a public issuer).
- A repurchase of common stock by an issuer at a price that is more than fair value (i.e., the current quoted market price for a public issuer).
- A tender offer by an issuer at other than fair value of the issuer’s stock (i.e., the current quoted market price for a public issuer).
- A distribution by an issuer to all common shareholders of securities other than common stock, evidence of indebtedness, warrants, or other assets or property of the issuer.
The counterparty in a gain position will be paid the monetary value it is due upon settlement regardless of the form of settlement (i.e., cash, shares, or other assets) — When the counterparty in a gain position is not paid the entire monetary value due upon settlement, an implicit assumption in standard valuation models is invalidated. In this case, an adjustment to the settlement amount does not necessarily preclude the instrument from being considered indexed to the entity’s stock. Implicit assumptions about the settlement amount may include the following:
- If settlement of an equity-linked instrument is in shares instead of cash, the party receiving the shares will not incur transaction costs to dispose of those shares (see Section 4.3.7.6).
- If an equity-linked instrument is issued by a public company, the fair value of the shares underlying the instrument is based on the quoted market price of the issuer’s shares (i.e., shares that are registered for resale and listed on a stock exchange; see Sections 4.3.7.7 and 4.3.7.8).
The holder of an equity-linked instrument will be able to participate in any extraordinary distribution of cash or noncash consideration or other similar event that is provided to all holders of the issuer’s common stock — This is most commonly associated with a tender offer provision in which all holders of common stock are entitled to receive consideration associated with the offer. Certain tender offers for an entity’s shares may be made by a third party. While a tender offer made by a third party is not considered a dilutive event (because the offer does not involve the issuer), if such an offer is available to all holders of the issuer’s common stock (contractually or by law), an adjustment to the settlement terms solely to reflect a pro rata participation in the tender offer would not preclude the instrument from being considered indexed to the entity’s stock.
The holder of an equity-linked instrument will be able to realize the remaining time value inherent in the instrument — The occurrence of certain events involving the issuer (e.g., a liquidation or change of control) may invalidate this implicit assumption. In this case, an adjustment to the settlement amount would not necessarily preclude the instrument from being considered indexed to the entity’s stock (see Sections 4.3.7.9 and 4.3.7.10 for an example). That is, a provision that requires an appropriate adjustment to the settlement amount in the event of an early settlement of the instrument does not preclude the instrument from being considered indexed to the entity’s stock. Such adjustments are intended to compensate the counterparty for the “lost” time value upon such early settlements. They would not necessarily preclude the equity-linked instrument from being considered indexed to the entity’s stock, even though the fair value of the instrument under ASC 820 (based on a market participant’s view of a similar instrument without such an adjustment provision) may not include any remaining time value because the specified event truncates any remaining time value in the instrument.

Below are examples of adjustments to the settlement amount that are not associated with the invalidation of an implicit assumption in a standard valuation model. Such adjustments indicate that the instrument is not indexed to the entity’s own equity and thus cannot be classified as equity:

An adjustment to protect the counterparty from the effect of a specified event on the stock price (e.g., a provision that results in settlement by using a stock price input that does not reflect the effect of the specified event on the fair value of the issuer’s shares). An adjustment that protects the counterparty from adverse changes in the issuer’s stock price (which is not permissible) differs from an adjustment that neutralizes the effect that a specified event would have on the remaining time value in an equity-linked instrument (which may be permissible).
An adjustment upon the occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4).
Certain adjustments upon a change of control of the issuer (see Section 4.3.7.4).
An adjustment upon a change in the number of authorized and unissued common shares of an issuer.
An adjustment upon a change in the number of outstanding common shares of an issuer that occurs as a result of a specified event other than a dilutive event.
An adjustment under a provision that requires shareholder approval.
An adjustment upon the bankruptcy or insolvency of the issuer unless the event results in a hedging disruption.
An adjustment upon the delisting of the issuer’s stock unless the event results in a hedging disruption.
An adjustment based on employee forfeitures of awards subject to ASC 718.
An adjustment based on the holder of the instrument.

Connecting the Dots

On April 12, 2021, the SEC staff issued Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACS”) (the “SEC staff statement”), which discusses certain indexation matters related to SPAC warrants. The SEC staff statement discusses a fact pattern related to the terms of warrants that were issued by a SPAC, and states, in part:

[T]he warrants included provisions that provided for potential changes to the settlement amounts dependent upon the characteristics of the holder of the warrant. Because the holder of the instrument is not an input into the pricing of a fixed-for-fixed option on equity shares, OCA staff concluded that, in this fact pattern, such a provision would preclude the warrants from being indexed to the entity’s stock, and thus the warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.

The SEC staff statement notes that the holder is not an input into the pricing of an equity-linked instrument. Therefore, if the holder of an instrument could potentially affect either the exercise (forward) price or the number of shares issued on settlement, the instrument is not considered indexed to the issuer’s stock. For example, certain nonpublicly traded warrants issued by a SPAC to its sponsor or an anchor investor (“private placement warrants”) have terms that differ from the terms of publicly traded warrants also issued by the SPAC (“public warrants”). In the event that the holder of private placement warrants transfers those warrants to a nonpermitted transferee (i.e., a nonaffiliate), the warrants become public warrants. In the fact pattern addressed by the SEC staff, there were differences between the public warrants and private placement warrants related to the following terms:

The issuer could force settlement of the public warrants if the entity’s stock price was $10 or more. The number of shares issuable on such settlement would depend on the date on which they were settled and the stock price (i.e., there was an adjustment to deliver additional shares to compensate the holder for lost time value). The private placement warrants were not subject to this provision but would become subject to it if they were transferred to a nonpermitted transferee.
Both the public warrants and private placement warrants were subject to an exercise price adjustment in the event of certain changes in control; however, the formula for the exercise price adjustment was different for each type of warrant. Further, a private placement warrant’s exercise price adjustment would change so that it would be adjusted in a manner consistent with the terms of a public warrant if it was transferred to a nonpermitted transferee.
Different formulas were used in the public warrants and private placement warrants for computing the number of shares deliverable in a cashless, or net share, settlement.

Because the holder is not an input into the pricing of a fixed-for-fixed forward or option on equity shares, the private placement warrants were considered not indexed to the issuer’s stock and their classification as liabilities was required. In addition, the public warrants issued by some entities included provisions that affected the warrants’ settlement amount when they were held by the entities’ directors or officers. Further, public warrants that contained such terms were considered not indexed to the issuer’s stock and were required to be classified as liabilities.

The SEC staff’s position that the holder of an instrument is not an input into the pricing of a fixed-for-fixed equity-linked instrument is based on the guidance in ASC 815-40-15 and therefore applies to all entities. While the SEC’s position addresses warrants issued by a SPAC, the guidance could apply in other circumstances. For more information about the classification of SPAC warrants, see Deloitte’s October 2, 2020 (last updated April 11, 2022), Financial Reporting Alert.

4.3.6.2 Evaluating Adjustments Based on an Implicit Input

An entity considers the three questions below when evaluating whether adjustments to the settlement provisions based on an implicit input preclude a freestanding or embedded equity-linked financial instrument from being considered indexed to its own stock. The entity evaluates each implicit input separately. These considerations are relevant regardless of whether the implicit input (1) affects the exercise price or forward price of the instrument or the number of equity shares used to calculate the settlement amount or (2) results in an immediate settlement of the instrument at an adjusted settlement amount:

Does the adjustment to the settlement provisions result from the occurrence or nonoccurrence of a specified event that invalidates an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

An equity-linked instrument does not qualify as equity if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event unless the occurrence or nonoccurrence of the event is inconsistent with an implicit assumption in a standard valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares.

The table below gives examples of events in response to which adjustments to the settlement amount may or may not preclude equity classification.

Permissible (Equity Classification Not Precluded)	Not Permissible (Equity Classification Precluded)
The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow). The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change of control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5). Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1). A down-round protection feature (see Section 4.3.7.2). The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8). The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party). The counterparty is not able to realize the remaining time value inherent in the instrument (i.e., loss of time value upon early settlement; see Section 4.3.7.9). The counterparty does not receive the shares underlying the instrument within a reasonable period (see Section 4.3.7.11).	Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4). Occurrence or nonoccurrence of a change of control (unless the adjustment arises from a discontinuity in stock price that causes a hedge disruption event). A change in the entity’s number of authorized and unissued common shares. A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event. A provision that requires shareholder approval. The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption). Delisting of the underlying shares (unless the event results in a hedging disruption). The identity of the holder (see Section 4.3.7.3).

Permissible (Equity Classification Not Precluded)

Not Permissible (Equity Classification Precluded)

The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow).
The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change of control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5).
Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1).
A down-round protection feature (see Section 4.3.7.2).
The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8).
The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party).
The counterparty is not able to realize the remaining time value inherent in the instrument (i.e., loss of time value upon early settlement; see Section 4.3.7.9).
The counterparty does not receive the shares underlying the instrument within a reasonable period (see Section 4.3.7.11).

Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4).
Occurrence or nonoccurrence of a change of control (unless the adjustment arises from a discontinuity in stock price that causes a hedge disruption event).
A change in the entity’s number of authorized and unissued common shares.
A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event.
A provision that requires shareholder approval.
The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption).
Delisting of the underlying shares (unless the event results in a hedging disruption).
The identity of the holder (see Section 4.3.7.3).

Is the adjustment to the settlement terms consistent with the effect that the occurrence or nonoccurrence of the specified event had on the fair value of the instrument (i.e., does the adjustment offset — at least partially — the net gain or loss on the instrument that occurs as a result of the specified event)?

