Chapter 5 — Classification Guidance
Chapter 5 — Classification Guidance
5.1 Overview
For an equity-linked instrument within the scope of ASC 815-40 (see Chapter 2) to qualify for equity
classification under ASC 815-40, it is not sufficient that it is considered indexed
to the entity’s stock under ASC 815-40-15 (as discussed in Chapter 4). In addition, the instrument must
require or permit the issuing entity to share settle the instrument (either
physically or net in shares). 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. If such circumstances
exist, then equity classification is generally prohibited. 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).
5.2 Settlement Methods
5.2.1 Overview
ASC 815-40
25-1 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.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
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.
One of the conditions for equity classification is that the entity is required
or permitted to share settle the equity-linked instrument. A share settlement
can either be physical or net in shares. In a physical settlement, the parties
exchange the full stated amount of cash specified by the instrument’s strike
price or forward price and the full stated number of shares specified in the
instrument. In a net share settlement, the party in a loss position delivers a
variable number of equity shares equal in value to the settlement amount to the
party in a gain position.
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 the application 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.
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 own 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, 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 fixed cash payment if the issuer
fails to file financial statements on time; see Section 5.3.5). With limited
exceptions (see Section
5.2.3.7), equity classification is precluded if an
equity-linked instrument could require the entity to make any cash payment
even if the payment is not the equivalent of a net cash settlement of the
entire instrument. By analogy, the ASC 815-40-25 guidance on top-off or
make-whole payments precludes equity classification in certain circumstances
in which the issuer is required to make only partial settlement payments
(see Section
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 precludes 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 redeem the shares that it
would deliver upon exercise of the contract. 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 holders of the shares underlying the contract would also receive cash in exchange for their shares (see Section 5.2.3.3) and the cash settlement is the result of either (1) a change of control (see Section 5.2.3.4) or (2) 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).
If the event is not solely within the entity’s control but the entity cannot
be forced to net cash settle the instrument (e.g., the feature requires the
instrument to be net share settled at an adjusted settlement amount), the
entity should evaluate the provision under the indexation guidance in ASC
815-40 (see Chapter
4).
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, 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
(whether or not the entity has adopted ASU 2020-06). 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). However, for entities that have not adopted ASU 2020-06, the
instrument cannot give the counterparty a higher claim in bankruptcy than
that of holders of the instrument’s underlying shares (see Section 5.3.7). Further,
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 if an entity can be forced to net cash
settle an equity-linked instrument only in circumstances in which all
holders of the shares underlying the instrument receive, or have a right to
receive, cash for their shares. For example, instruments that the entity can
be forced to net cash settle upon a change in control or other deemed
liquidation event might qualify as equity if all holders of the underlying
shares are paid 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 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
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 the holders are entitled as
owners of common shares underlying the warrants. 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.
ASC 815-40-55-2 through 55-5 illustrate that 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. 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 and generally outside the control of the
counterparty (e.g., delisting of the entity’s shares). 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 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) as amended by ASU 2020-06, 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 4.3.5.12).
-
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. Note that this conclusion is specific
to transfer agents and should not be applied to other scenarios
by analogy.
See Section 4.3.7.11 for discussion of the
application of the indexation guidance to buy-in and share delivery
failure payment provisions.
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 25-35 and 815-40-55-2 through 55-6 have been met.
Pending Content (Transition Guidance: ASC
815-40-65-1)
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
Before the adoption of ASU 2020-06, ASC 815-40-55-11 includes a table that
illustrates the application of the classification guidance in ASC 815-40-25
to embedded written put options (i.e., embedded features that give the
counterparty a right, but not an obligation, to put [sell] the entity’s
shares to the entity) and to embedded forward purchase contracts (i.e.,
embedded features that require the entity to purchase its shares). This
guidance is relevant in the evaluation of whether a redemption (put) option
or a mandatory redemption requirement embedded in an equity security issued
by the entity (such as redeemable preferred stock) is required to be
bifurcated as an embedded derivative under ASC 815-15 or is exempted from
such accounting under the scope exception for certain contracts on the
entity’s own equity in ASC 815-10-15-74(a).
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 table in ASC 815-40-55-11 does not apply to freestanding written put options
or freestanding forward purchase contracts that must be accounted for as
liabilities under ASC 480 (see Section
2.3 of this Roadmap and Deloitte’s Roadmap Distinguishing Liabilities
From Equity).
While the table contains information about the initial and subsequent
measurement of an embedded feature, an entity should not rely on these
aspects of the table in determining the appropriate accounting for the
feature. ASC 815-40 does not apply to the measurement of an embedded feature
and does not address whether such a feature should be separated from its
host contract. Instead, the entity should refer to other guidance, in
particular the guidance in ASC 815-15 on separating embedded
derivatives.
ASU 2020-06 removes the table in ASC 815-40-55-11 and
related guidance. Paragraph BC106 in ASU 2020-06 states, in part:
[T]he Board concluded that the information in the table
is not relevant for embedded features. . . . Subtopic 815-40 does not
apply to hybrid contracts or embedded features except when an entity is
analyzing whether an embedded feature must be bifurcated as an embedded
derivative under paragraph 815-15-25-1(c). Therefore, Subtopic 815-40
does not provide classification or measurement guidance for hybrid
contracts or embedded features. Because of this, stakeholders noted that
the information in the table could be misleading.
ASC 815-40
Embedded Written Put Options and Forward Purchase Contracts
55-8 Paragraph 815-40-15-3(e)
explains that financial instruments that are within
the scope of Topic 480 are not subject to any of the
provisions of this Subtopic. See paragraph
480-10-55-63 for a table for freestanding written
put options and forward purchase contracts that are
accounted for under Topic 480. The guidance that
follows applies to embedded derivatives analyzed
under paragraph 815-15-25-1(c).
Pending Content (Transition Guidance: ASC
815-40-65-1)
55-8 Paragraph superseded by Accounting
Standards Update No. 2020-06.
55-9 The entity (the buyer) agrees to buy from the seller shares 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 the counterparty may have a choice of settlement methods. Application of this Subtopic to purchased call options is discussed in paragraph 815-40-55-14.
Pending Content (Transition Guidance: ASC
815-40-65-1)
55-9 Paragraph superseded by Accounting
Standards Update No. 2020-06.
55-10 The guidance in the following table includes shareholder rights (sometimes referred to as SHARP rights) issued by the entity to shareholders that give the shareholders the right to put a specified number of common shares to the entity for cash.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
55-10
Paragraph superseded by Accounting Standards
Update No. 2020-06.
55-11 The guidance in this Subtopic would be applied as follows.
Note: In all cases above, the contracts must be reassessed at each reporting period in order to determine whether or not the contract must be reclassified.
Pending Content (Transition Guidance: ASC
815-40-65-1)
55-11 Paragraph superseded by Accounting
Standards Update No. 2020-06.
55-12 See paragraph 480-10-55-63 for a table for freestanding written put options and forward purchase contracts that are accounted for under Topic 480. This table applies to embedded derivatives analyzed under paragraph 815-15-25-1(c).
Pending Content (Transition Guidance: ASC
815-40-65-1)
55-12 Paragraph superseded by Accounting
Standards Update No. 2020-06.
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 [ASC 815-40-25-1 and 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, this Subtopic 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.
