5.2 Settlement Methods
5.2.1 Overview
ASC 815-40
25-1 The guidance in this
Section applies for the purpose of determining whether
an instrument or embedded feature qualifies for the
second part of the scope exception in paragraph
815-10-15-74(a). The first part of the scope exception
in paragraph 815-10-15-74(a) is addressed in Section
815-40-15. The initial balance sheet classification of
contracts within the scope of this Subtopic generally is
based on the concept that:
- Contracts that require net cash settlement are assets or liabilities.
- Contracts that require settlement in shares are equity instruments.
ASC 815-40 — Glossary
Net Cash
Settlement
The party with a loss delivers to the
party with a gain a cash payment equal to the gain, and
no shares are exchanged.
Net Share Settlement
The party with a loss delivers to the party with a gain shares with a current
fair value equal to the gain.
Physical Settlement
The party designated in the contract as the buyer delivers the full stated amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer.
ASC 815-10
Example 5: Net
Settlement Under Contract Terms — Net Share
Settlement
55-90 This
Example illustrates the concept of net share settlement.
Entity A has a warrant to buy 100 shares of the common
stock of Entity X at $10 a share. Entity X is a
privately held entity. The warrant provides Entity X
with the choice of settling the contract physically
(gross 100 shares) or on a net share basis. The stock
price increases to $20 a share. Instead of Entity A
paying $1,000 cash and taking full physical delivery of
the 100 shares, the contract is net share settled and
Entity A receives 50 shares of stock without having to
pay any cash for them. (Net share settlement is
sometimes described as a cashless exercise.) The 50
shares are computed as the warrant’s $1,000 fair value
upon exercise divided by the $20 stock price per share
at that date.
For an equity-linked instrument to qualify for equity classification, an entity
must be required or permitted to share settle it. A share settlement can be
either physical or net in shares.
Example 5-1
Settlement Methods
Entity A writes a call option on its own stock that permits the holder to purchase 100 shares of A’s common stock at an exercise price of $10 per share. Entity A’s stock price rises to $15 per share. Entity B, the holder of the option, exercises the option. If the contract specifies physical settlement, then:
Entity B pays A $1,000 (100 shares at $10 per share).
Entity A issues to B 100 shares with a fair value of $1,500.
If the contract specifies net share settlement (cashless exercise), then:
Entity A issues 33.33 of its shares1 to B as follows: 100 shares – ($1,000 ÷ $15
per share) = ($1,500 – $1,000) ÷ $15 per share.
If the contract is net cash settled, then:
Entity A makes a cash payment of $500 to B ($1,500 – $1,000).
An equity-linked instrument that will be physically settled may qualify as
equity even if it involves the issuer’s delivery of cash and receipt of shares.
For example, a physically settled purchased call option on an entity’s own stock
is not disqualified from equity classification even though the entity would
deliver cash and receive shares upon exercise. Similarly, a physically settled
embedded written put option (e.g., in a puttable share) could qualify as equity
even though the entity could be forced to deliver cash and receives shares if
the counterparty were to exercise the put option.
Under ASC 480-10-S99-3A and other SEC guidance, SEC registrants are required to
classify certain redeemable equity securities outside of permanent equity (for a
comprehensive discussion of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). In the evaluation of whether an embedded feature
(e.g., a written put option embedded in the entity’s preferred stock) meets the
scope exception for own equity in ASC 815-10-15-74(a), temporary equity is
considered equity even though it is presented outside of permanent equity (ASC
815-10-15-76). For example, if an SEC registrant issues equity shares that
contain an embedded written put option that permits the holder to put the shares
back to the registrant in exchange for a cash payment, the registrant may be
required to classify the shares in temporary equity under ASC 480-10-S99-3A. In
evaluating whether the embedded put option permits the issuer to settle in
shares, the entity would consider the equity shares to be equity even though
they are presented outside of permanent equity. See further discussion of the
scope of ASC 815-10-15-76 in ASC 815-40 in Section
2.2.2.
5.2.2 Effect of Net Cash Settlement Provisions
ASC 815-40
25-7 Contracts that include any
provision that could require net cash settlement cannot
be accounted for as equity of the entity (that is, asset
or liability classification is required for those
contracts), except in those limited circumstances in
which holders of the underlying shares also would
receive cash (as discussed in the following two
paragraphs and paragraphs 815-40-55-2 through 55-6).
25-8 Generally, if an event
that is not within the entity’s control could require
net cash settlement, then the contract shall be
classified as an asset or a liability. However, if the
net cash settlement requirement can only be triggered in
circumstances in which the holders of the shares
underlying the contract also would receive cash, equity
classification is not precluded.
25-9 This Subtopic does not
allow for an evaluation of the likelihood that an event
would trigger cash settlement (whether net cash or
physical), except that if the payment of cash is only
required upon the final liquidation of the entity, then
that potential outcome need not be considered when
applying the guidance in this Subtopic.
Except in certain limited instances, if there are any
circumstances under which an entity could be required to net cash settle an
equity-linked instrument (e.g., upon an early termination event), equity
classification is prohibited. Such an instrument cannot be classified as equity
even if it is considered indexed to the entity’s stock under ASC 815-40-15. An
entity is precluded from considering probability when assessing whether it could
be required to net cash settle an equity-linked instrument. Equity
classification would be prohibited even if net cash settlement could be required
only upon the occurrence of a remote event. Conversely, an instrument might
qualify as equity even if the entity expects or intends to net cash settle the
instrument as long as it could not be forced to net cash settle.