For the instrument to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.

An equity-linked instrument does not qualify as equity if the instrument’s terms include an adjustment in response to the occurrence or nonoccurrence of a specified event that is inconsistent with an implicit assumption in a standard valuation model unless the adjustment is consistent with the effect that the occurrence or nonoccurrence of the specified event has on the fair value of the instrument. Thus, adjustments to neutralize or partially offset the effects of events that invalidate an implicit assumption in a valuation model do not preclude an equity-linked instrument from being considered indexed to the entity’s stock (i.e., such adjustments do not preclude equity classification for the instrument). In this context, “neutralize” means that the calculation of the adjustment to the settlement terms of the equity-linked instrument appropriately offsets the net gain or loss on the instrument that occurred as a result of the specified event.

Adjustments from implicit inputs do not necessarily have to result in a complete neutralization of the effect that the occurrence or nonoccurrence of a specified event has on the fair value of an equity-linked instrument (i.e., the net gain or loss on the instrument that occurs as a result of the specified event). However, an adjustment to the terms of an instrument to reflect more than 100 percent of the effect that the variable has on the fair value of a fixed-for-fixed forward or option on equity shares precludes an instrument from being indexed to the entity’s stock because the additional exposure is inconsistent with a fixed-for-fixed forward or option on equity shares.

Note that an equity-linked instrument may be considered indexed to the entity’s stock even if no adjustments are made upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption. In a fixed-for-fixed forward or option on equity shares, no adjustments are made upon the occurrence of an event that is inconsistent with any of the implicit assumptions. Instead, the counterparty to the instrument is exposed to the risk of a change in the fair value of the instrument upon the occurrence or nonoccurrence of such events. Further, an instrument may be considered indexed to the entity’s stock even if an adjustment upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption only partially offsets the effect of the specified event.

For an equity-linked instrument to qualify as equity, the adjustment cannot compensate the counterparty for adverse changes in the entity’s share price that are not attributable to the effect of the specified event. This is because such an adjustment could “protect” the counterparty from an adverse price change that results from events other than an event that invalidates an implicit assumption. Similarly, an adjustment based on the difference between the pre-event share price and the post-event share price generally would preclude equity classification because the share price could have changed for reasons other than the event itself (ASC 815-40-55-42). The principle is that an adjustment should be designed to capture only the theoretical effect of the event that invalidates an implicit assumption (e.g., a dilutive event).

A settlement of an equity-linked instrument at its fair value as of the settlement date (i.e., that reflects the effect of a specified event) is not considered to have been affected by an implicit input because no additional value is exchanged between the counterparties (i.e., no adjustment is made for the net gain or loss resulting from the invalidation of an implicit input). However, when the settlement amount does not reflect fair value (e.g., the settlement amount will be adjusted to reflect the net gain or loss resulting from the occurrence of a specified event), the entity must perform an additional evaluation to determine whether the equity-linked instrument is indexed to its stock.

Further, as discussed in the example below, an entity must determine the adjustment by using commercially reasonable means.

Example 4-11

Use of Commercially Reasonable Means to Determine Adjustment

Assume a contract provision adjusts the settlement terms to offset the net gain or loss that results from a discontinuous stock price change that causes a hedge disruption event. The adjustment is calculated on the basis of the net change in fair value of the equity-linked instrument and an offsetting delta-neutral hedge position that is determined by using commercially reasonable means. The provision, which does not protect the counterparty from a mere adverse change in stock price, does not preclude the equity-linked instrument from being considered indexed to the entity’s own stock because an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares is that a counterparty is able to maintain a delta-neutral hedge. The equity-linked instrument is not considered indexed to the entity’s stock, however, if the adjustment is based on the counterparty’s actual offsetting hedge position and the counterparty is not required to maintain a delta-neutral hedge position. This is because if the entity calculates an adjustment on the basis of the counterparty’s actual hedging position, the adjustment is not considered to have been made in a commercially reasonable manner if there is any possibility that the counterparty’s actual hedging position could differ from a delta-neutral hedging position.

Example 4-12

Assessment of Adjustment for Lost Time Value

There is an implicit assumption in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares that the holder of the contract will be able to realize the remaining time value inherent in the instrument. If certain events were to occur that would require early settlement of an equity-linked option contract, the holder would lose any remaining time value in the option. A provision that results in an adjustment to the exercise price of an option contract to reflect a settlement on the basis of the “theoretical value” of the contract (calculated on the basis of the remaining time to expiration as of the date of the specified event and the stock price of the issuer on the date of the occurrence of the specified event) does not preclude the instrument from being considered indexed to the entity’s stock. The adjustment provision is considered to appropriately compensate the counterparty for the lost time value that results from the occurrence of a specified event that invalidates an implicit assumption in the pricing of the option contract. It does not adjust the settlement terms to protect the counterparty against a potential adverse change in the issuer’s stock price.
Could a change in an implicit input result in a settlement at a fixed monetary amount?

For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.

If a change in an implicit input can result in a settlement based on a fixed monetary amount, the equity-linked instrument is not indexed to the entity’s stock (see Section 4.3.7.12 for an example). This is because the occurrence of the specified event would result in a settlement amount that would be inconsistent with the effect that the event would have had on the fair value of a fixed-for-fixed forward or option on equity shares.

Example 4-13

Fixed Monetary Settlement

A warrant allows the holder to purchase 1,000 shares of an entity’s common stock for $10 per share. However, if there is a change of control of the issuer, the holder can require the entity to redeem the warrant for $20,000. The instrument is not indexed to the entity’s stock because of the potential for a fixed monetary settlement.

4.3.7 Implicit Inputs: Application Issues and Examples

4.3.7.1 Antidilution Adjustments

As discussed in Section 4.3.6, there is an implicit assumption in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares that dilutive events will not occur (or, if they occur, that the terms of the instrument will be adjusted solely to offset the effect of the dilutive events). When an equity-linked instrument contains adjustments upon the occurrence of a dilutive event and the adjustments always result in the same intrinsic value for the equity-linked instrument both before and after the dilutive events, the adjustments do not preclude the instrument from being considered indexed to the entity’s stock. That is, if an adjustment is designed to offset or neutralize the effect of the dilutive event on the holder of the instrument, it does not preclude equity classification.

Examples of such adjustments include those designed to offset or neutralize the effect of the following:

The entity effects a share split or share combination.
The entity issues shares of common stock as a dividend or distribution on all shares of common stock.
The entity issues to all holders of common stock any rights, options, or warrants entitling them to subscribe for or purchase shares of common stock at a price per share that is less than the currently quoted sales price or fair value of such shares.
The entity distributes to all holders of its common stock (1) shares of its capital stock, evidence of indebtedness, other assets, or its property or (2) rights, options, or warrants to acquire its capital stock or other securities.
The entity pays any cash dividend or distribution to all holders of its common stock.
The entity, or any of its subsidiaries, makes a payment on a tender offer or exchange offer for the entity’s common stock to the extent that the cash and value of any other consideration included in the payment per share of common stock exceeds the currently quoted sales price or fair value of such shares.
The entity repurchases shares of common stock at a price that exceeds the currently quoted sales price or fair value of such shares.

Example 4-14

Antidilution Adjustments

Entity Y issues freestanding warrants that allow the holder to purchase 1,000 shares of Y’s common stock for $10 per share any time before the warrants’ expiration date. The exercise price and number of shares underlying the warrants are adjusted (1) upon a change in the risk-free interest rate (on a nonleveraged basis) and (2) if Y undertakes a stock split (the adjustment solely offsets the dilution caused by the stock split). In this case, the warrants are not fixed for fixed because the settlement amount will not always equal the difference between the fair value of a fixed number of equity shares and a fixed exercise price. However, the warrants are still considered indexed to Y’s stock because (1) the risk-free interest rate is an explicit input used in the pricing (fair value measurement) of a fixed-for-fixed option on equity shares and there is no feature (such as a leverage factor) that increases exposure to that input in a manner that is inconsistent with a fixed-for-fixed option on equity shares and (2) an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed option on equity shares is that a stock split will not occur (or that the exercise price and number of shares underlying the warrants will be adjusted to offset the dilution caused by the stock split).

Example 17 in ASC 815-40-55 below illustrates adjustments to offset the effect of dilutive events.

ASC 815-40

Example 17: Variability Involving Various Underlyings

55-42 Entity A enters into a forward contract to sell 100 shares of its common stock for $10 per share in 1 year. Under the terms of the forward contract, the strike price of the forward contract would be adjusted to offset the resulting dilution (except for issuances and repurchases that occur upon settlement of outstanding option or forward contracts on equity shares) if Entity A does any of the following:

Distributes a stock dividend or ordinary cash dividend
Executes a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend
Issues shares for an amount below the then-current market price
Repurchases shares for an amount above the then-current market price.

The contractual terms that adjust the forward contract’s strike price are eliminating the dilution to the forward contract counterparty that would otherwise result from the occurrence of those specified dilutive events. The adjustment to the strike price of the forward contract is based on a mathematical calculation that determines the direct effect that the occurrence of such dilutive events should have on the price of the underlying shares; it does not adjust for the actual change in the market price of the underlying shares upon the occurrence of those events, which may increase or decrease for other reasons.

55-43 The forward contract is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The only circumstances in which the settlement amount will not equal the difference between the fair value of 100 shares and $1,000 ($10 per share) are upon the occurrence of any of the following:
1. The distribution of a stock dividend or ordinary cash dividend
2. The execution of a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend
3. The issuance of shares for an amount below the then-current market price
4. The repurchase of shares for an amount above the then-current market price.