Pending Content (Transition Guidance: ASC
815-40-65-1)
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. In the case of delivery of
unregistered shares, a discount from the fair value of
the corresponding registered shares that is a reasonable
estimate of the difference in fair values between
registered and unregistered shares (that is, the
discount reflects the fair value of the restricted
shares determined using commercially reasonable means)
is not considered a penalty.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
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.
Special considerations apply in the determination of the appropriate
classification for an equity-linked instrument that contains 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 (see Section 5.3.2.5).
In accordance with some equity-linked instruments, the value of shares to be
delivered to the counterparty must be in excess of the amount of cash that would
be delivered under a net cash settlement; however, a make-whole provision is
included in the instrument to ensure that the counterparty to the instrument
receives proceeds upon the ultimate disposition of the shares equal to the
amount that would be delivered under a net cash 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 480-10, 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.
Note that 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
480-10 (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.
5.3 Additional Equity Classification Conditions
5.3.1 Overview
ASC 815-40
25-10 Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in the preceding two paragraphs and paragraphs 815-40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:
- Settlement permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.
- Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
- Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
- No required cash payment if entity fails to timely file. There are no required cash payments to the counterparty in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
- No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
- No counterparty rights rank higher than shareholder rights. There are no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.
- No collateral required. There is no requirement in the contract to post collateral at any point or for any reason.
Paragraphs 815-40-25-39 through 25-42 explain the application of these criteria
to conventional convertible debt and other hybrid
instruments.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-10 Because any contract provision
that could require net cash settlement precludes
accounting for a contract as equity of the entity
(except for those circumstances in which the
holders of the underlying shares would receive
cash, as discussed in paragraphs 815-40-25-8
through 25-9 and paragraphs 815-40-55-2 through
55-6), all of the following conditions must be met
for a contract to be classified as equity:
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
- Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
- Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
- No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
- No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
Paragraphs 815-40-25-39 through 25-42 explain
the application of these criteria to convertible
debt and other hybrid instruments.
25-10A The following
conditions are not required to be considered in an
entity’s evaluation of net cash settlement (that
is, if any one of these provisions is in a
contract [or the contract is silent on these
points], they should not preclude equity
classification, except as described below):
- Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
- Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
- Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.
The fact that an equity-linked instrument specifies that it will be settled in
shares or permits the entity to settle in shares
does not necessarily justify a conclusion that the
entity could not be forced to net cash settle the
instrument. With certain exceptions, if there are
any circumstances under which the entity could be
required to net cash settle the instrument, the
instrument cannot be accounted for as equity (see
Section 5.2). For an entity to conclude
that it cannot be required to net cash settle an
equity-linked instrument, the entity must ensure
that the conditions in ASC 815-40-25-10 are met.
These conditions address whether there are
circumstances under which the issuer could be
forced to net cash settle the instrument given the
instrument’s terms and the regulatory and legal
framework.
The conditions apply even if the contract stipulates either physical settlement
or net share settlement. That is, an entity cannot
assume that it can physically settle or net share
settle an equity-linked instrument unless all the
conditions are met irrespective of whether the
instrument specifies that it will be share
settled.
The conditions are assessed without regard to the likelihood that an event could
force the entity to net cash settle the
instrument. Accordingly, if there are
circumstances under which the entity could be
forced to net cash settle the instrument during
its term, the instrument is classified as an asset
or a liability even if the likelihood is remote
that the circumstances will occur.
After adopting ASU 2020-06, an entity is no
longer required to consider whether the following
conditions for classifying an equity-linked
instrument as equity have been met:
- The entity is permitted to settle the instrument in unregistered shares.2
- No counterparty rights rank higher than shareholder rights.
- There is no requirement in the contract for the issuing entity to post collateral at any point for any reason.
An entity that has adopted ASU 2020-06 can
classify an equity-linked instrument within equity
if the above three conditions are not met;
however, SEC registrants must consider the
guidance in ASC 480-10-S99-3A that applies to
redeemable equity securities. An equity-linked
instrument that does not meet any one of the above
three conditions would generally need to be
classified as temporary equity. For example,
assume that an entity must settle an option in
shares of common stock that are registered for
resale. ASU 2020-06’s elimination of that
condition from the equity classification
conditions in ASC 815-40-25 does not mean that the
entity controls the ability to issue registered
shares. On the basis of informal discussions with
OCA staff, it is unclear whether ASC 480-10-S99-3A
will be amended to address the issue. In the
absence of preclearance with the SEC, an entity
should classify an equity-linked instrument
(including a hybrid financial instrument with an
embedded equity-linked feature) as temporary
equity if it does not meet one of the three
conditions in ASC 815-40-25 that ASU 2020-06
removes.
An entity evaluates the conditions in ASC 815-40-25-10 on an ongoing basis (see
Section 5.4). An equity-linked instrument
that initially meets the conditions and qualifies
as equity might need to be reclassified out of
equity if one or more of the conditions is no
longer met. Conversely, an instrument that does
not initially qualify for equity classification is
reclassified into equity if it later meets all the
conditions for equity classification.
Further, the conditions in ASC 815-40-25-10 do not apply to a conversion option
embedded in a convertible debt instrument if its terms specify that the investor
can realize the value of the conversion option only by exercising it and
receiving the entire proceeds in a fixed number of shares or the equivalent
amount of cash at the issuer’s discretion (see Section 5.5). Before the adoption of ASU
2020-06, ASC 815-40 describes such debt as “conventional convertible debt.”
EITF Issue 00-19 (before the FASB’s codification of U.S. GAAP) identified an
additional equity classification condition stating that a “contract requires
net-cash settlement only in specific circumstances in which holders of shares
underlying the contract also would receive cash in exchange for their shares.”
Under ASC 815-40, this condition still applies but it is not one of the
conditions described in ASC 815-40-25-10 (see Sections 5.2.2 and 5.2.3).
If the issuer cannot be required to deliver any shares to settle the instrument,
the conditions that address the entity’s ability to settle in shares do not
apply (e.g., that the entity has sufficient authorized and unissued shares).
Depending on the instrument’s terms, therefore, scenarios in which those
conditions may not apply include the following:
-
A net-share-settled put or call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
-
A physically settled call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
-
A physically settled written put option embedded in own stock. (If the counterparty elects to exercise the embedded put option, the entity will receive, not deliver, shares.)
-
A contingent physically settled forward contract to repurchase own stock that is embedded in an outstanding share. (If the contingency is met, the entity will receive, not deliver, shares.)
Those conditions do apply, however, to a physically settled put option held by
the entity, since the entity would deliver shares
upon exercise. This is the case even though the
decision to exercise the option is within the
entity’s control (ASC 815-40-25-11).
5.3.2 Settlement Permitted in Unregistered Shares
ASC 815-40
25-11 The events or actions necessary to deliver registered shares are not controlled by an entity and, therefore, except under the circumstances described in paragraph 815-40-25-16, if the contract permits the entity to net share or physically settle the contract only by delivering registered shares, it is assumed that the entity will be required to net cash settle the contract. As a result, the contract shall be classified as an asset or a liability.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
25-11
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-12 Delivery of unregistered shares in a private placement to the counterparty is within the control of an entity, as long as a failed registration statement (that is, a registration statement that was filed with the SEC and subsequently withdrawn) has not occurred within six months before the classification assessment date. If a failed registration statement has occurred within six months of the classification assessment date, whether an entity can deliver unregistered shares to the counterparty in a net share or physical settlement is a legal determination.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-12
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-13 Accordingly, the contract shall be classified as a permanent equity instrument assuming all of the following conditions exist:
- A failed registration statement does not preclude delivery of unregistered shares.