5.2.2.1 Cash Settlement Outside the Entity’s Control
If cash settlement of an equity-linked instrument is
controlled by the holder, the instrument cannot be classified in equity (see
Section 5.2.4). In addition, if an
entity can be required to cash settle an equity-linked instrument upon the
occurrence or nonoccurrence of an event that is not solely within the
entity’s control, the instrument cannot (with limited exceptions; see
Section 5.2.3) be classified in
equity. The SEC’s Current Accounting and Disclosure Issues in the
Division of Corporation Finance (as updated
November 30, 2006) notes the following as one of the most common reasons
warrants must be classified as liabilities under ASC 815-40-25:
[T]he warrants could be required to be settled in cash
if certain events occurred, such as delisting from the registrant’s
primary stock exchange or in the event of a change of control. . . .
Even if delisting is not considered probable of ever occurring, the
warrants would still be classified as a liability under the [ASC
815-40-25] analysis. Similarly, the likelihood that a change in control
could occur is not a factor.
Equity-linked instruments (e.g., those executed under ISDA
standard documentation) often include early termination provisions that give
the counterparty a right to early settle the instrument in specified
circumstances. If those circumstances are outside the entity’s control and
could require the entity to net cash settle the instrument (e.g., because
the counterparty obtains the right to terminate the contract net in cash
under a “cancellation and payment” provision), the instrument cannot be
classified as equity. Examples of events that may be referred to in standard
documentation and would be considered outside the entity’s control
include:
-
The counterparty’s ability to establish or maintain a hedge position against the contract by using commercially reasonable means (hedge disruption event).
-
A material increase in the counterparty’s cost of hedging (increased cost of hedging).
-
The counterparty’s inability to borrow the shares underlying the contract (loss of stock borrow).
-
The counterparty’s cost to borrow the shares underlying the contract exceeds a specified rate.
In remarks at the 2007 AICPA Conference on
Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow
Ashley Carpenter said:
[ASC 815-40-25] is clear that
equity classification is precluded if an entity does not control the
ability to share settle the contract. The [SEC] staff understands that
the ISDA Agreements incorporated into many equity derivative contracts
contain provisions that may allow the counterparty to net-cash settle
the contract upon the occurrence of events outside the control of the
entity. To address this issue, the transaction Confirmation often
includes an overriding provision to allow the entity to share settle the
contract upon the occurrence of events outside its control. Absent this
provision, the contract may not meet the equity classification
requirements in [ASC 815-40-25].
If the early termination provision is outside the entity’s
control but does not require the entity to net cash settle the instrument
(e.g., because of an override provision), the feature must still be
evaluated under the indexation guidance and other equity classification
conditions in ASC 815-40.
Some equity-linked instruments contain provisions that could
require the issuer, upon the occurrence of events outside its control, to
make cash payments that do not represent a net cash settlement of the entire
instrument (e.g., a requirement to make a cash payment if the issuer fails
to file financial statements on time or if the counterparty sells the
underlying shares for less than their fair value on the settlement date).
These types of payments could preclude the classification of an
equity-linked instrument as equity even though the payments do not result in
the net cash settlement of the entire contract (see Sections 5.2.3.7 and 5.3.6).
5.2.2.2 Cash Settlement Provisions in the Shares Underlying the Contract
In evaluating the appropriate classification of an
equity-linked instrument, entities should consider any cash settlement
provisions in the shares underlying it. If such shares embody an obligation
to transfer cash or other assets and the entity could be forced to issue
those shares, ASC 480-10-25-8 precludes equity classification (see Chapter 5 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity). For
example, equity classification is inappropriate if the shares that would be
delivered upon settlement of a written call option or a forward sale on the
entity’s own equity embody an obligation to transfer cash or other assets
(e.g., certain redeemable preferred stock).
Some equity-linked instruments are not within the scope of
ASC 480 because they do not embody any obligation of the issuer (see
Section
2.2.1.3 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Nevertheless, ASC 815-40-25 may preclude equity
classification if the shares that would be delivered upon the contract’s
settlement embody an obligation to deliver cash or other assets. For
example, a purchased put option that permits an entity to require the
counterparty to purchase the entity’s shares would be outside the scope of
ASC 480. However, such a contract could not be classified in equity under
ASC 815-40-25 if the entity could be forced to immediately redeem the shares
that it would deliver upon exercise of the contract at the then-current fair
value of such shares. Although the entity has the ability to avoid a cash
settlement by electing not to exercise the put option, it cannot disregard
the cash settlement provision in the shares underlying the contract in its
accounting analysis under ASC 815-40-25. This is because that guidance
involves an assessment of whether an entity, assuming that a contract is
settled, could be forced to cash settle the contract. That is, ASC 815-40-25
does not permit an entity to assume that it will elect not to exercise a
contract. For the same reason, if an entity has purchased a net-cash-settled
option on its own stock, ASC 815-40-25 precludes equity classification even
though the entity could avoid a cash settlement by electing not to exercise
the option. Further, although an entity may adopt either a “warrant-level”
or a “look-through” view when applying the indexation requirements in ASC
815-40-15 (see Section
4.3.10), it cannot elect a “warrant-level” view when applying
the equity classification requirements in ASC 815-40-25.
5.2.3 Permissible Net Cash Settlement Provisions
As an exception to the requirement to classify equity-linked instruments that
the entity could be forced to net cash settle as assets or liabilities, a
contractual term that could require an instrument to be net cash settled is
permitted in the following circumstances:
-
The event that would cause net cash settlement is within the entity’s control (see Section 5.2.3.1).
-
The contract must be net cash settled only upon the final liquidation of the entity (see Section 5.2.3.2).
-
The contract must be net cash settled only if (1) all holders of the shares underlying the contract would also receive (or be entitled to receive) cash in exchange for their shares (see Section 5.2.3.3) or (2) the cash settlement is the result of a change of control (see Section 5.2.3.4) or nationalization or expropriation (see Section 5.2.3.5).