An implicit assumption in standard pricing models for equity-linked financial instruments is that such events will not occur (or that the strike price of the instrument will be adjusted to offset the dilution caused by such events). Therefore, the only variables that could affect the settlement amount in this example would be inputs to the fair value of a fixed-for-fixed option on equity shares.

Questions are often raised regarding how transaction costs should be treated in the determination of whether an adjustment arising from a dilutive event precludes an instrument from being considered indexed to the entity’s stock. For example, a provision may result in an adjustment to the settlement terms of an equity-linked instrument if an issuer sells additional common shares at less than fair value. The adjustment may be calculated on the basis of the difference between the actual number of common shares issued and the number of common shares that could have been purchased at the current quoted market price with the net proceeds (including transaction costs) received in the issuance. Alternatively, the adjustment may be calculated on the basis of the difference between the actual number of common shares issued and the number of common shares that could have been purchased at the current quoted market price with the gross proceeds (excluding transaction costs) received in the issuance.

Whether transaction costs are included in, or excluded from, the calculation of adjustments from dilutive events should generally not affect the assessment of whether the equity-linked instrument is considered indexed to the entity’s stock. Transaction costs incurred by an issuer may affect the post-event fair value of the issuer’s shares and thus could be included in a dilutive-type adjustment. Such costs could also be excluded because the exclusion results in an adjustment that does not fully neutralize the effect of the dilutive event and does not otherwise create leverage.

4.3.7.2 Down-Round Protection

ASC Master Glossary

Down Round Feature

A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.

A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.

A down-round feature is a term in an equity-linked financial instrument (e.g., a freestanding warrant or an equity conversion feature embedded within a host debt or equity contract) that triggers a downward adjustment to the instrument’s strike price (or conversion price) if equity shares are issued at a lower price (or equity-linked financial instruments are issued at a lower strike price) than the instrument’s then-current strike price. The purpose of the feature is to protect the instrument’s counterparty from future issuances of equity shares at a more favorable price. For example, a warrant may specify that the strike price is the lower of $5 per share or the common stock offering price in any future offering of the shares. Similarly, a debt instrument may include an embedded conversion feature whose conversion price is the lower of $5 per share or the future offering price. Such provisions are frequently included in warrants, convertible shares, and convertible debt issued by private entities and development-stage companies.

Note that a conversion feature that economically represents a share-settled redemption feature is not a down-round feature.

Example 4-15

Adjustment That Is Not a Down-Round Feature

An entity has issued a debt instrument with a principal amount of $10 million that is automatically converted into the issuer’s equity shares upon an IPO. The conversion price is the lower of 80 percent of the stock price in the IPO or $50. Although the conversion price in this scenario is reduced to the IPO price if the IPO price is below $50, the potential adjustment is not a down-round feature because the associated settlement has a monetary value equal to a fixed monetary amount ($10,000,000 ÷ 0.80 = $12,500,000). The entity should evaluate this share-settled redemption feature in a manner similar to how it evaluates a put or call option embedded in a debt host contract to determine whether the feature must be separated as a derivative under ASC 815-15 (see Section 8.4.7.2.5 of Deloitte’s Roadmap Issuer’s Accounting for Debt). Note that an entity must also evaluate the facts and circumstances of each adjustment provision to determine whether it is a down-round feature. In some circumstances, a pre-specified adjustment feature based on an IPO price could represent a down-round feature.

Example 4-16

Adjustment That Is a Down-Round Feature

An entity has issued a 10-year convertible debt instrument with a principal amount of $10 million. The conversion price is $50. If an IPO were to occur with an IPO price of less than $50, the conversion price would be reduced to the IPO price. The holder is not required to convert the debt upon an IPO; it can continue to hold the debt and elect to convert it later. In such a scenario, the potential adjustment to the conversion price upon an IPO is a down-round feature because the conversion feature has a monetary value that varies on the basis of changes in the issuer’s stock price both before and after the IPO. If, however, the entity was required to convert the debt upon the IPO, the adjustment would not meet the definition of a down-round feature because the associated settlement has a monetary value that is equal to a fixed monetary amount.

Economically, a down-round provision is different from an antidilution feature. An antidilution feature may be designed to adjust the terms of an equity-linked instrument in such a way that the holder is not worse off because of a dilutive event (e.g., stock split). As a result of the adjustment, the holder is protected against the effect of the dilutive event but is not in an economically better position than it was before the event. The holder of a down-round feature, however, can obtain equity shares at a more favorable price than before the event, giving it an advantage relative to existing holders of the underlying shares. The issuance of new equity shares is not dilutive to existing investors if the new investors pay fair value for the shares.

The ASC master glossary definition of a down-round feature does not explicitly refer to a down-round adjustment effected through an increase in the number of shares issuable under the instrument instead of, or in addition to, a reduction of the strike price for an issuer that sells shares at a lower price or issues an equity-linked financial instrument with a lower strike price. On the basis of informal discussions with the SEC staff, however, it is acceptable to evaluate such an adjustment as a down-round feature if it economically achieves the same outcome as a down-round feature. For instance, if an equity-linked instrument specified an economically proportional increase to the number of shares issuable, the same economic outcome might be achieved. Alternatively, the same economic outcome might be achieved through a combination of a strike price reduction and an increase in the number of shares issuable. However, an adjustment effected through an increase in the number of shares issuable under the instrument should not be evaluated as a down-round feature if it potentially could result in the transfer of more value than would be possible through a reduction in the strike price. In particular, the value of shares transferred could not exceed the value that would be transferred if the strike price were zero, because the strike price cannot be reduced to a negative amount. Further, an adjustment indexed to the number of outstanding shares (e.g., an adjustment based on a percentage of equity; see Section 4.3.5.8) would not meet the definition of a down-round feature.

To meet the definition of a down-round feature, the feature should not protect the holder against changes in inputs other than those directly related to the issuer’s subsequent (1) issuance of any equity shares at a lower stock price or (2) issuance or repricing of any equity-linked financial instruments at a lower strike price. For example, a feature would not meet the definition of a down-round feature if it specifies that a substantively identical adjustment must be made to the instrument’s terms if the terms of any new convertible instrument issued by the entity are more favorable to the holder (e.g., a more favorable conversion rate, interest rate, or other term), because it could protect the holder against adverse changes in interest rates or other inputs unrelated to the types of adjustments that are contemplated by the definition of a down-round feature.

A financial instrument may contain a feature that requires a reduction to its strike price if the issuer subsequently modifies the terms of any other outstanding financial instrument so that its strike price is below that of the instrument with the feature. Although such a feature might be triggered even if the issuer has not issued any new financial instruments, it is acceptable to evaluate the feature as a down-round feature under ASC 815-40 since an instrument has come into existence whose strike price is below the currently stated strike price of the instrument with the feature. Conversely, a feature that requires a reduction in an instrument’s strike price if a subsequent estimate of a share’s value is below the instrument’s current strike price would not meet the definition of a down-round feature because that definition does not contemplate adjustments to the strike price that are not triggered by the creation of an instrument with more favorable terms.

ASC 815-40

15-5D When classifying a financial instrument with a down round feature, the feature is excluded from the consideration of whether the instrument is indexed to the entity’s own stock for the purposes of applying paragraphs 815-40-15-7C through 15-7I (Step 2).

Example 9: Variability Involving Future Equity Offerings and Issuance of Equity-Linked Financial Instruments

55-33 This Example illustrates the application of the guidance beginning in paragraph 815-40-15-5 for a financial instrument that includes a down round feature. Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms and are exercisable at any time. However, the terms of the warrants specify both of the following:

If the entity sells shares of its common stock for an amount less than $10 per share, the strike price of the warrants is reduced to equal the issuance price of those shares.
If the entity issues an equity-linked financial instrument with a strike price below $10 per share, the strike price of the warrants is reduced to equal the strike price of the newly issued equity-linked financial instrument.

55-34 The warrants are considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. In accordance with paragraph 815-40-15-5D, when classifying a financial instrument with a down round feature, an entity shall exclude that feature when considering whether the instrument is indexed to the entity’s own stock for the purposes of applying paragraphs 815-40-15-7C through 15-7I (Step 2). The instrument does not contain any other features to be assessed under Step 2.

55-34A See paragraph 260-10-45-12B for earnings-per-share considerations, paragraph 260-10-25-1 for recognition considerations, and paragraphs 505-10-50-3 through 50-3A for disclosure considerations.

A contractual provision that meets the definition of a down-round feature does not affect the entity’s analysis of whether the related instrument is indexed to the entity’s own stock under step 2 in ASC 815-40-15-7 (i.e., the guidance in ASC 815-40-15-7C through 15-8). That is, the down-round feature does not preclude the entity from concluding that the instrument that includes the down-round feature is indexed to the entity’s own stock.

For example, an entity’s evaluation of whether it is required to classify a freestanding warrant that gives the counterparty the right to acquire the entity’s common stock as a liability or equity under ASC 815-40 would not be affected by the existence of the down-round feature. Accordingly, if the warrant otherwise is considered indexed to the entity’s own equity under ASC 815-40-15 and meets the other condition for equity classification in ASC 815-40-25, it would be classified as equity. Similarly, in the analysis of whether an embedded conversion feature in a debt host contract must be bifurcated as an embedded derivative under ASC 815-15, the existence of a down-round provision would not prevent the instrument from qualifying for the scope exception in ASC 815-10-15-74 that applies to contracts indexed to an entity’s own stock and classified in stockholders’ equity (see Section 2.2.2).

