5.1 Overview
To qualify for equity classification, an equity-linked instrument within the
scope of ASC 815-40 (see Chapter
2) must be indexed to the entity’s stock, and the issuing entity must be
required or permitted to share settle it. Any provision that could require the
issuer to net cash settle the instrument precludes equity classification, with
limited exceptions. The likelihood of an event that would trigger a net cash
settlement does not matter. Some equity-linked instruments provide either the issuer
or the counterparty with a choice of settlement method (i.e., physical, net shares,
or net cash). In other instruments, the settlement method depends on the occurrence
or nonoccurrence of a specified event. In these circumstances, the existence of
settlement alternatives may affect the classification of the instrument (see Section 5.2).
Even if an equity-linked instrument ostensibly requires or permits an entity to
settle in shares (e.g., a warrant that requires physical settlement), the entity
cannot assume that it has the ability to do so unless there are no circumstances in
which it could be forced to net cash settle the instrument. The accounting
literature contains a series of conditions that must be met (see Section 5.3) and assessed
continually (see Section 5.4)
for an issuer to conclude that it is able to share settle an instrument. Some of the
conditions do not apply to certain convertible debt instruments (see Section 5.5).
Freestanding equity-linked instruments are often executed and documented by
using ISDA standard documentation (see Section 3.1.3). For such instruments, the entity needs to consider not
only the trade confirmation but also the provisions of any related master agreement
and the applicable ISDA equity derivatives definitions in determining whether there
are circumstances under which the entity could be forced to net cash settle the
instrument. For example, the ISDA documentation may include early settlement
provisions that give the counterparty a right to net cash settle the instrument in
certain circumstances (see Section
5.2.2).