-
The contract is an own-share lending arrangement executed in conjunction with a convertible debt issuance, and the cash settlement provision has certain characteristics (see Section 5.2.3.6).
See Section 5.2.3.7
for further discussion of cash payment provisions that do not represent a cash
settlement of the entire instrument. Application of the equity conditions to
certain convertible instruments is discussed in Section 5.5.
5.2.3.1 Net Cash Settlement Within the Entity’s Control
If a net cash settlement can be triggered only by the occurrence or
nonoccurrence of an event that is solely within the entity’s control, that
net cash settlement provision does not preclude the instrument from being
classified as equity. If the event or circumstance that can trigger a net
cash settlement is not solely within the entity’s control, the instrument is
classified as an asset or a liability unless an exception applies (see
Sections 5.2.3.2
through 5.2.3.6).
The assessment of whether an event or circumstance is within the entity’s
control depends on the entity’s governance structure. Normally, decisions
made by management or the board of directors are considered to be within the
entity’s control. On the other hand, decisions made by shareholders are
considered to be outside the entity’s control (see, for example, ASC
815-40-25-19). At the 2009 AICPA Conference on Current SEC and PCAOB
Developments, then Professional Accounting Fellow Brian Fields made the
following remarks:
I’d like to turn now to the evaluation of contracts
on own stock and redeemable shares. A key question in accounting for
both types of instruments is whether the company can avoid settling
the instrument in cash or other assets even in contingent scenarios
that may be improbable. With a few defined exceptions, a share-based
derivative, such as a warrant or option on common stock, is
accounted for by its issuer as an asset or liability (rather than as
equity) if there is any circumstance in which the issuer could be
required to settle it in cash. . . .
In some cases determining whether a company can
avoid paying out cash in all possible circumstances can be a
difficult question, requiring a detailed analysis of both the
instrument’s terms and various debt versus equity accounting
requirements. One question that has come up several times recently
is-specifically who needs to have the power to decide how an
instrument is settled to conclude that the company is in control of
a settlement alternative? . . .
So who does need to have the power? In a typical corporate structure, the power to
control the form of settlement might be expected to reside with
the Board of Directors or executive management. However,
there are a variety of governance structures in practice. For a limited partnership, the governance
structure of the entity would often consist of the general
partner, and one would usually expect cash versus share
settlement decisions to reside with that partner in order for a
decision to be within the company’s control. In any case, in order
for a settlement option to be under company control, one would generally expect that control would
rest with the party or parties tasked with management or
governance by the owners of the entity. [Emphasis added]
The table below lists events and circumstances that may be considered within and outside the entity’s
control. Note, however, that the assessment of whether an event is within the entity’s control could differ
depending on the specific facts and circumstances (e.g., whether the counterparty controls the entity’s
decision to net cash settle through board representation or other rights or the issuer is firmly committed to undertaking an action that will cause the event to occur).
Solely Within the Issuer’s Control | Not Solely Within the Issuer’s Control |
|---|---|
|
|
Note that if the event that could cause a net cash settlement is within the
entity’s control, and the event occurs, the entity would need to reclassify
the equity-linked instrument as an asset or a liability until it is settled
(see Section 5.4).
If the instrument is subject to a netting provision (e.g.,
under standard ISDA terms), the entity should consider whether such a
provision could require the company to net settle the instrument against
contracts not classified as equity. If the netting provision could result in
the netting of the instrument against contracts not classified as equity
(e.g., receivables or payables) in circumstances outside the entity’s
control (e.g., the counterparty’s default), equity classification is
precluded. To avoid this outcome, the entity may seek to include terms in
the instrument that specify that the instrument cannot be netted or can only
be netted against other equity-classified instruments.
Connecting the Dots
Many standby equity purchase agreements (SEPAs) contain provisions
that may require the issuer to net cash settle a forward issuance of
shares upon the occurrence of events outside the issuer’s control
(e.g., bankruptcy or a change of control). As a result, SEPAs
generally do not meet the equity classification conditions in ASC
815-40-25. For more information about SEPAs, see Section
6.2.5.
5.2.3.2 Net Cash Settlement Upon Final Liquidation of the Entity
If net cash settlement of an equity-linked instrument is required only upon the
entity’s final liquidation, equity classification is not precluded (ASC
815-40-25-9). A deemed liquidation provision that requires net cash
settlement of the instrument upon the redemption of one or more classes of
equity securities but not all classes of equally or more subordinated equity
instruments (e.g., upon a change in control) does not qualify for this
exception.
5.2.3.3 Net Cash Settlement When Holders of Underlying Shares Receive Same Form of Consideration
Equity classification is not precluded when an entity can only be forced to net
cash settle an equity-linked instrument if all
holders of the shares underlying the instrument receive, or have a right to
receive, cash for their shares. Similarly, an equity-linked instrument that
permits the counterparty to settle the instrument into the kind and amount
of consideration to which it would have been entitled had the instrument
been converted into stock does not preclude the instrument from being
classified as equity. If all holders of the underlying shares are given a
choice of the form of consideration, for example, equity classification is
not precluded if the counterparty to the instrument is given the same
choice.
An equity-linked instrument could not be classified as equity if the form of
consideration in settling the instrument (e.g., cash, shares, property, or
other assets) would be different from the form of consideration paid to
holders of the underlying shares.
Example 5-2
All Holders of Underlying Shares Receive Same Form of
Consideration
Entity A has issued warrants on shares of its common stock. If A effects a
reorganization, the holders of the warrants have the
right to exercise the warrants immediately before
the reorganization and receive, in lieu of shares of
common stock, the capital stock, securities, or
other property to which all common stockholders are
entitled as owners of common shares. The terms of
the warrants define a reorganization as any
reclassification, capital reorganization,
conversion, or change to A’s common stock (other
than cash dividends or distributions or a
subdivision or combination), any consolidation or
merger involving A, or any sale of all or
substantially all of A’s assets. The only
circumstance that would result in settlement of the
warrants through the issuance of consideration other
than shares of A’s common stock is a reorganization.