- The contract permits an entity to net share settle the contract by delivery of unregistered shares.
- The other conditions in this Subtopic are met.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-13
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-14 If both the following conditions are met, then net cash settlement is assumed if the entity is unable to deliver registered shares (because it is unlikely that nonperformance would be an acceptable alternative):
- A derivative instrument requires physical or net share settlement by delivery of registered shares and does not specify any circumstances under which net cash settlement would be permitted or required.
- The derivative instrument does not specify how the contract would be settled in the event that the entity is unable to deliver registered shares.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-14
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-15 Consequently, the derivative instrument shall be classified as an asset or a liability because share settlement is not within the entity’s control.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-15
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-16 If a derivative instrument involves the delivery of shares at settlement that are registered as of the inception of the derivative instrument and there are no further timely filing or registration requirements, the requirement that share delivery be within the control of the entity is met, notwithstanding the guidance in paragraph 815-40-25-11.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-16
Paragraph superseded by Accounting Standards
Update No. 2020-06.
Before the adoption of ASU 2020-06, an entity must evaluate whether it has the
right to settle an equity-linked instrument in
unregistered shares. This evaluation focuses on
the entity’s legal ability to deliver the shares
when settling the instrument. It is not sufficient
for the contract to state that the issuer is
required or permitted to settle by delivering
shares. Under the Securities Act of 1933, offers
and sales of securities must be registered with
the SEC unless a specific exemption from the
registration requirements applies. Accordingly,
depending on the facts and circumstances, an
entity may not be able to deliver shares in
settling an instrument unless those shares have
been registered with the SEC. As an issuer of
shares, however, an entity cannot control whether
the SEC will approve the registration of its
shares, and even if it has an effective
registration statement, the SEC may suspend the
registration before the equity-linked instrument
is settled. Further, the entity cannot control
whether its auditor will provide it with an audit
opinion or any consents required for share
registration. Consequently, if it is unable to
deliver registered shares because of such
circumstances, the entity may be forced to net
cash settle the instrument unless it is legally
able to settle the instrument by delivering
unregistered shares.
An entity meets this condition if one or more of the following apply:
-
The entity has a legally enforceable right to settle the instrument in unregistered shares and there was no failed registration statement within the past six months (ASC 815-40-25-12). (Further, the instrument cannot contain an economic penalty associated with the delivery of unregistered shares; see Sections 5.3.2.1 and 5.3.2.5.)
-
The instrument involves the delivery of shares at settlement that were registered at contract inception and there are no further timely filing or registration requirements (ASC 815-40-25-16; see Section 5.3.2.2).
-
The instrument clearly states that the issuer has no obligation to net cash settle the instrument if it is unable to deliver registered shares (see Section 5.3.2.3).
-
The entity will never be required to deliver any shares under the instrument (see Section 5.3.2.4).
After the adoption of ASU
2020-06, entities are no longer required to evaluate whether they have the right
to settle an equity-linked instrument in unregistered shares. Accordingly, the
guidance discussed in Sections
5.3.2.1 through 5.3.2.5 does not apply to such entities. Under
ASC 815-40, as amended by ASU 2020-06, an equity-linked instrument can qualify
as equity even if it requires settlement in registered shares as long as it does
not explicitly state that the entity must cash settle the instrument if
registered shares are unavailable. In practice, equity-linked instruments
generally do not contain such provisions.
5.3.2.1 Right to Settle in Unregistered Shares
If the entity has a legally enforceable right to settle an equity-linked
instrument in unregistered shares in a private
placement and there was no failed registration
statement (i.e., the entity filed and later
withdrew the registration statement) within the
past six months, equity classification is not
precluded as long as the instrument does not
contain an economic penalty associated with the
delivery of unregistered shares (see Section
5.3.2.5).
If the contract is silent on whether settlement in unregistered shares is
permitted, the issuer cannot assume that it has
the right to such settlement; accordingly, it may
need to perform a legal analysis to make this
determination. In a speech at the 2006 AICPA
Conference on Current SEC and PCAOB Developments,
Stephanie Hunsaker, then associate chief
accountant in the SEC’s Division of Corporation
Finance, said:
[The] staff
believes that if the warrant agreement requires
delivery of registered shares, does not specify
how the contract would be settled in the event the
company is unable to deliver registered shares,
and does not specify any circumstances under which
net cash settlement would be permitted or
required, net cash settlement must be assumed
since it is unlikely that noncompliance is an
acceptable alternative.
Likewise, an entity cannot assume that it has a right to settle in unregistered shares even if the contract specifies that the entity has such a right. If no specific exemption from the SEC’s registration requirements is available, U.S. securities laws may require settlement in registered shares even if the contract says otherwise or is silent. Thus, if the contract specifies that the entity has a right to settle in unregistered shares but settlement in unregistered shares would violate U.S. securities laws, the entity will not be able to legally assert that it can settle the contract by delivering unregistered shares. This is a legal determination. Ms. Hunsaker said in her speech:
[We] have seen numerous situations where registrants have tried to assert that the contract permits settlement in unregistered shares. This assertion appears to stem from the fact that oftentimes the contract itself does not specifically state that the company must settle in registered shares. However, U.S. Securities Laws may implicitly require settlement in registered shares because the company will not be able to find an exemption from registration and therefore settling in unregistered (or restricted) shares would be a violation of U.S. Securities laws. . . .
[I]f the warrants were sold in a registered offering, there will likely not be an exemption available to the company for the sale of the shares underlying the warrants. If there is not a current prospectus, the company will not be able to deliver registered shares upon exercise of the warrants.
If the entity has had a failed registration statement within the past six months, the entity cannot assume that it will be able to deliver unregistered shares even if the contract ostensibly allows it because delivery of unregistered shares may not be legally permitted. This is a legal determination. Issue Summary 1 of EITF Issue 00-19 (prepared July 6, 2000) states, in part:
The staff of the SEC has taken the view that the filing of a registration statement for a specific securities offering (other than a shelf registration statement) constitutes a general solicitation for that offering. Thus, if an issuer wishes to follow a withdrawn registration statement with a private offering, there may be, depending on the facts, some legal risk that a private offering exemption would be unavailable.
5.3.2.2 No Further Timely Filing or Registration Requirements
An entity is not precluded from classifying an equity-linked instrument as equity if the shares to be delivered were registered at contract inception and there are no further timely filing or registration requirements related to the shares. This is an exception to the requirement that the instrument permit settlement in unregistered shares. Issue Summary 1, Supplement 2, of EITF Issue 00-19 (prepared October 23, 2000) explains the reason for this
exception:
[I]f a legal determination is made that
delivery of shares at settlement of the contract will not require
registration . . . , then delivery of shares is within the control of
the issuer and equity classification is appropriate if the other
conditions . . . are met.