While instruments or features that contain down-round features are not precluded from being considered indexed to the entity’s stock, they may still not qualify for equity classification for other reasons (e.g., if the issuer could be forced to net cash settle the instrument or feature; see Chapter 5).

4.3.7.3 Identity of the Holder

The identity or nature of the holder is not an input into the pricing of a fixed-for-fixed forward or option on equity shares. Therefore, to be considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7, the settlement amount must not vary on the basis of the party that holds the equity-linked instrument.

As discussed in Section 4.3.6.1, if the identity or nature of the holder of an instrument could potentially affect the exercise (forward) price or the number of shares issued on settlement, the instrument is not considered indexed to the entity’s stock. The following are examples of situations in which equity-linked instruments are not indexed to the entity’s stock under step 2 in ASC 815-40-15-7 because the settlement amount varies on the basis of the holder of the instrument:

Private placement warrants issued by SPACs (see Section 4.3.6.1).
Warrants with provisions that require the issuer to reimburse the holder for taxes that are holder-specific (see Section 4.3.5.13).
Warrants for which the share price input used in a net share settlement changes if the holder transfers the warrants (see Section 4.3.5.1). (Note that if any settlement provision of an equity-linked instrument changes as a result of the transfer of the instrument by the holder, the instrument is not indexed to the entity’s stock under step 2 in ASC 815-40-15-7.)

4.3.7.4 Adjustment Contingent on the Occurrence or Nonoccurrence of an IPO or a Change of Control, Including Share-Settleable Earnouts

The occurrence or nonoccurrence of an IPO is not an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on the entity’s shares. Therefore, a provision that adjusts the settlement amount upon the occurrence of an IPO (e.g., adjusts to a different fixed price) indicates that the equity-linked instrument is not indexed to the entity’s own equity and would disqualify the instrument from equity classification unless the adjustment provision meets the definition of a down-round feature (see Section 4.3.7.2). Keep in mind that to meet the definition of a down-round feature, the adjustment must be a reduction in the exercise price and can only be required if the IPO price is lower than the exercise price.

Example 4-17

Adjustment Contingent on Occurrence of an IPO

Entity X issues freestanding warrants that allow the holder to purchase 1,000 shares of X’s common stock for $10 per share. The warrants are exercisable at any time for 10 years. The exercise price of the warrants is adjusted if there is an IPO of X, which is an implicit input. However, whether X has an IPO is not used in the pricing (fair value measurement) of a fixed-for-fixed option on equity shares. Therefore, the warrants are not considered indexed to X’s stock and do not qualify as equity unless the adjustment provision meets the definition of a down-round feature (see Section 4.3.7.2).

As discussed in Sections 4.3.7.5 and 4.3.7.9, adjustments that occur upon a merger of the issuing entity that reasonably compensate the holder for the loss of time value or a hedging disruption do not prevent an equity-linked instrument from being indexed to the entity’s stock under step 2 in ASC 815-40-15-7. However, some equity-linked instruments contain provisions that change the settlement amount solely on the basis of whether a change of control occurs (i.e., the contract is indexed to the occurrence or nonoccurrence of a change of control irrespective of whether such event results in the investor’s loss of time value or a hedging disruption). Variability in the settlement amount as a result of the occurrence or nonoccurrence of a change of control that does not neutralize the effect of an implicit assumption in the pricing of a fixed-for-fixed forward or option on equity shares precludes an equity-linked instrument from being considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7.

A common type of equity-linked instrument that may be indexed to a change of control is a share-settleable earnout arrangement issued in conjunction with a merger or other business combination. A number of these types of arrangements have been issued in business combinations involving a SPAC and an operating entity (or a “target”).

As discussed in Section 2.5.3, a SPAC and target may agree to enter into a share-settleable earn-out arrangement as a form of additional consideration for a SPAC merger transaction. Such an arrangement represents an equity-linked instrument that must be evaluated under ASC 815-40 unless the arrangement (1) contains only transfer restrictions that lapse upon the passage of time (and therefore the arrangement is treated as an outstanding share) or (2) is within the scope of ASC 718.

All share-settleable earn-out arrangements contain contingent exercise provisions (e.g., the combined company’s stock price or a change of control), which generally do not prevent the contract from meeting the criterion in step 1 under ASC 815-40-15-7 (see Section 4.2.3.2). Most share-settleable earn-out arrangements also contain settlement provisions, which may prevent them from being indexed to the combined company’s stock under step 2 of such guidance.

The following are some common terms in these arrangements that affect the settlement amount but generally do not prevent the contract from meeting the step 2 criterion:

The combined company’s stock price (i.e., the quoted price or a reasonable average of quoted prices [see Section 4.3.5.1]).
Standard antidilutive adjustments (see Section 4.3.7.1).
Adjustments for dividends on the combined company’s stock (see Section 4.3.5.3).
Adjustments for lost time value upon an early settlement (provided that those adjustments reflect only reasonable compensation for lost time value [see Example 4-12]).

The following are some common terms in these arrangements that affect the settlement amount but generally prevent the contract from meeting the step 2 criterion:

All remaining shares would be issuable (or the forfeiture provisions would lapse) upon any change of control involving the combined company.
All remaining shares would be issuable (or the forfeiture provisions would lapse) upon a bankruptcy or insolvency of the combined company.
The number of shares that would be issuable varies on the basis of employee forfeitures of awards subject to ASC 718-10.

In practice, share-settleable earn-out arrangements can be generally categorized into four different types, which are discussed in the table below.

Type	Evaluation of Indexation Guidance
A fixed number of shares will be issued if (1) the combined company’s stock price meets or exceeds a stated price or (2) there is a change of control of the combined company. Example: As additional consideration for a SPAC transaction, 5 million common shares of the combined company will be issued to the target’s shareholders if either (1) the quoted price of the stock exceeds $20 during a stated period or (2) there is a change of control.	If either of these two conditions is met, the issuance of the earn-out shares is only considered an exercise contingency because there is no variability in the number of shares issuable. This exercise contingency does not preclude the earn-out share arrangement from being considered indexed to the combined company’s stock.
A variable number of shares will be issued on the basis of the combined company’s stated stock prices. If there is a change of control, all the earn-out shares will be issued. Example: 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 — The VWAP 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. Level 2 — The VWAP 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. Level 3 — The VWAP 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. Level 4 — The VWAP 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. 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. If, however, the combined company is acquired in a change of control, all previously unissued shares will be issued.	This arrangement contains a provision that affects the settlement amount. The number of earn-out shares issuable varies on the basis of whether there is a change of control of the combined company. That is, in the absence of a change of control, a variable number of shares will be issued on the basis of stock price. However, if a change of control occurs, all of the earn-out shares will be issued (i.e., 4 million shares will be issued regardless of the combined company’s stock price). Because the arrangement contains a settlement provision that precludes it from being indexed to the combined company’s stock under step 2 in ASC 815-40-15-7, liability classification is required.
A variable number of shares will be issued on the basis of the combined company’s stated stock prices. If there is a change of control at a price per share that equals or exceeds a stated amount that is less than the price needed for all the earn-out shares to be issued, all of the earn-out shares will nevertheless be issued. Example: 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 — The VWAP 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. Level 2 — The VWAP 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. Level 3 — The VWAP 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. Level 4 — The VWAP 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. 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. If, however, the combined company is acquired in a change of control at a price of $15 or more, all previously unissued shares will be issued.	This arrangement contains a provision that affects the settlement amount. The number of earn-out shares issuable varies depending on whether there is a change of control of the combined company at a stated price. That is, in the absence of a change of control at a stated price, a variable number of shares will be issued on the basis of stock price. However, if a change of control occurs at a price per share of $15 or more, all the earn-out shares will be issued (i.e., 4 million shares will be issued regardless of the combined company’s stock price). Because the arrangement contains a settlement provision that precludes it from being indexed to the combined company’s stock under step 2 in ASC 815-40-15-7, liability classification is required.
A variable number of shares will be issued on the basis of either (1) the combined company’s stated stock prices or (2) the price per share in a change of control of the combined company. See Example 2-3.	This arrangement contains a provision that affects the settlement amount. The determination of whether the arrangement is indexed to the combined company’s stock under step 2 in ASC 815-40-15-7 depends on (1) how the price per share is calculated in a change of control of the combined company and (2) an entity’s interpretation of the application of ASC 815-40-15 to the potential settlement that would occur upon a change of control. Some entities have determined that the settlement amount is affected by the occurrence or nonoccurrence of a change of control, which is not an input into the pricing of a fixed-for-fixed forward or option on equity shares. These entities have therefore concluded that the share-settleable earn-out arrangement is not indexed to the combined company’s stock under step 2 in ASC 815-40-15-7. As a result, the earn-out arrangement is classified as a liability. Note that these entities reach this conclusion without evaluating the calculation of the price per share in a change of control of the combined company. Other entities focus on the calculation of price per share in the event of a change of control. On the basis of a preclearance with the staff of the SEC’s Office of the Chief Accountant (OCA), there are two possible outcomes: If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that excludes the shares issuable under the earn-out share arrangement or other potentially issuable shares of the issuer, the arrangement is not considered indexed to the combined company’s stock under step 2 in ASC 815-40-15-7 and must be classified as a liability. If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that includes the shares issuable under the earn-out share arrangement and all other potentially issuable shares of the issuer, the arrangement is considered indexed to the combined company’s stock under step 2 in ASC 815-40-15-7 and may be classified as an equity instrument as long as no other condition in ASC 815-40 precludes such classification. A price-per-share calculation that includes the number of shares issuable under the share-settleable earn-out arrangement and other potentially issuable shares of the issuer can be described as a “circular,” “net,” or “as-diluted” calculation. Although computable, it is not a simple calculation. In addition, the terms of the provision that apply in the event of a change of control are often subject to interpretation (i.e., ambiguous). In these situations, entities may wish to consult with attorneys to obtain a legal interpretation that supports equity classification of the instrument. However, if the terms of the provision in the earn-out agreement do not specifically indicate that a calculation method consistent with the circular, net, or as-diluted approach applies, the entity would not have sufficient evidence to support a conclusion that the share-settleable earn-out arrangement is indexed to the entity’s stock under step 2 in ASC 815-40-15-7; therefore, liability classification is required. That is, an entity cannot rely on an attorney’s interpretation of an ambiguous provision and conclude that the circular, net, or as-diluted calculation applies, because it would not be able to support such a conclusion with sufficient evidence.