Entity A controls the actions or events that could
result in delivery of consideration other than
common stock for each event that constitutes a
reorganization, with the exception of a
consolidation, which could include a change of
control that is outside A’s control. Upon the
occurrence of a consolidation, the holders of the
warrants are not entitled to receive cash or any
other form of consideration (including a choice
among forms of consideration) that differs from the
form of consideration that each holder of common
stock is entitled to receive because, as stated
above, the holders of the warrants merely have
exercised those warrants before the consolidation
and are able to “stand in line” with all other
holders of common shares. Therefore, this settlement
provision would not preclude equity classification
for the warrant.
Consider a warrant that specifies that the counterparty will receive the same
form of consideration (in cash or shares) as the holders of the underlying
shares if the value of the consideration exceeds the warrant exercise price.
If the value of the consideration is less than the warrant exercise price,
the counterparty will receive a cash payment equal to the fair value (i.e.,
time value) of the warrant. Such a provision does not qualify for the
exception in ASC 815-40-25-8 because the warrant holder may receive
consideration that is different from that received by shareholders.
5.2.3.4 Change of Control Clauses
ASC 815-40
55-2 An event that causes a change in control of an entity is not within the entity’s control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.
55-3 However, if a
change-in-control provision requires that the
counterparty receive, or permits the counterparty to
deliver upon settlement, the same form of
consideration (for example, cash, debt, or other
assets) as holders of the shares underlying the
contract, permanent equity classification would not
be precluded as a result of the change-in-control
provision. In that circumstance, if the holders of
the shares underlying the contract were to receive
cash in the transaction causing the change in
control, the counterparty to the contract could also
receive cash based on the value of its position
under the contract.
55-4 If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt).
55-5 Similarly, a change-in-control provision could specify that if all stockholders receive stock of an acquiring entity upon a change in control, the contract will be indexed to the shares of the purchaser (or issuer in a business combination accounted for as a pooling of interests) specified in the business combination agreement, without affecting classification of the contract.
An entity must further analyze an equity-linked instrument
that requires net cash settlement upon a change in control to determine
whether that net cash settlement requirement precludes equity
classification. If the change-in-control provision specifies that the
counterparty will receive the same form of consideration as holders of the
underlying shares, equity classification is not precluded. On the basis of
informal discussions with the SEC staff, this exception applies only if the
event that gives rise to cash settlement is a change of control. In this
scenario, a change of control is considered a transaction in which the
acquirer of the entity’s shares would obtain control of the entity.
Before the SEC staff’s issuance on April 12, 2021, of
Staff Statement on Accounting and Reporting
Considerations for Warrants Issued by Special Purpose Acquisition
Companies (“SPACS”) (the “SEC staff statement”),
it was our understanding that holders of equity-linked instruments could be
entitled to receive cash (i.e., to be net cash settled) only if all holders of the shares underlying the instrument
would also receive or be entitled to receive cash for their shares (see
Section 5.2.3.3). Under this
interpretation, ASC 815-40-55-2 through 55-5 did not provide an exception to
the general principle in ASC 815-40 that if net cash settlement could be
required for an event that is not within the entity’s control, an
equity-linked financial instrument should be classified as an asset or
liability unless all holders of the shares
underlying the instrument would also receive cash. However, in the SEC staff
statement, the OCA staff clarified that it believes that ASC 815-40-55-2
through 55-5 contain an exception to this principle that would apply only in
change-of-control situations. That is, if there is a change of control, it
is unnecessary for all holders of the shares underlying the instrument to
receive cash. This exception would not apply in situations such as the
following:
- An entity has a dual-class common stock structure, and the acquisition by a third party of any number of shares of one class would not result in a change of control because the holder of the other class of common shares would continue to control the entity.
- An entity has a dual-class common stock structure and, as a result of the acquisition by a third party of shares of one class, the holders of equity-linked instruments of the other class would be entitled to receive cash even though holders of the outstanding shares of that class are not entitled to receive cash.
- An equity-linked instrument on a class of preferred stock is redeemable if a third party acquires more than 50 percent of the entity’s preferred stock but the common stock controls the entity.
Note that the exception would never apply to a class of shares that is not
the most residual class of the entity’s equity.
Connecting the Dots
The term “change of control” is not defined in ASC 815-40 or the ASC
master glossary. On the basis of informal discussions with the SEC
staff, we understand that it is reasonable to interpret the term to
represent a transaction in which more than 50 percent of the voting
power of an entity is obtained by an acquirer (or acquirer group).
In practice, some contracts use the phrase “50 percent or more” as
opposed to “more than 50 percent” to define what constitutes a
change of control of the entity. When the contractual terms of an
equity-linked instrument include the phrase “50 percent or more” to
define a change of control, it is generally acceptable to apply the
change of control exception discussed above on the basis that (1)
the previous shareholder group has lost control of the entity and
(2) the distinction between the two phrases is minimal (e.g., a 0.1
percent difference in ownership is not substantive enough to affect
the classification of the contract). However, an entity should
consider consulting with its accounting and legal advisers in
determining whether the change of control exception discussed above
may be applied to an equity-linked instrument.
5.2.3.5 Nationalization (Expropriation) Clauses
ASC 815-40
55-6 In the event of nationalization, cash compensation would be the consideration for the expropriated assets and, as a result, a counterparty to the contract could receive only cash, as is the case for a holder of the stock underlying the contract. Because the contract counterparty would receive the same form of consideration as a stockholder, a contract provision requiring net cash settlement in the event of nationalization does not preclude equity classification of the contract.