In practice, however, it is sometimes difficult for an entity to meet the
criteria for this exception. If securities laws (e.g., the Securities
Exchange Act of 1934) require the entity to periodically file (e.g., Form
10-K or 10-Q) and deliver a current, updated prospectus to maintain the
shares’ registration, this exception is not available. An entity may need to
consult legal counsel to determine whether the exception is available.
Ms. Hunsaker suggested in her 2006 speech that the legal analysis of whether
there are further timely filing or registration
requirements may depend on whether the
counterparty will make an investment decision upon
the instrument’s exercise or settlement. For a
warrant, for example, the counterparty may need to
make an investment decision regarding whether to
exercise the warrant (whereas for a forward
contract, the investment decision would be made at
contract inception). She said:
During the term of the
warrants, the issuer will have to deliver a
‘current prospectus’ to the warrant holders in
connection with any exercises by them. These further registration
requirements stem from the fact that the holder of
the warrant has to make a separate investment
decision at the time of the exercise of the
warrant and therefore a current prospectus
must be delivered to the holder. Initially the
issuer will be able to use the prospectus that was
declared effective with respect to the unit
offering when it sells shares to exercising
warrant holders. However, as time passes, the
prospectus will be required to be updated to
disclose additional information or provide updated
financial information. . . .
[A] forward contract requires
the holder to purchase shares of common stock on a
preset date in the future. . . .
The
conclusion that there are not further timely
filing or registration requirements stems from the
fact that the investment decision (to purchase
common stock in the future under the stock
purchase contract) has been made at inception and
there is no further investment decision to be
made. In effect, there really is just a
delayed delivery of the shares underlying the
stock purchase contract. [Emphasis added]
In evaluating whether further timely filing or registration requirements exist, an entity should consider whether any specific exemption from the SEC’s registration requirements applies. Ms. Hunsaker emphasized in her 2006 speech that an exemption may be available under Section 3(a)(9) of the Securities Act of 1933 if one class of securities of an issuer is exchanged for a different class of securities of the same issuer as long as no consideration or commissions are being paid. She said:
Let’s take [an] example related to either registered convertible debentures or registered convertible preferred stock that could be immediately converted into shares of common stock of the registrant. In this case, the issuer would register the convertible debt or convertible preferred stock, plus the common shares underlying the convertible debt or convertible preferred stock, since the issuer is really transacting a sale of both the convertible security and an offer of the underlying common shares. There will typically be an exemption available to the company for the issuance of common shares upon conversion. This exemption is under Section 3(a)(9) of the Securities Act, and pertains to the exchange of one class of securities of an issuer for a different class of securities of the same issuer, in which no consideration or commissions are being paid. This is important, and different from my earlier general statement that once you start an offering publicly, you must complete it publicly. In this case, the Section 3(a)(9) exemption is typically available even if the offering of the convertible security takes place in a registered format. In general, the conditions of Section 3(a)(9) will be met at the time of conversion of the publicly held debt or convertible preferred stock. . . . [A]ssuming Section 3(a)(9) is available, which is generally the case, the offering of securities that underlie the convertible debentures that commenced in the registration process can be completed without the availability of a current prospectus. The shares delivered by the company will be freely tradeable since the transaction and the shares underlying the conversion option were registered upfront. As a result, even if the convertible debt or convertible preferred stock offering was conducted publicly, the registrant would not be required to conclude the embedded conversion option fails equity classification under [ASC 815-40-25-11 through 25-18]. Of course, this assumes that the settlement alternatives are equivalent and that the remaining criteria for equity classification must also be met before the final analysis is completed.
Further, Ms. Hunsaker stressed that registrants may need to consult with legal counsel:
However, registrants should ensure they have discussed with their legal counsel the availability of the Section 3(a)(9) exemption to their fact pattern, particularly in unusual circumstances such as when it is uncertain if the securities are convertible into those of the same issuer, arrangements which may involve the payment of remuneration for soliciting the exchange, or arrangements where the convertible securities are not potentially immediately convertible into shares of common stock of the registrant and the issuer has not registered all of the shares which could be issued upon conversion at inception along with the convertible debt.
5.3.2.3 No Obligation to Net Cash Settle the Contract
The condition related to an entity’s ability to
settle an equity-linked instrument in unregistered
shares does not apply if the entity is not
required to perform because of its inability to
deliver registered shares. As noted in ASC
815-40-25-14, “net cash settlement is assumed if
the entity is unable to deliver registered shares
(because it is unlikely that nonperformance would
be an acceptable alternative).” Thus, if
nonperformance is an acceptable alternative, net
cash settlement would not be assumed.
The SEC staff has indicated that if there are no circumstances in which the
entity would be required to net cash settle an
equity-linked instrument, the staff would not
object to the conclusion that the instrument
qualifies for equity classification even if the
entity does not have an effective registration
statement. Ms. Hunsaker said in her 2006
speech:
[T]he staff has seen
circumstances . . . whereby [a] warrant agreement
clearly indicates, in either the original
agreement or by clarifying amendment, that in the
event the company does not have an effective
registration statement, there is no circumstance
that would require the registrant to net cash
settle the warrants. In such a case, the staff
would not object to the company’s conclusion that
the warrants would not be required to be
classified as liabilities.
For example, a provision in a contract might specify that the entity will use
its best efforts to maintain a current prospectus
and, if the entity nevertheless is unable to
deliver registered shares, the contract cannot be
exercised. Such a provision must clearly indicate
that in no circumstance would the issuer be
required to cash settle the contract.
5.3.2.4 No Obligation to Deliver Shares
If there are no circumstances in which an equity-linked instrument would require
the entity to deliver shares, the condition that
the entity is able to settle the instrument by
delivering unregistered shares does not apply.
Thus, depending on the contract terms, the
condition may not apply to, for example, a
purchased call option on the entity’s own equity
in which the entity would receive, not deliver,
shares upon exercise (see Section 5.3.1).
5.3.2.5 Discount on the Value of Unregistered Shares
ASC 815-40
25-17 A contract may specify
that the value of the unregistered shares to be
privately placed under share settlement is to be
determined by the counterparty using commercially
reasonable means. That valuation is used to
determine the number of unregistered shares that
must be delivered to the counterparty. The term
commercially reasonable means is
sufficiently objective from a legal perspective to
prevent a counterparty from producing an unrealistic
value that would then compel an entity to net cash
settle the contract. Similarly, a contractual
requirement to determine the fair value of
unregistered shares by obtaining market quotations
is sufficiently objective and would not suggest that
the settlement alternatives have different economic
values.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-17
Paragraph superseded by Accounting Standards
Update No. 2020-06.
Uneconomic Settlement Alternatives
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. In the case of delivery of unregistered shares, a discount from the fair value of the corresponding registered shares that is a reasonable estimate of the difference in fair values between registered and unregistered shares (that is, the discount reflects the fair value of the restricted shares determined using commercially reasonable means) is not considered a penalty.
Pending Content (Transition Guidance: ASC
815-40-65-1)
Uneconomic Settlement
Alternatives
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.
Investors usually will prefer to receive registered shares so they can sell
those shares more easily. Before the adoption of
ASU 2020-06, if an entity has the right to settle
in unregistered shares but there is an economic
penalty in the contract associated with the
delivery of unregistered shares, the entity must
presume net cash settlement, and the equity-linked
instrument cannot be classified as equity.