Connecting the Dots

In the table above, it is assumed that none of the earn-out shares are within the scope of ASC 718. In practice, share-settleable earn-out share arrangements may be issuable to employees of the target that hold vested or unvested shares or options on the date on which the SPAC merges with a target. In addition to considering the guidance in ASC 718, entities should assess whether the potential shares issuable to common stockholders under ASC 815-40 could be affected by the number of shares issuable to recipients whose earn-out shares are within the scope of ASC 718 (i.e., recipients that receive those shares as a form of stock-based compensation). For example, assume that earn-out shares will be issued to holders of unvested stock options on the merger date provided that those holders are still employees on the date on which the earn-out share target or targets are met. If an option holder is no longer an employee as of that date, the earn-out shares otherwise receivable by the holder will be reallocated to the pool of shares receivable by common stockholders that did not receive such shares in return for services (i.e., that were not within the scope of ASC 718). In this situation, as a result of the guidance on the unit of account in ASC 815-40, the portion of the share-settleable earn-out arrangement that is within the scope of ASC 815-40 would not be considered indexed to the combined company’s stock because the number of shares varies on the basis of employee behavior. In a manner consistent with Example 20 in ASC 815-40-55, the share-settleable earn-out arrangement within the scope of ASC 815-40 must be classified as a liability in its entirety.

4.3.7.5 Merger Adjustments

There is an implicit assumption in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares that a discontinuous stock price event will not affect the counterparty’s ability to hedge the price risk inherent in the instrument by using a delta-neutral strategy. If a discontinuous stock price event occurs as a result of a merger announcement, the terms of an equity-linked instrument related to the exercise price or the number of the entity’s shares used to calculate the settlement amount may need to be adjusted to neutralize the effect that the discontinuous stock price event has on the counterparty’s ability to maintain a delta-neutral hedging strategy. The calculation of the adjustment may be based on the difference between (1) the aggregate fair value of the instrument and a standard delta-neutral hedging position immediately before the occurrence of the specified event and (2) the aggregate fair value of the instrument and a standard delta-neutral hedging position immediately after the occurrence of the specified event. This results in an adjustment to the settlement terms for the effects of the hedging disruption as if the specified event had not occurred. The adjustment does not protect the counterparty from a change in stock price of the issuer as a result of a specified event. Accordingly, the adjustment does not preclude the instrument from being considered indexed to the entity’s stock.

Example 6 in ASC 815-40-55 below illustrates these concepts.

ASC 815-40

Example 6: Variability Involving Merger Announcement

55-30 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms and are exercisable at any time. However, the terms of the warrants specify that if there is an announcement of a merger involving Entity A, the strike price of the warrants will be adjusted to offset the effect of the merger announcement on the net change in the fair value of the warrants and of an offsetting hedge position in the underlying shares. The strike price adjustment must be determined using commercially reasonable means based on an assumption that the counterparty has entered into a hedge position in the underlying shares to offset the share price exposure from the warrants. That strike price adjustment is not affected by the counterparty’s actual hedging position (for example, the strike price adjustment does not differ in circumstances when the counterparty is over-hedged or under-hedged). The warrants are considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share), unless there is a merger announcement. If there is a merger announcement, the settlement amount would be adjusted to offset the effect of the merger announcement on the fair value of the warrants. In that circumstance, the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed option on equity shares. For further discussion, see paragraphs 815-40-15-7E and 815-40-15-7G.

A change-of-control provision may specify that the equity-linked instrument will become indexed to the equity shares of the acquirer in a business combination if all the entity’s stockholders receive stock of the acquiring entity. ASC 815-40 specifically states that such a clause does not preclude a conclusion that the instrument is indexed to the entity’s own stock (ASC 815-40-55-5; see Section 5.2.3.4). However, a change-of-control provision that affects the exercise price or number of shares issued upon the settlement of an equity-linked instrument could cause the instrument to be considered not indexed to the entity’s stock.

The occurrence or nonoccurrence of a change of control is not an implicit input into the pricing of a fixed-for-fixed forward or option on equity shares. Thus, an instrument would be considered not indexed to the entity’s stock if it contains adjustments to the exercise (forward) price or number of shares that are based solely on the occurrence or nonoccurrence of a change of control (i.e., an adjustment subject to step 2 under ASC 815-40-15-7). However, if the adjustments are designed only to neutralize the effect of a discontinuous stock price event that affects the counterparty’s ability to hedge the instrument, they would not necessarily preclude the instrument from being considered indexed to the entity’s stock. Rather, the implicit input that is invalidated is related to an assumption that stock price movements will be continuous and the counterparty can reasonably use a delta-neutral strategy as opposed to the occurrence or nonoccurrence of a change of control. That implicit assumption could be invalidated for a number of reasons other than just the occurrence of a change of control.

For some equity-linked instruments, the number of shares issuable depends on the entity’s stock price (e.g., contingent consideration and other similar earn-out arrangements). If the number of shares also depends on the occurrence or nonoccurrence of a change of control, the instrument is considered not indexed to the entity’s stock. If, however, the price paid in a change of control is used as a measure of stock price, the evaluation depends on the facts and circumstances. For additional discussion of share-settleable earn-out arrangements issued by SPACs, see Section 4.3.7.4.

4.3.7.6 Adjustments Based on the Counterparty’s Transaction Costs

There is an implicit assumption in the pricing of a fixed-for-fixed forward or option on equity shares that the counterparty will receive the full monetary value it is due upon settlement irrespective of the form of settlement (e.g., cash or shares). This assumption is invalidated if an entity elects to settle an equity-linked instrument in shares instead of cash, and the counterparty incurs transaction costs to dispose of those shares. Therefore, a commercially reasonable adjustment for transaction costs would not necessarily preclude equity classification. For example, some equity-linked instruments include symmetrical make-whole provisions that guarantee that the proceeds will equal what a cash settlement would have been (see Sections 5.2.5 and 5.3.6).

Example 4-18

Adjustment Based on Counterparty’s Transaction Costs

An entity issues a stock purchase warrant that allows the counterparty to purchase 100,000 common shares. The issuer is allowed to settle the warrant in either cash or its common shares, at its option. The terms of the warrant also state that if the issuer elects share settlement, additional shares will be issued in an amount equal to the actual transaction costs incurred by the investor to dispose of the shares received within a reasonable period, up to a maximum of 1,000 additional common shares.

There is an implicit assumption in the pricing of a fixed-for-fixed forward or option on equity shares that the party receiving the shares will not incur transaction costs to dispose of those shares. If the issuer elects to settle the stock purchase warrant in shares, this implicit assumption is invalidated because the investor will incur costs to dispose of such shares. The additional share delivery is intended to offset the investor’s actual transaction costs, not to exceed 1,000 additional shares.

In this example, the adjustment to the settlement terms may not fully offset the costs incurred by the investor, because it is possible that the fair value of an additional 1,000 shares is less than the actual transaction costs incurred by the investor. Nevertheless, because the adjustment is for an amount equal to or less than 100 percent of the actual transaction costs of the investor, the warrants may still be considered indexed to the issuer’s stock.

4.3.7.7 Adjustments Based on the Entity’s Inability to Deliver Registered Shares

An equity-linked instrument may specify that if the entity settles the instrument by delivering unregistered shares (e.g., if securities laws preclude the entity from delivering registered shares), the number of unregistered shares it will deliver is greater than the number of registered shares it would otherwise have delivered. Such an adjustment does not preclude equity classification if the difference is intended to account for any marketability discount applicable to the unregistered shares and the adjustment is determined by using commercially reasonable methods. In this case, the value of the unregistered shares delivered is intended to approximate the value of the registered shares that would have otherwise been deliverable. For example, some equity-linked instruments include symmetrical make-whole provisions that guarantee that the proceeds will equal what the value of a settlement in registered shares or cash would have been.

4.3.7.8 Adjustments to the Conversion Price of a Convertible Instrument Under a Registration Payment Arrangement

A convertible instrument may specify that the conversion price is adjusted if the issuer fails to file a registration statement for the resale of the shares underlying the instrument or fails to have the registration statement declared effective by the end of a specified grace period. Such an adjustment is excluded from the scope of the guidance on registration payment arrangements in ASC 825-20 because it is related to the conversion ratio (see Section 3.2.4). Therefore, the adjustment provision is taken into account in the evaluation of the conversion feature under ASC 815-40-15.

If the adjustment compensates the holder merely for the difference between the fair value of registered and unregistered shares, the adjustment does not necessarily preclude equity classification for the conversion feature. If the feature compensates the holder for an amount in excess of the difference, however, the conversion feature does not qualify as equity because the adjustment is not consistent with the effect the failed registration statement has on the fair value of a fixed-for-fixed forward or option on the entity’s equity shares.