An equity-linked instrument that requires net cash settlement if the entity is
nationalized does not preclude equity classification. This is because the
counterparty would be legally entitled to receive cash compensation for the
expropriated contract in a manner similar to a holder of the underlying
stock.
5.2.3.6 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
The terms of some share-lending arrangements executed in conjunction with a
convertible debt issuance (see Section 2.9) may allow the borrower
(e.g., the bank) to cash settle all or a portion of an arrangement if, after
making its reasonable best effort, the borrower is unable to obtain a
sufficient number of the entity’s common shares to settle the entire
arrangement through physical delivery or is otherwise prohibited from
settling via physical delivery in accordance with a law, rule, or regulation
of a government authority. ASC 470-20-50-2A requires entities to disclose
circumstances in which cash settlement would be required. Except for certain
limited instances, equity classification is precluded under ASC 815-40-25 if
there are any circumstances in which the issuer could be required to net
cash settle an equity-linked instrument. Because ASC 470-20-50-2A specifies
disclosure requirements for cash settlement provisions related to
equity-classified share-lending arrangements (see Section 6.1.6), a situation in which a
share-lending arrangement could have a cash settlement requirement and still
be classified in equity appears to be specifically contemplated in ASC
470-20, regardless of the requirements of ASC 815-40-25. However, to be
classified in equity by the issuing entity, the share-lending arrangement
should meet all of the other conditions for equity classification in ASC
815-40.
Therefore, a share-lending arrangement executed in conjunction with a
convertible debt issuance is not precluded from classification in equity if
it allows the counterparty to cash settle the arrangement upon the
occurrence of certain events, but it must make its reasonable best effort to
effect a physical settlement, and the situations in which cash settlement
may be permitted must be limited, outside the control of the counterparty
(e.g., delisting of the entity’s shares), and highly unlikely to occur. In
addition, the best-effort requirement must be substantive, and there should
be an expectation at the inception of the arrangement that the counterparty
would physically settle the arrangement. A share-lending arrangement would
not be classified in equity if it unilaterally allowed the counterparty to
cash settle the arrangement at its option or without having made a
reasonable effort to obtain shares to physically settle the arrangement.
5.2.3.7 Cash Payments Other Than Net Cash Settlements
As noted in Section
5.2.2, some equity-linked instruments contain provisions that
could require the issuer, upon the occurrence of events outside its control,
to make cash payments that do not represent a net cash settlement of the
entire instrument. Except for the following types of provisions, equity
classification is precluded if an equity-linked instrument could require the
entity to make any cash payments:
-
Penalty payments if the entity fails to file on a timely basis — Under ASC 815-40-25-10(d), an equity-linked instrument can qualify as equity even if it requires the entity to make penalty payments for failing to file financial statements with the SEC on time. Paragraph BC79 of ASU 2020-06 notes that such a provision is permissible “because [it does] not result in settlement of a contract.” However, an equity-linked instrument could not be classified as equity if it must be net cash settled because the entity fails to file on a timely basis (see Section 5.3.5) or requires the entity to make other types of cash payments. As noted in paragraph BC84 of ASU 2020-06, an instrument that requires a cash payment to be made upon settlement (e.g., cash-settled top-off, make-whole provisions, or compensation for the difference in value between registered and unregistered shares) does not qualify as equity irrespective of whether such a payment represents a net cash settlement of the instrument. Therefore, to apply this exception, an entity must conclude that the cash payment is (1) akin to a penalty payment as opposed to a partial settlement of the contract and (2) not made in conjunction with the settlement of the contract (i.e., the equity-linked instrument must continue to exist after the payment is made). See discussion in Section 5.2.3.7.1 of buy-in and share delivery payments.
-
Normal contractual remedies for the entity’s contract breach — An equity-linked instrument may qualify as equity even if it (1) includes an indemnification clause that holds each party harmless against damages, losses, or claims resulting from the breach of contract or gross negligence and (2) requires any such obligations to be paid in cash. This is because such payments are considered to be the result of an action that was within the entity’s control.
-
Cash payment provisions within the scope of the guidance on registration payment arrangements — Sometimes an equity-linked instrument requires the entity to pay cash penalties if it is unable to register the shares underlying the instrument or is unable to maintain an effective registration statement. In such a case, the entity should consider whether that penalty provision meets the definition in ASC 825-20 of a registration payment arrangement. Under ASC 825-20-25-1, a registration payment arrangement that has the characteristics described in ASC 825-20-15-3 is recognized as a unit of account that is separate from the instrument subject to the agreement. In accordance with ASC 825-20-25-2, an equity-linked instrument that is subject to a registration payment arrangement within the scope of ASC 825-20 is evaluated under ASC 815-40 without regard to the contingent obligation to transfer consideration under the registration payment agreement. See Section 3.2.4.
-
Minimal or nonsubstantive payment provisions associated with the issuance or delivery of the entity’s equity shares — Equity classification of an equity-linked instrument that otherwise qualifies for classification within equity is not precluded if the entity is obligated to pay stamp duties, transfer taxes, or other governmental charges that might be imposed with respect to the issuance of the entity’s equity shares upon the instrument’s settlement if (1) the entity’s obligation is limited to costs (if any) that would be unavoidable upon the entity’s issuance of equity shares; (2) the entity would be legally liable to pay such costs if the counterparty does not pay them; (3) the obligation does not encompass expenses related to any applicable capital gains taxes, withholding taxes, or any other expenses, taxes, or charges that depend on holder-specific factors; and (4) the entity expects to incur no or only minimal costs associated with meeting its obligation. However, a requirement to reimburse the holder for any applicable capital gains, withholding taxes, or other holder-specific taxes associated with an equity-linked instrument precludes equity classification irrespective of the likelihood and expected amount of such payments (see also Section 4.3.5.13).