However, a discount from the fair value of the
corresponding registered shares is permitted if it
is a reasonable estimate of the difference in fair
value between registered and unregistered shares
that is determined by using commercially
reasonable means. For example, an equity-linked
instrument may specify that the entity has the
right to settle the instrument in either
unregistered or registered shares. If the entity
delivers unregistered shares, the number of
unregistered shares required to settle the
instrument will be adjusted by a calculation agent
to reflect an appropriate liquidity discount based
on the fair value difference between a freely
tradeable and an unregistered share (i.e., the
entity would be required to deliver additional
shares to reflect the discount).
Consider a freestanding warrant on an entity’s stock that specifies that the
entity has the right to settle in either registered or unregistered shares.
If the entity elects to deliver unregistered shares, it must give the
counterparty a greater number of shares than if it were to settle by
delivering registered shares. If the value of the incremental shares the
entity has to deliver in case it elects to settle in unregistered shares
reflects a commercially reasonable estimate of the difference in value
between registered and unregistered shares as a result of illiquidity,
settlement in unregistered shares is not considered uneconomic. If the value
of the incremental shares exceeds such an estimate, however, the entity’s
right to settle in unregistered shares is considered uneconomic and is
disregarded in the classification of the instrument (see Section 5.2.5). The
warrant therefore does not meet the condition related to the entity’s
ability to settle the instrument in unregistered shares and, before the
adoption of ASU 2020-06, does not qualify as equity. (As discussed in Section 5.5, the
condition under which the instrument may be settled in unregistered shares
does not apply to features embedded in certain types of convertible
debt.)
Under some equity-linked instruments, the number of shares to be delivered to
the counterparty if the entity elects to settle in
unregistered shares must be in excess of the
number of shares required to be delivered if the
entity elects to settle in registered shares;
however, a make-whole provision is included in the
instrument to ensure that the counterparty to the
instrument would receive proceeds upon the
ultimate disposition of the unregistered shares
equal to the value of the shares that would have
been delivered under a settlement in registered
shares. 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.
5.3.2.6 Interaction With 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 this case,
the entity should consider whether that penalty
provision meets the definition of a registration
payment arrangement under ASC 825-20 (see Section
3.2.4). 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 contract subject to the agreement. Thus,
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 (ASC 825-20-25-2). In other
words, an equity-linked instrument is not
necessarily precluded from equity classification
because it specifies cash penalties if the entity
is unable to register the shares underlying the
instrument, as long as the entity is not required
to net cash settle the instrument.
If an equity-linked instrument permits the entity to settle by delivering
unregistered shares, the instrument can qualify as
equity even if it requires the entity to use
commercially reasonable best efforts to register
any unregistered shares delivered. This is
analogous to ASC 815-40-25-28, which states, in
part:
Use of the entity’s best
efforts to obtain sufficient authorized shares to
settle the contract is within the entity’s
control.
5.3.3 Entity Has Sufficient Authorized and Unissued Shares
ASC 815-40
25-19 If an entity could be required to obtain shareholder approval to increase the entity’s authorized shares to net share or physically settle a contract, share settlement is not controlled by the entity.
25-20 Accordingly, an entity shall evaluate whether a sufficient number of authorized and unissued shares exists at the classification assessment date to control settlement by delivering shares. In that evaluation, an entity shall compare both of the following amounts:
- The number of currently authorized but unissued shares, less the maximum number of shares that could be required to be delivered during the contract period under existing commitments, including any of the following:
- Outstanding convertible debt that is convertible during the contract period
- Outstanding stock options that are or will become exercisable during the contract period
- Other derivative financial instruments indexed to, and potentially settled in, an entity’s own stock.
- The maximum number of shares that could be required to be delivered under share settlement (either net share or physical) of the contract.
25-21 When evaluating whether
there are sufficient authorized and unissued
shares available to settle a contract, an entity
shall consider the maximum number of shares that
could be required to be delivered under a
registration payment arrangement to be an existing
share commitment, regardless of whether the
instrument being evaluated is subject to that
registration payment arrangement.
25-22 If the amount in paragraph 815-40-25-20(a) exceeds the amount in paragraph 815-40-25-20(b) and the other conditions in this Subtopic are met, share settlement is within the control of the entity and the contract shall be classified as a permanent equity instrument. Otherwise, share settlement is not within the control of the entity and asset or liability classification is required.
25-23 For purposes of this calculation, if a contract permits both (a) net share and (b) physical settlement by delivery of shares at the entity’s option (both alternatives permit equity classification if the other conditions in this Section are met), the alternative that results in the lesser number of maximum shares shall be included in this calculation.
25-24 If a contract is classified as either an asset or a liability because the counterparty has the option to require settlement of the contract in cash, then the maximum number of shares that the counterparty could require to be delivered upon settlement of the contract (whether physical or net share) shall be assumed for purposes of this calculation.
An equity-linked instrument cannot be classified as equity unless either of the
following criteria is met:
-
The entity currently has a sufficient number of authorized and unissued shares available to share settle the instrument.
-
The entity is able, without shareholder approval, to increase the number of authorized shares to make a sufficient amount of authorized and unissued shares available to share settle the instrument.
Whether shareholder approval would be required for an increase in the number of
authorized shares is a legal determination (e.g., it may differ across jurisdictions). If shareholder approval is required for such an increase (e.g., under corporate law), the instrument cannot be classified as equity unless the entity currently has a sufficient number of authorized and unissued shares available to share settle the instrument. Issue Summary 1 of EITF Issue 00-19 (prepared July 6, 2000) explains the
reason for this guidance:
[B]ecause the company cannot be assured that the
shareholders will vote for the increase in the
number of authorized shares, net share settlement
is not within the control of the company.
If shareholder approval is obtained for an increase in the number of authorized
shares, the entity should consider whether
equity-linked instruments that previously were
classified as assets or liabilities (because the
number of authorized shares was insufficient) will
need to be reclassified as equity (see Section
5.4).
In assessing whether it has a sufficient number of authorized and unissued
shares, an entity does not take into account only
the number of its currently authorized and
unissued shares. It must also consider how many
shares it might be required to deliver under any
other commitment to deliver shares during the
maximum period in which the equity-linked
instrument being evaluated might remain
outstanding, including any top-off or make-whole
commitments (see Section 5.3.6). Such
commitments include not only instruments within
the scope of ASC 815-40 but also instruments
within the scope of other accounting guidance such
as ASC 480 or ASC 718. Examples include warrants,
options, forwards, employee stock options,
convertible debt, convertible preferred stock,
share-settled contingent consideration in a
business combination, and share-settled
registration payment arrangements.
The entity deducts the maximum number of shares it could be required to deliver
during the contract period under such commitments
from the number of currently authorized but
unissued shares. Equity classification for the
instrument being assessed is precluded unless the
number of authorized and unissued shares that
remains after deduction of all the shares the
entity might have to deliver under other
commitments exceeds the maximum number of shares
that the entity could be required to deliver under
the instrument. In determining this number, the
entity does not consider the likelihood that it
might have to deliver shares under other
commitments.