4.3.7.9 Adjustments Based on a Formula or a Table

An equity-linked instrument may contain a formula or table that is used to calculate an adjustment to the settlement amount as a result of the occurrence or nonoccurrence of a specified event that invalidates an implicit assumption used in the pricing of a fixed-for-fixed forward or option on equity shares. The inputs into these provisions are often stock price and time. For instance, Example 19 in ASC 815-40-55 (see Section 4.3.7.10) illustrates a contractual adjustment to the settlement terms that (1) applies if the entity is acquired for cash before a specified date and (2) is defined “by reference to a table with axes of stock price and time.” The formula or tables discussed in this section are those that are designed to compensate the counterparty for a loss of time value related to a specified event.

Example 4-19

Make-Whole Table

Entity A has issued convertible notes. Each note is convertible into A’s common stock at the holder’s election at a conversion rate of 15 shares of common stock per $1,000 principal amount of notes. The terms of the notes specify that if a change of control, the sale of substantially all of A’s assets, or another fundamental change (as defined in the terms of the notes) occurs and the holder elects to convert, A will adjust the conversion rate by increasing the number of shares that will be delivered upon conversion. The number of additional shares, if any, that will be delivered is determined by reference to the make-whole table below on the basis of (1) the effective date on which the fundamental change occurs and (2) the stock price as of that date. The adjustment to the conversion rate is designed to compensate the holder for the expected option value that the holder would lose as a result of the fundamental change. That is, the adjustment is intended to make the holder whole for the expected loss of the time value of money that would result from an early exercise of the conversion option. Accordingly, the aggregate fair value of the shares deliverable (including the make-whole shares) upon conversion is expected to approximate the fair value of the conversion option on the settlement date as long as there has been no change in relevant pricing inputs (other than stock price and time) since the instrument’s inception. In no event will the conversion rate be increased to exceed 20.36 shares of common stock per $1,000 principal amount of notes.

In the make-whole table above, the conversion option is not precluded from being considered indexed to A’s own stock because the adjustment (1) results from the occurrence of an event that invalidates an implicit assumption used in the pricing of a fixed-for-fixed option on equity shares (i.e., that the holder will realize the remaining time value inherent in the notes), (2) is consistent with compensating the holders for lost time value (i.e., the number of additional shares that will be delivered is reduced as the stock price increases and as time to maturity decreases), (3) does not protect the holder from an adverse price change that is unrelated to the event, (4) is not leveraged (i.e., does not contain compensation in excess of expected lost time value), and (5) does not result in the delivery of shares worth a fixed monetary amount.

Although the inputs (stock price and time) for these types of provisions are explicit and are used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, an entity is still required to evaluate whether the provisions are designed to neutralize (in whole or in part) the effect that the specified event would have on the time value of the instrument. If, at the instrument’s inception, the provisions are designed to (if all other factors are held constant) neutralize no more than 100 percent of the effect that the specified event would have on the time value of the instrument, the provisions do not preclude the instrument from being considered indexed to the entity’s stock.

The provisions would, however, preclude the instrument from being considered indexed to the entity’s stock if they are designed so that they could result in (1) protection against an adverse change in the fair value of the issuer’s stock, (2) an adjustment to the terms of the instrument that exceeds the effect that the specified event would have on the time value of the instrument (i.e., contains leverage), (3) a settlement based on a fixed monetary amount, or (4) an adjustment to compensate the counterparty for lost time value in a separate freestanding financial instrument. See Section 4.3.6 for more information.

Connecting the Dots

To conclude that a make-whole provision does not preclude equity classification under step 2 in ASC 815-40-15-7, an entity must determine that (1) the provision is appropriately designed to neutralize no more than 100 percent of the effect that the specified event would have on the time value of the instrument and (2) the adjustment only compensates the holder for that lost time value. Because of the complexity of the calculations entities must perform to evaluate the amounts in a make-whole table or other similar formula, they and their auditors generally will need to engage valuation specialists for assistance. It is not sufficient to simply observe that the values prescribed by a make-whole table are directionally consistent with expected amounts on the basis of axes of time and stock price.

4.3.7.10 Example of a Make-Whole Provision in Contingent Convertible Debt

Example 19 in ASC 815-40-55 below illustrates multiple types of exercise contingencies and adjustments that do not necessarily preclude equity classification for an equity feature embedded in a debt security under ASC 815-40-15:

Exercise contingencies that depend on the following variables:
- A market price trigger that is based on the entity’s stock price.
- A parity provision that is based on the trading price of the convertible debt in which the equity feature being evaluated is embedded.
- A merger announcement involving the entity.
An adjustment to the settlement amount in the form of make-whole shares if the entity is acquired for cash before a specified date. The adjustment is defined by reference to a table with axes of stock price and time.

ASC 815-40

Example 19: Variability Involving Contingently Convertible Debt With a Market Price Trigger, Parity Provision, and Merger Provision

55-45 Entity A issues a contingently convertible debt instrument with a par value of $1,000 that is convertible into 100 shares of its common stock. The convertible debt instrument has a 10-year term and is convertible at any time after any of the following events occurs:

Entity A’s stock price exceeds $13 per share (market price trigger).
The convertible debt instrument trades for an amount that is less than 98 percent of its if-converted value (parity provision).
There is an announcement of a merger involving Entity A.

55-46 The terms of the convertible debt instrument also include a make-whole provision. Under that provision, if Entity A is acquired for cash before a specified date, the holder of the convertible debt instrument can convert into a number of shares equal to the sum of the fixed conversion ratio (100 shares per bond) and the make-whole shares. The number of make-whole shares is determined by reference to a table with axes of stock price and time. That table was designed such that the aggregate fair value of the shares deliverable (that is, the fair value of 100 shares per bond plus the make-whole shares) would be expected to approximate the fair value of the convertible debt instrument at the settlement date, assuming no change in relevant pricing inputs (other than stock price and time) since the instrument’s inception. The embedded conversion option is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The market price trigger and parity provision exercise contingencies are based on observable markets; however, those contingencies relate solely to the market prices of the entity’s own stock and its own convertible debt. Also, the merger announcement exercise contingency is not an observable market or an index. Therefore, Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
Step 2. An acquisition for cash before the specified date is the only circumstance in which the settlement amount will not equal the difference between the fair value of 100 shares and a fixed strike price ($1,000 fixed par value of the debt). The settlement amount if Entity A is acquired for cash before the specified date is equal to the sum of the fixed conversion ratio (100 shares per bond) and the make-whole shares. The number of make-whole shares is determined based on a table with axes of stock price and time, which would both be inputs in a fair value measurement of a fixed-for-fixed option on equity shares.

Although the conclusion in step 2 in ASC 815-40-55-46 focuses on the axes in the table (i.e., stock price and time), the discussion refers to the table’s objective. Therefore, an entity is required to evaluate the design and purpose of an adjustment to the settlement terms of an equity-linked instrument that is based on a table in determining whether the adjustment meets the indexation requirements of ASC 815-40.

The adjustment to the terms of the embedded conversion option (i.e., the make-whole provision) results in the aggregate fair value of the shares deliverable upon settlement approximating the fair value of the convertible debt instrument on the settlement date, assuming no change in relevant pricing inputs (other than stock price and time) since the debt’s inception. On the basis of informal discussions with the FASB staff, we understand that the adjustment actually reflects a settlement at the “theoretical value” of the embedded conversion option. Such value is calculated on the basis of (1) the fair value of the underlying common shares, including the effect of the specified event that resulted in early settlement, and (2) an amount for time value, determined by using (a) the issuer’s stock price, including the effect of the specified event that resulted in early settlement, and (b) the remaining time to contractual expiration as of the date of the specified event. That is, the adjustment provision compensates the counterparty for lost time value upon early settlement and does not result in a settlement that is based on the fair value of the convertible instrument. Because the lost time value is calculated on the basis of the time to expiration as of the adjustment date and the relevant share price on the adjustment date (which takes into account the effect that the event resulting in early settlement had on the issuer’s share price), the provision does not preclude the instrument from being considered indexed to the entity’s stock.

4.3.7.11 Buy-In and Share Delivery Failure Payments

Some equity-linked financial instruments contain “buy-in” provisions that require the issuing entity to make a stated cash payment for each day shares are not delivered to the holder in a timely manner (e.g., deliveries that occur after a two- to three-day settlement period). A “share delivery failure” provision further requires the issuer to make the counterparty whole if, because of the entity’s failure to transfer the shares on a timely basis, the holder incurs a loss by purchasing (in the open market or otherwise) shares of the entity’s common stock to deliver in satisfaction of a sale order that the holder anticipated fulfilling with the shares receivable from the issuer upon settlement of the instrument.

Both buy-in and share delivery payments arise from the invalidation of an implicit input into the pricing of a fixed-for-fixed forward or option on equity shares that the holder will receive the shares underlying an equity-linked instrument within a reasonable period after the exercise or settlement date. As long as the amount of such payments represents reasonable compensation to the holder for the damages incurred as a result of the issuer’s failure to perform, these provisions will not preclude an equity-linked instrument from being indexed to the entity’s stock under step 2 in ASC 815-40-15-7. See Section 5.2.3.7.1 for discussion of the application of the equity classification criteria to buy-in and share delivery failure payment provisions.

4.3.7.12 Contingent Obligation to Settle an Equity-Linked Instrument at a Fixed Monetary Amount

If a change in a variable (other than the entity’s stock price) could result in the instrument’s settlement based on a fixed monetary amount, the instrument cannot be classified as equity. Example 10 of ASC 815-40-55 below illustrates such a scenario.