-
Fractional shares — An equity-linked instrument that requires fractional shares (i.e., a quantity of shares that is less than one full share) to be settled in cash is not precluded from equity classification if it does not otherwise require or permit cash settlement.
Example 5-3
Contract With Fractional Shares Settled in Cash
Company A has written a call option to Company B. The option permits Company B
to purchase 100,000 shares of A’s common stock at an
exercise price of $120 per share. The contract
specifies net share settlement except that any
fractional share will be settled in cash. Company B
exercises the option when A’s stock price is $140.
Accordingly, the fair value of the settlement amount
is $2 million, or 100,000 shares × ($140 – $120),
which is equivalent to 14,285.714 shares ($2 million
÷ $140). Because the contract specifies net share
settlement with cash settlement of any fractional
share, A delivers 14,285 whole shares as well as
$100 of cash (0.714 share × $140). This contract
could qualify as equity under ASC 815-40 even though
it includes a requirement to cash settle any
fractional share.
5.2.3.7.1 Buy-In and Share Delivery Failure Payments
As discussed in Section 4.3.7.11, some
equity-linked financial instruments contain “buy-in” provisions that
require the issuing entity to make a stated cash payment for each day on
which 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.
If triggered, buy-in and share delivery payments are
made in conjunction with settlement of the related equity-linked
instrument.2 As a result, they do not meet the exception for penalty payments
(see Section
5.3.5). However, the issuer of the equity-linked
instrument often controls the ability to avoid the actions for which
such payments would be required (i.e., the issuer generally controls the
ability to deliver shares in a timely manner upon the settlement of an
equity-linked instrument).
Connecting the Dots
Many issuers of equity-linked instruments use
the services of a transfer agent to deliver shares to the
counterparty. In some cases, the buy-in and share delivery
payments are required only if the issuer fails to instruct the
transfer agent to transfer the shares on a timely basis. In
these situations, the issuer controls the ability to avoid
making such payments (i.e., to avoid defaulting) as long as it
has sufficient authorized and unissued shares to settle the
contract, which is an existing condition for equity
classification. In other contracts, the issuer is obligated to
make the payments if the transfer agent fails to deliver the
shares in a timely manner upon instruction of the issuer.
However, there are controls in place to ensure that the transfer
agent performs as instructed. Furthermore, the transfer agent is
acting as an extension of the issuer in the delivery of shares
in accordance with a contract that establishes an agency
relationship between the issuer and the transfer agent. In fact,
the use of transfer agents by publicly traded entities is often
necessary. Therefore, provided that the established timely
delivery period is reasonable, it is acceptable to conclude that
even though the transfer agent is a third party, it is
performing at the direction, and as an extension of, the issuer.
The issuer would thus still be considered to control the ability
to avoid making these payments. As a result, such payment
provisions would not affect the classification of the
equity-linked instrument. This conclusion is specific to
transfer agents and should not be applied to other scenarios by
analogy.
5.2.4 Settlement Alternatives: General Requirements
ASC 815-40
25-2 Further, an entity shall observe both of the following:
- If the contract provides the counterparty with a choice of net cash settlement or settlement in shares, this Subtopic assumes net cash settlement.
- If the contract provides the entity with a choice of net cash settlement or settlement in shares, this Subtopic assumes settlement in shares.
25-4 Accordingly, unless the
economic substance indicates otherwise:
- Contracts shall be initially
classified as either assets or liabilities in both
of the following situations:
- Contracts that require net cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the control of the entity)
- Contracts that give the counterparty a choice of net cash settlement or settlement in shares (physical settlement or net share settlement).
- Contracts shall be initially
classified as equity in both of the following
situations:
- Contracts that require physical settlement or net share settlement
- Contracts that give the entity a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement), assuming that all the criteria set forth in paragraphs 815-40-25-7 through 25-30 and 815-40-55-2 through 55-6 have been met.
35-2 Contracts that are initially classified as equity under Section 815-40-25 shall be accounted for in permanent equity as long as those contracts continue to be classified as equity. . . . Both of the following shall be reported in permanent equity:
- Contracts that require that the entity deliver shares as part of a physical settlement or a net share settlement
- Contracts that give the entity a choice of either of the following:
- Net cash settlement or settlement in shares (including net share settlement and physical settlement that requires that the entity deliver shares)
- Either net share settlement or physical settlement that requires that the entity deliver cash.
35-5 Net share settlement should be assumed for contracts that are classified under Section 815-40-25 as equity instruments that provide the entity with a choice of either of the following:
- Net share settlement
- Physical settlement that may require that the entity deliver cash.
35-6 Physical settlement should be assumed for contracts that are classified under Section 815-40-25 as equity instruments that provide the counterparty with a choice of either of the following:
- Net share settlement
- Physical settlement that may require that the entity deliver cash.
The table below describes various settlement alternatives that may be specified
in an equity-linked instrument and the instrument’s resulting classification
provided that (1) any settlement alternatives have the same economic value (see
Section 5.2.5), (2) the
gain and loss positions for the settlement alternatives do not differ (see Section 5.2.6), and (3) the
instrument is not otherwise precluded from equity classification (e.g., under
the indexation guidance in ASC 815-40-15 or the additional equity classification
conditions in ASC 815-40-25; see Chapter 4 and Section
5.3).
Classification | |
|---|---|
|
Equity Provided All Other Conditions for
Equity Classification Are Met
|
Asset or Liability
|
|
|
If an entity intends or expects to net cash settle an equity-linked instrument
but cannot be forced to do so, the instrument is not precluded from being
classified in equity. What matters is not whether the entity expects or intends
to settle in shares but whether it has the legal right to settle in shares (and
controls the ability to settle in shares). If the entity elects to settle net in
cash, however, the entity should consider whether the instrument needs to be
reclassified as an asset or a liability until it is settled (e.g., if the
election is binding and cannot be revoked).