If an entity anticipates issuing shares but is not committed to doing so, it
would not consider those shares in the
calculation, but it would consider them in its
periodic reassessment of the classification of
equity-linked instruments when the issuances
actually occur. This practice is consistent with
the minutes of the EITF’s November 15–16, 2000,
meeting, which state, in part:
It is not necessary to subtract anticipated
voluntary share issuances from the number of
authorized but unissued shares because such
issuances are, by definition, within the control
of the company. However, such voluntary issuances
(when they actually occur) would be considered in
the periodic reassessment of
classification.
Example 5-4
Sufficient Authorized and Unissued Shares
An entity has issued a warrant that expires in one year. If the holder exercises the warrant, the contractual terms of the warrant require the entity to deliver 20,000 shares of the entity’s stock in exchange for a cash payment of $5 million. Further, the entity determines that (1) it currently has 100,000 authorized shares, of which 40,000 are in issuance, and (2) the maximum number of shares that it could be required to deliver during the warrant’s one-year term because of other commitments (e.g., outstanding convertible debt, employee stock options) is 35,000.
The entity would calculate the number of shares available to share settle the warrant being evaluated as follows:
Calculation and Comparison | Number of Shares |
---|---|
Currently authorized shares | 100,000 |
Less: Issued shares | (40,000) |
Less: Maximum number of shares the entity could be forced to deliver during the contract term under other commitments | (35,000) |
Equals: Shares available to share settle the contract | 25,000 |
Compare: Maximum number of shares that the entity could be forced to deliver under the contract being evaluated | 20,000 |
The warrant being evaluated is not precluded from equity classification because the entity has a sufficient number of authorized and unissued shares available to share settle the contract. That is, the contract being evaluated would never require delivery of more than 20,000 shares, and the entity has 25,000 shares available to share settle the contract.
In calculating the maximum number of shares that might have to be delivered
under an equity-linked instrument that (1) could
require the entity to deliver shares and (2)
includes a choice of settlement method (e.g.,
physical settlement, net shares, or net cash), the
entity considers which party controls the manner
of settlement. If the entity has the option to
elect either net share or physical settlement, the
entity reflects the alternative with the lesser
number of shares in the calculation (i.e., net
share settlement), since the entity cannot be
forced to deliver the greater number of shares
that would be delivered in a physical settlement.
If the counterparty can elect the settlement
method, the entity reflects the alternative that
will require delivery of the greater number of
shares in the calculation. If this is the case,
the entity incorporates the greater number of
shares in the calculation even if the instrument
is classified as an asset or a liability (e.g.,
because the counterparty has the right to elect
net cash settlement).
Note that the classification requirements in ASC 815-40 apply to each
equity-linked instrument as a whole unless the instrument permits partial net
share settlement. If an equity-linked instrument does not permit partial net
share settlement, the whole instrument is classified as an asset or a liability
if the entity does not have sufficient shares to share settle the entire
instrument. ASC 815-40-35-11 addresses contracts that permit partial net share
settlement.
If the issuer cannot be required to deliver any shares to settle
an equity-linked instrument, the entity does not need to satisfy the condition
that it have sufficient authorized and unissued shares to settle the instrument.
Depending on the instrument’s terms, therefore, the condition may not apply to,
for example, a purchased call option on the entity’s own equity, in which the
entity will receive, not deliver, shares upon exercise (see Section 5.3.1).
5.3.3.1 Sequencing Considerations
If an entity concludes that it does not have sufficient authorized and unissued
shares to satisfy all its commitments to deliver
shares, it should apply a sequencing policy to
determine how to allocate any authorized and
unissued shares among those commitments. In
establishing a sequencing policy, an entity should
consider the guidance on reclassification methods
in ASC 815-40-35-11 through 35-13 (see Section
5.4). While that guidance addresses
“reclassifications,” it is also relevant in the
determination of the initial classification of
equity-linked instruments. Depending on how
authorized and unissued shares are allocated under
an entity’s sequencing policy, the entity may
conclude that it has a sufficient number of
authorized and unissued shares available to share
settle the instrument being evaluated.
5.3.4 Contract Contains an Explicit Share Limit
ASC 815-40
25-26 For certain contracts, the number of shares that could be required to be delivered upon net share settlement is essentially indeterminate. If the number of shares that could be required to be delivered to net share settle the contract is indeterminate, an entity will be unable to conclude that it has sufficient available authorized and unissued shares and, therefore, net share settlement is not within the control of the entity.
For equity classification to be appropriate, the number of shares the entity
might be required to deliver under the contract
must be limited (capped). If determining the
maximum number of such shares is not possible,
then equity classification is not permitted
because it would be impossible to establish
whether the entity has a sufficient number of
authorized and unissued shares available to settle
the instrument in shares. That is, an
equity-linked instrument that could require the
entity to deliver an unlimited number of shares
would not qualify as equity. The number of shares
that it expects to deliver is not relevant to this
determination, nor is whether there is only a
remote likelihood that the entity will deliver
more than some specific number of shares.
The SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006) notes that one of the most common causes of improper accounting for a conversion feature embedded in convertible debt or convertible preferred stock is that:
[T]he number of shares issuable upon conversion of the convertible instrument is variable, and there is no cap on the number of shares which could be issued. [Since] there is no explicit limit on the number of shares that are to be delivered upon exercise of the conversion feature, the registrant is not able to assert that it will have sufficient authorized and unissued shares to settle the conversion option. As a result, the conversion feature would be accounted for as a derivative liability, with changes in fair value recorded in earnings each period. Additionally, registrants should note that a variable share settled instrument that results in liability classification may impact the classification of previously issued instruments, as well as instruments issued in the future.
An equity-linked instrument’s terms do not necessarily need to use the words
“explicit share limit” — it may be possible for an entity to infer an explicit
share limit from the terms. For example, a convertible bond may have a par value
of 1,000, a fixed conversion price of $20, and no adjustment provisions that
could increase the number of shares that would be delivered. If the par value of
1,000 is divided by the conversion price of $20, it is implied that the entity
would never deliver more than 50 shares. Thus, 50 shares would be considered the
explicit share limit. If the issuer writes a freestanding call option on its own
outstanding shares, the terms of the option contract may similarly establish an
explicit share limit. For example, if the written call option has a fixed
notional amount of 100 shares and no adjustment provisions, the entity will
never deliver more than 100 shares irrespective of whether the contract provides
for physical settlement or net share settlement.
Many equity-linked instruments require adjustments to the number of shares to be
delivered upon the occurrence or nonoccurrence of
a specified event (e.g., an antidilution
adjustment that specifies that the number of
shares will be increased in case of a stock
split). A contractual provision that increases the
number of shares to be delivered upon the
occurrence or nonoccurrence of an event is not
inconsistent with this condition if the event that
triggers the adjustment is within the entity’s
control (see Section
5.2.3.1). If the triggering event is
outside the entity’s control (e.g., a merger or a
consolidation), the instrument may still meet this
condition if the event causes the instrument to be
settled and holders of the underlying shares
receive the same form of consideration (see Section
5.2).
If the issuer cannot be required to deliver any shares to settle the instrument,
the condition that the instrument contains an explicit share limit does not
apply. (Alternatively, the instrument could be analyzed as having a share limit
of zero since the entity could not be required to deliver any shares.) Depending
on the instrument’s terms, therefore, the condition may not apply to, for
example, a purchased call option on the entity’s own equity in situations in
which the entity would receive, not deliver, shares upon exercise (see Section 5.3.1).