ASC 815-40

Example 10: Variability Involving Regulatory Approval

55-35 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms and are exercisable at any time. However, the terms of the warrants specify that if Entity A does not obtain regulatory approval of a particular drug compound within 5 years, the holder can surrender the warrants to Entity A for $2 per warrant (settleable in shares). The contingently puttable warrants are not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share), unless regulatory approval of a particular drug compound is not obtained within 5 years. If that approval is not obtained within the allotted time period, the holder could elect to surrender the warrants to Entity A in exchange for $2 per warrant. The contingent obligation to settle the warrants by transferring consideration with a fixed monetary value if regulatory approval of a particular drug compound is not obtained within a specified time period does not represent an input to the fair value of a fixed-for-fixed option on equity shares. A freestanding equity-linked instrument that provides for a fixed payoff upon the occurrence of a contingent event which is not based on the issuer’s share price is not indexed to an entity’s own stock.

4.3.7.13 Bail-In Provisions

The European Union (EU)’s Bank Recovery and Resolution Directive (Directive 2014/59/EU; BRRD) specifies that resolution authorities in EU member states must be able to apply bail-in powers to banks and other financial institutions within the BRRD’s scope. Such powers include the right to write down liabilities of a failing institution or convert such liabilities into the institution’s equity (or both). Under BRRD Article 55, EU member states must, in certain circumstances, require institutions to include a bail-in provision in the contractual terms of some liabilities. Under such a provision, “the creditor or party to the agreement creating the liability [recognizes] that liability may be subject to the write-down and conversion powers and agrees to be bound by any reduction of the principal or outstanding amount due, conversion or cancellation that is effected by the exercise of those powers by a resolution authority” even if the contract otherwise is governed by laws outside of the EU.

On April 23, 2018, Deloitte participated in a discussion with the staff of the SEC’s Office of the Chief Accountant (OCA) about the impact of the EU bail-in provisions on an entity’s evaluation of an equity-linked instrument under ASC 815-40. The specific fact pattern discussed with the SEC staff involved an equity-linked instrument between an EU-domiciled bank with a U.S. branch and a U.S.-domiciled commercial entity (the issuer) that, other than having incorporated BRRD Article 55, was governed by New York state law. The SEC staff indicated that it would not object to a conclusion that the addition of a bail-in provision under BRRD Article 55 to a contract would not in itself prevent the contract from being classified in equity under ASC 815-40 if the contract otherwise qualifies for equity classification. The SEC staff also indicated that it would not object to an entity’s decision to classify such types of contracts as liabilities on the basis of this provision. The SEC staff’s view applies only to the fact pattern discussed herein.

4.3.7.14 Tax Integration of Capped Calls and Convertible Debt

Sometimes issuers purchase freestanding capped call options on their own equity shares in connection with the issuance of convertible debt to increase the effective conversion price of the combination of the debt and the capped call. Further, the contractual terms of the capped call may include a “tax cap” on the amount payable to the issuer if the capped call is settled early because of early conversion of the related convertible debt. The purpose of the tax cap is to help ensure that the capped call and the related convertible debt can be integrated (i.e., treated as a single, combined synthetic instrument) for tax purposes. Upon early settlement of the capped call because of the early conversion of the related convertible debt, the tax cap places a ceiling on the capped call’s settlement amount (e.g., the lower of the capped call’s fair value and the tax cap amount). That tax cap might be defined as the excess, if any, of the amount paid (in cash or shares) to the holder of the convertible debt upon early conversion over the original issue price of the convertible debt (e.g., $1,000). Alternatively, it might be defined as the excess, if any, of the amount paid (in cash or shares) to the holder of the convertible debt upon early conversion over an amount that varies solely as a function of time (e.g., as indicated in a table showing the projected “synthetic instrument adjusted price” of the combination of the convertible debt and the capped call for tax purposes at different settlement dates).

Depending on its terms, a tax cap on the settlement amount of a capped call that is integrated with a related convertible debt instrument for tax purposes does not necessarily preclude the capped call from being considered indexed to the entity’s own equity if it varies solely as a function of the conversion consideration paid upon early conversion, as function of time (e.g., as indicated in a table), or both. It is assumed in U.S. GAAP that many issuers of convertible debt purchase capped calls and integrate them with the convertible debt for tax purposes. Accordingly, it is reasonable to evaluate capped calls that are integrated with convertible debt for tax purposes against a fixed-for-fixed capped call linked to convertible debt; that is, it is not necessary to evaluate it against a traditional fixed-for-fixed option on the entity’s own equity shares. In addition, holders of convertible debt typically act rationally on the basis of marketplace assumptions about the entity’s stock price and the market price of the convertible debt, and uneconomical exercises can be ignored for these instruments (e.g., the possibility of early conversion if it would involve a loss of time value). Moreover, ASC 815-40-55-46 implies that equity classification under step 1 in ASC 815-40-15-7 is not precluded for an exercise contingency in convertible debt that is related solely to the market prices of the entity’s own stock and its own convertible debt. Therefore, the exercise contingency that is related to the capped calls may be appropriately analyzed as the event that permits early conversion of the convertible debt as opposed to conversion option exercise behavior. For these reasons, it is not necessary to analyze the capped call’s settlement amount as being indexed to conversion option exercise behavior, which would have represented an impermissible input (see Section 4.3.5.9). However, the acceptability of a tax cap on the settlement amount of a capped call depends on a conclusion that in no circumstance can the settlement amount of the capped call exceed its fair value on the settlement date. The only acceptable tax caps are those that have the effect of preventing the issuer from potentially receiving the full fair value of the capped call on the early settlement date.

4.3.8 Foreign Currency Provisions

ASC 815-40

15-7I The issuer of an equity-linked financial instrument incurs an exposure to changes in currency exchange rates if the instrument’s strike price is denominated in a currency other than the functional currency of the issuer. An equity-linked financial instrument (or embedded feature) shall not be considered indexed to the entity’s own stock if the strike price is denominated in a currency other than the issuer’s functional currency (including a conversion option embedded in a convertible debt instrument that is denominated in a currency other than the issuer’s functional currency). The determination of whether an equity-linked financial instrument is indexed to an entity’s own stock is not affected by the currency (or currencies) in which the underlying shares trade.

Example 11: Variability Involving a Currency Other Than the Entity’s Functional Currency

55-36 Entity A, whose functional currency is U.S. dollars (USD), issues warrants with a strike price denominated in Canadian dollars (CAD). The warrants permit the holder to buy 100 shares of its common stock for CAD 10 per share. Entity A’s shares trade on an exchange on which trades are denominated in CAD. The warrants have 10-year terms and are exercisable at any time. The warrants are not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
Step 2. The strike price of the warrants is denominated in a currency other than the entity’s functional currency, so the warrants are not considered indexed to the entity’s own stock.

Example 18: Variability Involving Forward Contract Settled in a Currency Other Than the Entity’s Functional Currency

55-44 Entity A, whose functional currency is US$, enters into a forward contract that requires Entity A to sell 100 shares of its common stock for 120 euros per share in 1 year. The forward contract is not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
Step 2. The strike price of the forward contract is denominated in a currency other than the entity’s functional currency, so the forward contract is not considered indexed to the entity’s own stock.

Example 20: Variability Involving Functional Currency Debt Convertible to a Stock That Trades in a Currency Other Than the Entity’s Functional Currency

55-47 Entity A, whose functional currency is the Chinese yuan (CNY), issues a debt instrument denominated in CNY with a par value of CNY 1,000 that is convertible into 100 shares of its common stock. Entity A’s shares only trade on an exchange in which trades are denominated in US$. Those shares do not trade on an exchange (or other established marketplace) in which trades are denominated in CNY. The convertible debt instrument has a 10-year term and is convertible at any time. The embedded conversion option is considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The embedded conversion option does not contain an exercise contingency. Proceed to Step 2.
Step 2. Upon exercise of the embedded conversion option, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price denominated in its functional currency (CNY 1,000 fixed par value of the debt). The determination of whether the embedded conversion option is indexed to the entity’s own stock is not affected by the currency (or currencies) in which the underlying shares trade.

If an equity-linked instrument’s exercise price, forward price, or conversion price is denominated in a currency other than the issuer’s functional currency (as determined under ASC 830), the instrument is not considered to be indexed to the entity’s own equity even if the amount is fixed in that currency. This is the case even if the shares that would be delivered under the instrument are traded or quoted in the foreign currency. (This is different from the guidance on share-based payment arrangements in ASC 718-10-25-14A.)

Some equity-linked instruments include a strike price expressed in the functional currency, but the amount of functional currency varies in such a way that it equals a fixed amount of foreign currency translated into the functional currency at the spot rate on the date of exercise or settlement. Including a settlement term like this is economically the same as having a strike price denominated in the foreign currency. Although the strike price will be converted at the spot rate on the date of exercise such that payment will be made in the functional currency, the instrument should be analyzed as if it were denominated in a foreign currency.

Example 4-20

Strike Price Denominated in Functional Currency

An entity’s functional currency is the U.S. dollar. The entity issues an option that gives the holder the right to purchase a fixed number of 1,000 equity shares. The contractual terms of the option describe the strike price as a U.S. dollar amount and require the holder to use U.S. dollars to pay the strike price upon the option’s exercise. The amount of U.S. dollars that will be paid upon exercise is defined as a fixed strike price of €10 converted to U.S. dollars at the spot foreign exchange rate on the date of settlement. The option is precluded from equity classification because the strike price effectively is denominated in a foreign currency from the perspective of the issuing entity.