5.2.4.1 Application to Convertible Securities With “Greater-of” Redemption Features
Some convertible securities give the investor a share-settled equity conversion option and a cash-settled redemption option in which the redemption amount is the greater of the fair value of the underlying shares or the face amount of the securities. In such a scenario, the “greater-of” redemption option effectively gives the security’s holder the ability to net cash settle the embedded conversion option. Accordingly, the conversion option does not qualify as equity under ASC 815-40. ASC 815-15 addresses whether an entity is required to bifurcate the option as an embedded derivative (see Section 2.2).
5.2.4.2 Application to Certain Freestanding Equity-Linked Instruments
ASC 815-40-55-13 contains a table that illustrates the effect of different
settlement methods and alternatives on the classification of a freestanding
equity-linked instrument under which the entity sells its shares (including
forward sale contracts, written call options or warrants, and purchased put
options on the entity’s own equity). The table also applies to purchased
call options on the entity’s own equity.
ASC 815-40
Forward Sale Contracts, Written Call Options or Warrants, and Purchased Put Options
55-13 The issuing entity (the seller) agrees to sell shares of its stock to the buyer of the contract at a specified price at some future date. The contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing entity or counterparty may have a choice of settlement methods. The guidance in this Subtopic would be applied as follows.
Note: In all cases above, the contracts must be reassessed at each reporting period to determine whether the contract
must be reclassified.
Purchased Call Options
55-14 The entity (the buyer) purchases call options that provide it with the right, but not the obligation, to buy from the seller, shares of the entity’s stock at a specified price. If the options are exercised, the contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing entity or the counterparty may have a choice of settlement methods. The entity should follow the preceding table in accounting for purchased call options.
5.2.4.3 Application to Certain Embedded Features
In the evaluation of whether the scope exception for own equity is met,
temporary equity is considered equity (ASC 815-10-15-76). For example, if an
SEC registrant issues equity shares that contain an embedded written put
option that permits the holder to put the shares back to the registrant in
exchange for a cash payment, the registrant may be required to classify the
shares in temporary equity under ASC 480-10-S99-3A (for a comprehensive
discussion of the application of this guidance, see Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity). In
evaluating whether the embedded put option qualifies for the scope exception
in ASC 815-10-15-74(a) under the equity classification guidance in ASC
815-40 (e.g., in assessing whether the instrument permits the issuer to
settle in shares), the entity would consider the equity shares to be equity
even though they are presented outside of permanent equity. The guidance on
treating temporary equity as equity under ASC 815-40 does not apply to
freestanding equity-linked instruments.
5.2.5 Settlement Alternatives With Different Economic Value
ASC 815-40
25-3 Except as noted in the
last sentence of this paragraph, the approach discussed
in paragraphs 815-40-25-1 through 25-2 does not apply if
settlement alternatives do not have the same economic
value attached to them or if one of the settlement
alternatives is fixed or contains caps or floors. In
those situations, the accounting for the instrument (or
combination of instruments) shall be based on the
economic substance of the transaction. For example, if a
freestanding contract, issued together with another
instrument, requires that the entity provide to the
holder a fixed or guaranteed return such that the
instruments are, in substance, debt, the entity shall
account for both instruments as liabilities, regardless
of the settlement terms of the freestanding contract.
However, the approach discussed in paragraphs
815-40-25-1 through 25-2 does apply to contracts that
have settlement alternatives with different economic
values if the reason for the difference is a limit on
the number of shares that must be delivered by the
entity pursuant to a net share settlement
alternative.
25-18 If a settlement
alternative includes a penalty that would be avoided by
an entity under other settlement alternatives, the
uneconomic settlement alternative shall be disregarded
in classifying the contract.
Some equity-linked instruments contain settlement alternatives (e.g., net share
or net cash) that could have different economic values (i.e., the net monetary
amount of consideration receivable or payable differs depending on which
settlement alternative applies). For example, one settlement alternative might
have an economic value that is different from other settlement alternatives
because:
-
It is for a fixed dollar amount.
-
It specifies a cap or a floor (e.g., the entity has a right to either net cash or net share settle an instrument, but the number of shares that would be delivered in a net share settlement is subject to a cap).
-
It contains a penalty that would not be incurred under other settlement alternatives (e.g., the entity has a right to either net cash or net share settle an instrument, but the fair value of the net cash settlement alternative is at a discount to the net share settlement alternative).
In such cases, the entity should consider the instrument’s substance in
determining its classification. The entity should ignore any share settlement
alternative that would always be uneconomic. If one of the settlement
alternatives is associated with a penalty that the entity could avoid by
electing a different settlement alternative, the entity would disregard the
alternative with the penalty in determining the appropriate classification.
However, if one of the settlement alternatives involves delivery of unregistered
shares, a reasonable discount from the value of registered shares is permitted
if it is determined by using commercially reasonable means and reflects the
difference in fair value between registered and unregistered shares.
Under some equity-linked instruments, the number of shares to be delivered to
the counterparty if the contract is settled in unregistered shares must be in
excess of the amount of cash or the number of registered shares that would
otherwise be delivered; however, a make-whole provision is included in the
instrument to ensure that the counterparty receives proceeds upon the ultimate
disposition of the shares equal to the amount that would be delivered under a
net cash or registered share settlement. This settlement alternative should not
be viewed as including a penalty as long as the make-whole provision is
symmetrical. In other words, any excess value received by the counterparty must
be returned to the entity. The additional shares delivered at settlement are
meant to provide a cushion to reduce the likelihood that the entity will have to
deliver additional shares after the counterparty sells the shares it received
upon settlement.