An equity-linked instrument may contain a clause that limits the holder’s
ability to exercise and beneficially own more than
a specified percentage of the issuer’s outstanding
shares (e.g., the counterparty cannot exercise an
option contract if it owns or would obtain more
than 4.99 percent of outstanding shares). Such a
cap does not qualify as an explicit share limit
since the counterparty can sell the shares it
holds before exercise and any shares it receives
upon exercise.
If the entity is able, without shareholder approval, to increase the number of
authorized shares to make a sufficient number of
authorized and unissued shares available to share
settle an equity-linked instrument, the
requirement that the instrument must contain an
explicit share limit does not apply because the
entity could not be forced to cash settle the
instrument (see Section
5.3.3).
Including an explicit share limit in a contract’s terms solely to meet the
condition that the instrument have such a limit would not preclude a conclusion
that the instrument is a fixed-for-fixed forward or an option on the entity’s
equity shares (see Section
4.3.2).
5.3.4.1 Interaction Between the Sufficient Share and Explicit Share Limit Conditions
ASC 815-40
25-27 If a contract limits or caps the number of shares to be delivered upon expiration of the contract to a fixed number, that fixed maximum number can be compared to the available authorized and unissued shares (the available number after considering the maximum number of shares that could be required to be delivered during the contract period under existing commitments as addressed in paragraph 815-40-25-20 and including top-off or make-whole provisions as discussed in paragraph 815-40-25-30) to determine if net share settlement is within the control of the entity. A contract termination trigger alone (for example, a provision that requires that the contract will be terminated and settled if the stock price falls below a specified price) does not satisfy this requirement because, in that circumstance, the maximum number of shares deliverable under the contract is not known with certainty unless there is a stated maximum number of shares.
If an entity determines that an equity-linked instrument contains an explicit
share limit (i.e., it satisfies the condition in
ASC 815-40-25-26), the entity can then compare
that share limit with the number of available
shares. If there is a share limit but it exceeds
the number of available shares, the instrument
fails to meet the condition in ASC 815-40-25-19.
In this case, the entity classifies the instrument
as an asset or a liability. On the other hand, if
there is a share limit and the number of available
shares exceeds that limit, the instrument
potentially qualifies for equity classification if
the other conditions for equity classification are
met.
5.3.4.2 Equity-Linked Instrument With Share Limit and Best-Efforts Arrangement
ASC 815-40
25-28 This paragraph addresses a contract structure that caps the number of shares that must be delivered
upon net share settlement but would also provide that any contract valued in excess of that capped amount
may be delivered to the counterparty in cash or by delivery of shares (at the entity’s option) when authorized,
unissued shares become available. The structure requires the entity to use its best efforts to authorize
sufficient shares to satisfy the obligation. Under the structure, the number of shares specified in the cap is less
than the entity’s authorized, unissued shares less the number of shares that are part of other commitments
(see paragraph 815-40-25-20). Use of the entity’s best efforts to obtain sufficient authorized shares to settle
the contract is within the entity’s control. If the contract provides that the number of shares required to settle
the excess obligation is fixed on the date that net share settlement of the contract occurs, the excess shares
need not be considered when determining whether the entity has sufficient, authorized, unissued shares to
net share settle the contract pursuant to paragraph 815-40-25-20. However, the contract may provide that the
number of shares that must be delivered to settle the excess obligation is equal to a dollar amount that is fixed
on the date of net share settlement (which may or may not increase based on a stated interest rate on the
obligation) and that the number of shares to be delivered will be based on the market value of the stock at the
date the excess amount is settled. In that case, the excess obligation represents stock-settled debt and shall
preclude equity classification of the contract (or, if partial net share settlement is permitted under the contract
pursuant to paragraph 815-40-35-11, precludes equity classification of the portion represented by the excess
obligation).
The counterparty to an equity-linked instrument may be reluctant to accept an
explicit share limit that caps the gain it could
make on the instrument. In this case, the entity
may agree to (1) deliver the shares that are in
excess of the limit (the number of which becomes
fixed as of the instrument’s settlement date) only
once authorized, unissued shares become available,
and (2) use its best efforts to obtain such
shares. In this situation, the entity does not
need to consider the excess shares in determining
whether it has sufficient authorized and unissued
shares to net share settle the instrument because
it cannot be forced to deliver those shares.
However, if the contract specifies that the entity will deliver a variable
number of shares equal in value to that of the excess shares determined as
of the settlement date, the excess obligation is considered stock-settled
debt. In this case, the instrument must be classified as a liability either
for the part that exceeds the explicit share limit (if the contract permits
partial net share settlement) or in its entirety (if it cannot be partially
net share settled or otherwise does not meet the conditions for equity
classification). Once the monetary amount of the stock-settled debt becomes
fixed as of the instrument’s original settlement date, that obligation is
outside the scope of ASC 815-40 under ASC 815-40-15-3(e) and is instead
accounted for as a liability under ASC 480-10 (see Section 2.3 of this Roadmap and Chapter 6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity).
5.3.5 No Required Cash Payment if Entity Fails to File on a Timely Basis
ASC 815-40
25-29 The ability to make timely SEC filings is not within the control of the entity. Accordingly, if a contract permits share settlement but requires net cash settlement in the event that the entity does not make timely filings with the SEC, that contract shall be classified as an asset or a liability.
If an equity-linked instrument must be net cash settled in the event that the
entity does not file reports with the SEC on a
timely basis, the instrument cannot be accounted
for as equity. In the evaluation of whether this
condition is met, the likelihood of the entity’s
being unable to file in a timely manner is
irrelevant.
The reason for this requirement is that the ability to file reports with the SEC
in a timely manner is not solely within the
entity’s control. For example, an entity cannot
control whether its auditor will provide it with
an audit opinion that is required in filing the
entity’s annual financial statements. Some filings
may require the consent of the entity’s auditor or
third-party experts.
An equity-linked instrument might require the entity to make a cash payment for
failing to file financial statements with the SEC
or other body in a timely manner (e.g., an amount
in cash equal to 2 percent of the instrument’s
exercise price on the day of a failure to file and
on every 30th day thereafter until the date such
failure is cured). ASU 2020-06 clarifies that such
penalty payments do not preclude equity
classification since they do not cause the
instrument to be settled (see Section 5.2.3.7).
Connecting the Dots
Under ASC 815-40-25-10(d), one of the conditions for equity
classification is that there must be no required cash payment — except
for penalty payments — if the entity fails to file in a timely manner.
Although the exception for penalty payments is discussed solely in the
context of payments for an entity’s failure to file financial statements
on a timely basis, it is acceptable to apply this exception to other
cash payments that are (1) akin to penalty payments 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). If a cash payment is
required in connection with the settlement of an equity-linked
instrument, the exception for penalty payments does not apply and the
contract cannot be classified in equity.
A requirement that the entity use its best efforts to make timely filings is within its control and would not preclude equity classification.
Some hybrid financial instruments specify that the entity will pay cash
penalties or additional interest if the entity does not file on a timely basis.