ASC 815-10

Example 15: Contracts Involving an Entity’s Own Equity — Derivative Instrument Indexed to Both the Issuer’s Equity Price and a Foreign Currency Exchange Rate

55-144 This Example illustrates the application of paragraph 815-10-15-74(a). Assume that Entity A, whose functional currency is the U.S. dollar (USD), and the Counterparty enter into a one-year forward contract that is indexed to Entity A’s common share price translated into euros (EUR) at spot rates and that will be settled in net shares of Entity A. If the value of Entity A’s common stock in EUR appreciates, then Entity A will receive from the Counterparty a number of shares of Entity A stock equal to the appreciation. If the value of Entity A’s stock in EUR depreciates, then Entity A will pay Counterparty a number of shares of Entity A stock equal to the depreciation. Thus, the forward contract is indexed both to Entity A’s common stock and the USD/EUR currency exchange rates.

55-145 Assume further that Entity A’s common stock price at inception is USD 100 per share, and the forward exchange rate of USD to EUR is 1:1.2. The strike price of the forward contract is then set at EUR 120. One year later, the share price of Entity A rises to USD 150, and the spot exchange rate of USD to EUR is 1:1. Then, the share price of Entity A translated is EUR 150. At settlement, Entity A will receive from the Counterparty 20 shares of its own common stock according to the following calculation:

(EUR 150 – EUR 120) × 100 shares = EUR 3,000

EUR 3,000 ÷ EUR 150 per share = 20 shares

55-146 A forward contract that is indexed to both an entity’s own stock and currency exchange rates should be accounted for as a derivative instrument in its entirety by both parties to the contract if the contract in its entirety meets the definition of a derivative instrument in paragraphs 815-10-15-83 through 15-139.

55-147 Paragraph 815-20-25-71(a)(2) prohibits separating a derivative instrument into components based on different risks. Consequently, it would be inappropriate to bifurcate the forward contract described in this Example according to its differing exposures to changes in Entity A’s stock price and changes in the USD/EUR exchange rate and then attempt to apply paragraph 815-10-15-74(a) only to the exposure to changes in Entity A’s stock price. That paragraph must be applied to an entire contract.

ASC 815 prohibits an entity from separating derivative instruments into components on the basis of risk in determining the appropriate accounting for the instrument. Thus, an entity could not bifurcate an equity-linked instrument that has a strike price denominated in a foreign currency into an instrument with a strike price denominated in the functional currency and an instrument exchanging functional currency and foreign currency (ASC 815-10-55-147).

4.3.9 Uneconomic Settlement Terms

4.3.9.1 Subjective Modification Provisions

ASC 815-40

15-7H Some equity-linked financial instruments contain provisions that provide an entity with the ability to unilaterally modify the terms of the instrument at any time, provided that such modification benefits the counterparty. For example, the terms of a convertible debt instrument may explicitly permit the issuer to reduce the conversion price at any time to induce conversion of the instrument. For purposes of applying Step 2, such provisions do not affect the determination of whether an instrument (or embedded feature) is considered indexed to an entity’s own stock.

In some circumstances, the settlement terms contain subjective modification provisions that allow the issuer to unilaterally modify the terms of the instrument at any time. Such provisions do not affect the determination of whether an equity-linked instrument is considered indexed to the entity’s stock as long as the modifications benefit the counterparty. For example, if the terms permit the issuer to decrease the exercise price or increase the conversion rate, those terms would not preclude a conclusion that the instrument is indexed to the entity’s own stock.

If a modification occurs, an entity should reconsider whether the equity-linked freestanding financial instrument (or embedded feature) is still considered indexed to the entity’s stock. The entity should also evaluate whether the modification has any accounting consequence in the period in which it occurs (e.g., as an induced conversion under ASC 470-20-40-13 or an effect on EPS under ASC 260). For further discussion of the accounting for induced conversions, see Section 12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt. For additional guidance on the calculation of EPS, see Deloitte’s Roadmap Earnings per Share.

Example 4-21

Subjective Modification Provision in a Convertible Debt Instrument

The following is an example of a subjective modification provision in a convertible debt instrument:

The indenture permits us to increase the conversion rate, to the extent permitted by law and subject to the stockholder-approval requirements (if any) of any relevant national securities exchange or automated dealer quotation system, for any period of at least 30 days. We will give notice of at least 10 days of any such increase. In addition to the above increases, we may, as our board of directors deems advisable, increase the conversion rate to avoid or diminish any income tax to holders of our common stock resulting from any dividend or distribution of stock (or rights to acquire stock) or from any event treated as such for income tax purposes.

An example of a subjective modification provision is one that permits the entity to increase the conversion rate at its discretion, to the extent permitted by law if such an increase is to avoid or diminish any U.S. federal income tax to holders of the entity’s common stock resulting from any dividend or distribution of stock (or rights to acquire stock) or from any event treated as such for U.S. federal income tax purposes.

4.3.9.2 Right to Settle at Less Than Fair Value

Some equity-linked instruments include terms that give one or both of the parties the right to settle early at an amount that would always be unfavorable relative to settling the instrument at its fair value (e.g., because of lost time value). A provision under which one of the parties has the right, but not the obligation, to settle early at an unfavorable price relative to the instrument’s fair value would not prevent a contract from being considered indexed to the issuer’s stock as long as the settlement amount does not incorporate any extraneous factors into such early settlement.

4.3.10 Warrants on Convertible Stock With Conversion Price Adjustments

Sometimes entities issue warrants that permit the holder to purchase a fixed number of the entity’s nonredeemable convertible preferred shares for a fixed price. The preferred shares that the entity would deliver upon exercise of the warrants are convertible into the entity’s common shares at a fixed price except for an adjustment to the conversion price that precludes the conversion feature from being considered indexed to the entity’s own equity (e.g., variability involving a revenue target, see Section 4.3.5.7).

To determine whether this warrant potentially qualifies as equity, the entity needs to ascertain whether the conversion price adjustment in the preferred stock precludes a conclusion that the warrant is indexed to the entity’s own equity. (A similar issue arises for an embedded conversion option in a debt host; e.g., an option to convert debt into convertible preferred stock that has conversion price adjustments.)

In circumstances in which the following apply, two views are acceptable depending on the entity’s policy regarding whether to assess indexation to its own shares by (1) evaluating only the warrant’s direct exercise provision (the warrant-level view) or (2) “looking through” to all indirect exercise provisions (i.e., exercise provisions in instruments underlying the warrant — the look-through view):

There are no other features in the warrant (excluding the conversion price adjustment) that would preclude the entity from concluding that the warrant is indexed to its own stock.
The preferred stock underlying the warrant would, upon issuance, qualify for classification in permanent equity under ASC 480-10-S99-3A. If the preferred stock does not meet the conditions for classification in permanent equity under ASC 480-10-S99-3A, the warrant would be accounted for as a liability under ASC 480-10-25-8 because it embodies an obligation to issue an instrument (the convertible preferred stock) that may require a transfer of assets (see Section 5.2.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity). In determining whether the preferred stock qualifies for permanent equity classification, the entity should evaluate the liquidation preferences of the preferred stock (including “deemed liquidation” provisions) to identify features that may result in a conclusion that the stock is redeemable.
The preferred stock is substantive (i.e., it is reasonably possible that an investor would exercise the warrant and not immediately convert the preferred stock into common stock).
The conversion option in the preferred stock would not be required to be bifurcated from the preferred stock and accounted for separately as a derivative under ASC 815 once the holder exercises the warrant.

Once an entity adopts one of the two views as its accounting policy, it should consistently apply that policy. An entity’s ability to select an alternative accounting policy is limited to the analysis of whether a warrant is indexed to the entity’s own stock under ASC 815-40-15 and should not be applied by analogy to the analysis of the entity’s ability to control settlement in shares upon exercise (see Chapter 5) or the classification of instruments under ASC 480 (see Deloitte’s Roadmap Distinguishing Liabilities From Equity).

4.3.10.1 Warrant-Level View

Under this view, the warrant is not precluded from being considered indexed to an entity’s own stock because of the conversion price adjustment. The number of preferred shares issuable upon the warrant’s exercise and the warrant’s exercise price are both fixed. Therefore, in accordance with ASC 815-40-15-7C, the warrant is not precluded from being considered indexed to the entity’s own stock. In this case, the entity does not look through the convertible preferred stock to assess whether the ultimate number of common shares to which the holder is entitled is fixed.

4.3.10.2 Look-Through View

Under this view, the warrant is not considered indexed to an entity’s own stock. The ultimate number of common shares to which the holder of the warrant is entitled (by first exercising the warrants into shares of convertible preferred stock and then converting those shares into shares of common stock) is variable because of the conversion price adjustment. Further, the adjustment provision in the convertible preferred stock is not an input in the pricing model of a fixed-for-fixed forward or option on equity shares.

This approach is analogous to the look-through view that an entity would apply to settlement provisions in determining the classification of warrants on puttable shares (i.e., an entity would consider the holder’s indirect right to settle in cash under the put right that is embedded in the puttable shares in assessing whether a warrant on puttable shares should be accounted for as a liability under ASC 480).

Footnotes

When the indexation that was incorporated into ASC 815-40-15 was being developed, the standard setters were mindful of standard ISDA terms and definitions. Nevertheless, without analyzing the contractual terms, an entity cannot assume that a contract prepared in accordance with standard ISDA documentation meets the indexation guidance in ASC 815-40-15.

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