5.2.5.1 Certain Put Warrants
ASC 815-40
55-15 An entity issues senior
subordinated notes with a detachable warrant that
gives the holder both the right to purchase 6,250
shares of the entity’s stock for $75 per share and
the right (that is, a put) to require that the
entity repurchase all or any portion of the warrant
for at least $2,010 per share at a date several
months after the maturity of the notes in about 7
years. The proceeds should be allocated between the
debt liability and the warrant based on their
relative fair values, and the resulting discount
should be amortized in accordance with Subtopic
835-30. The warrants should be considered, in
substance, debt and accounted for as a liability
because the settlement alternatives for the warrants
do not have the same economic value attached to them
and they provide the holder with a guaranteed return
in cash that is significantly in excess of the value
of the share-settlement alternative on the issuance
date.
If a warrant was issued to give the counterparty a fixed or guaranteed return so
that the instrument is in-substance debt, the instrument would be classified
as a liability. ASC 815-40-55-15 describes a warrant that contains a right
for the counterparty to either exercise the warrant at a price of $75 per
share or put the warrant to the entity for cash of at least $2,010 per
share. The guidance suggests that this warrant would be classified as a
liability because the settlement alternatives have different economic values
and give the holder a guaranteed return that is significantly in excess of
the fair value of the share settlement alternative as of the issuance date.
Note, however, that the detachable stock purchase warrant in this example
represents a put warrant. Even if the detachable stock purchase warrant in
ASC 815-40-55-15 gave the counterparty a right to put the warrant at an
amount of cash that was not significantly in excess of the share settlement
alternative, this type of warrant would be classified as a liability as
illustrated in ASC 480-10-55-31 (see Section 5.2.4 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity). The wording of ASC
815-40-55-15 was developed before the issuance of the requirements that were
later incorporated into ASC 480, under which all redeemable warrants on the
entity’s own equity are liabilities.
5.2.6 Settlement Alternatives That Differ in Gain and Loss Positions
ASC 815-40
25-36 This guidance addresses two circumstances in which settlement alternatives differ in gain and loss positions:
- Net cash payment required in loss position
- Net-stock alternative in loss position.
Net Cash Payment Required in Loss Position
25-37 A contract indexed to, and potentially settled in, an entity’s own stock, with multiple settlement alternatives that require the entity to pay net cash when the contract is in a loss position but receive (a) net stock or (b) either net cash or net stock at the entity’s option when the contract is in a gain position shall be accounted for as an asset or a liability.
Net-Stock Alternative in Loss Position
25-38 A contract indexed to, and potentially settled in, an entity’s own stock, within the scope of this Subtopic and with multiple settlement alternatives that require the entity to receive net cash when the contract is in a gain position but pay (a) net stock or (b) either net cash or net stock at the entity’s option when the contract is in a loss position shall be accounted for as an equity instrument. This guidance does not apply to a contract that is predominantly a purchased option in which the amount of cash that could be received when the contract is in a gain position is significantly larger than the amount that could be paid when the contract is in a loss position because, for example, there is a small contractual limit on the amount of the loss. Those contracts shall be accounted for as assets or liabilities.
Some equity-linked instruments allow different settlement methods depending on
whether the instrument is in a gain or a loss position from the entity’s
perspective. For example, a forward sale contract may require or permit net
share settlement if the contract is in a loss position (i.e., the entity would
deliver a net number of shares equal in value to the settlement amount if the
contract is unfavorable) but require net cash settlement if the contract is in a
gain position (i.e., the entity would receive cash from the counterparty equal
to the settlement amount if the contract is favorable). If the instrument
permits the entity to net share settle when the instrument is in a loss
position, a net cash settlement requirement that applies when the instrument is
in a gain position would not preclude the instrument from being classified as
equity.
This guidance cannot be used to justify equity classification for purchased
option contracts that require or permit the counterparty to settle the contract
net in cash even though the contract would never require the entity to deliver
cash. The guidance also does not apply to an equity-linked instrument that is
predominantly a purchased option (e.g., because there is a small contractual
limit on the amount of loss). Such an instrument would be classified as an asset
or a liability even if the entity has the right to net share settle the
instrument in a loss position.
5.2.7 Settlement in Shares Issued by Another Entity Within a Consolidated Group
Some equity-linked instruments require or permit settlement in a variable number
of equity shares issued by another entity within a consolidated group (e.g., a
contract issued by a parent that the holder is permitted to settle either in a
fixed number of equity shares issued by the parent or a variable number of
equity shares issued by its subsidiary that have an aggregate fair value at
settlement equal to that of a fixed number of parent shares). If (1) the equity
indexation and classification conditions in ASC 815-40 are met and (2) the
instrument is not required to be classified as an asset or a liability under ASC
480 (see Deloitte’s Roadmap Distinguishing Liabilities From Equity), such an
instrument is not precluded from being classified in equity in consolidated
financial statements that include both entities since the shares that will be
delivered qualify as equity in the consolidated financial statements. However,
such an instrument would not qualify as equity in financial statements that do
not include consolidated information of both entities since the instrument would
be indexed to, or involve delivery of shares that do not qualify as, equity in
the reporting entity’s financial statements. See Section 2.6 for further discussion about
the analysis under ASC 815-40 of instruments indexed to, or settled in, the
shares of an affiliated entity.
Footnotes
1
Even if Entity A were to be
required to pay an equivalent amount of cash
instead of delivering 0.33 fractional shares, the
contract would still be considered net share
settled. The payment (receipt) of cash for
fractional shares does not affect the
classification of an equity-linked contract under
ASC 815-40-25.
2
It is uncommon that (1) the issuer has the unconditional right to
reinstate the equity-linked instrument or (2) the instrument is
automatically reinstated when such payments are made.