For example, a convertible debt instrument may indicate that additional interest
is payable if the entity fails to file reports in a timely manner. Such a
feature may be attributed to the hybrid instrument and evaluated separately as
an embedded derivative provided that the penalty paid does not vary on the basis
of the value of the conversion option. Accordingly, it would not disqualify the
conversion option from being classified as equity.
5.3.6 No Cash-Settled Top-Off or Make-Whole Provision
ASC 815-40
25-30 A top-off or make-whole provision would not preclude equity classification if both of the following conditions exist:
- The provision can be net share settled.
- The maximum number of shares that could be required to be delivered under the contract (including any top-off or make-whole provisions) is both:
- Fixed
- Less than the number of available authorized shares (authorized and unissued shares less the maximum number of shares that could be required to be delivered during the contract period under existing commitments as discussed in paragraph 815-40-25-20).
If those conditions are not met, equity classification is precluded.
ASC 815-40 — Glossary
Make-Whole Provision
A cash payment to a counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due. While the exact terms of such provisions vary, they generally are intended to reimburse the counterparty for any losses it incurs or to transfer to the entity any gains the counterparty recognizes on the difference between the following:
- The settlement date value
- The value received by the counterparty in subsequent sales of the securities within a specified time after the settlement date.
Top-Off Provision
See Make-Whole Provision.
Some equity-linked instruments contain make-whole or top-off provisions that
reimburse the counterparty if it incurs a loss on
the sale of the shares it will receive upon
settlement of the instrument. The counterparty to
an equity-linked instrument (e.g., a warrant, a
written call option, or a convertible instrument)
may seek to include such a provision to ensure
that it does not stand to lose from declines in
the stock price following its exercise of the
instrument.
The existence of a top-off or a make-whole provision precludes equity
classification for the entire equity-linked
instrument unless both of the following conditions
are met:
-
The entity has the right to net share settle the make-whole or top-off obligation.
-
The maximum number of shares that is required to settle the instrument (including the top-off or make-whole provision) is both:
-
Fixed (i.e., there is an explicit share limit).
-
Less than the number of available authorized and unissued shares after deduction of the maximum number of shares for which delivery could be required during the contract period under other commitments (i.e., the entity has sufficient authorized and unissued shares to share settle the make-whole or top-off provision).
-
Example 5-5
Top-Off Provision
An entity writes a net-share-settled call option on 1,000 of the entity’s common
shares. The entity has the right to settle the
call option by delivering unregistered shares. On
a per-share basis, the option’s settlement amount
equals the difference between the quoted stock
price on the settlement date and $46. The option
contains a top-off provision that specifies that
if the holder sells the shares it receives upon
settlement of the option and such sale occurs
within 10 days of option settlement, the holder
will receive a variable number of shares equal in
value to the excess, if any, of (1) the stock
price used in settling the option divided by (2)
the price at which the holder subsequently sells
the shares. The entity has the right to settle the
top-off provision in unregistered shares. The
option also specifies that under no circumstances
will the entity deliver more than 1,000 shares to
satisfy both the option settlement and the top-off
provision. The entity has 2,000 authorized and
unissued shares available.
On the option’s settlement date, the quoted stock price is $50. Because the
option is net share settled, the holder receives a
variable number of the entity’s shares equal in value to
$4,000, or 1,000 × ($50 – $46); that is, 80 shares
($4,000 ÷ $50). Ten days later, the holder sells the
shares in the market for $40 per share and incurs an
aggregate loss of $800, or 80 × ($50 – $40). Under the
top-off provision, therefore, the entity delivers an
additional number of shares to the counterparty equal in
value to $800. At a stock price of $40, the entity
delivers an additional 20 shares ($800 ÷ $40) to the
counterparty to satisfy the top-off provision.
Even though this option contains a top-off provision, the option is not
precluded from equity classification since the
entity has the right to net share settle the
top-off provision, and the maximum number of
shares it might be required to deliver is both
fixed and less than the available authorized and
unissued shares. If the entity can be forced to
net cash settle the top-off provision, however,
the entire option is classified as a
liability.
5.3.7 No Counterparty Rights Rank Higher Than Shareholder Rights
ASC 815-40
25-31 To be
classified as equity, a contract cannot give the
counterparty any of the rights of a creditor in
the event of the entity’s bankruptcy. Because a
breach of the contract by the entity is within its
control, the fact that the counterparty would have
normal contract remedies in the event of such a
breach does not preclude equity classification. As
a result, a contract cannot be classified as
equity if the counterparty’s claim in bankruptcy
would receive higher priority than the claims of
the holders of the stock underlying the
contract.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-31
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-32
Generally, based on existing law, a net share
settled derivative instrument that an entity has a
right to settle in shares even upon termination
could be net share settled in bankruptcy. If the
derivative instrument is not net share settled,
the claim of the counterparty would not have
priority over those of the holders of the
underlying stock, even if the contract specified
cash settlement in the event of bankruptcy. In
federal bankruptcy proceedings, a debtor cannot be
compelled to affirm an existing contract that
would require it to pay cash to acquire its shares
(which could be the case, for example, with a
physically settled forward purchase or written
put). As a result, even if the contract requires
that the entity (debtor) pay cash to settle the
contract, the entity could not be required to do
so in bankruptcy. Because of the complexity of
federal bankruptcy law and related case law, and
because of the differences in state laws affecting
derivative instruments, it is not possible to
address all of the legal issues associated with
the status of the contract and the claims of the
counterparty in the event of bankruptcy.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-32
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-33 A
contract provision requiring net cash settlement
in the event of bankruptcy does not preclude
equity classification if it can be demonstrated
that, notwithstanding the contract provisions, the
counterparty’s claims in bankruptcy proceedings in
respect of the entity could be net share settled
or would rank no higher than the claims of the
holders of the stock underlying the contract.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-33
Paragraph superseded by Accounting Standards
Update No. 2020-06.
25-34
Determination of the status of a claim in
bankruptcy is a legal determination.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-34
Paragraph superseded by Accounting Standards
Update No. 2020-06.
Before adoption of ASU 2020-06, equity
classification is prohibited if an equity-linked
instrument gives creditor rights to the
counterparty upon an entity’s bankruptcy. After
adoption, an entity is no longer required to
consider whether it has satisfied this
condition.
Evaluating whether a contract
gives creditor rights to the counterparty in bankruptcy can be complex.
Provisions suggesting that the counterparty has creditor rights in bankruptcy
are not necessarily enforceable under the law. Equity classification is
precluded only if such provisions are enforceable. This is a legal determination
that may require involvement of legal counsel.
Provisions that specify normal contractual
remedies for a breach are not inconsistent with
this condition.
In the context of convertible
debt, any creditor rights associated with the debt do not need to be assessed
under this condition. The entity needs to assess only whether senior rights are
attached to the conversion option.
If an equity-linked instrument is subject to a
netting provision (e.g., under standard ISDA
terms), the entity should consider whether the
netting provision gives the counterparty the
rights of a creditor in bankruptcy. If the netting
provision could result in the netting of the
instrument with contracts not classified as
equity, the counterparty would have a right that
would rank higher than that of a holder of the
underlying shares, in which case equity
classification would be precluded. To avoid this
outcome, the entity may seek to include terms in
the contract that specify that the instrument
cannot be netted or can be netted only against
other equity-classified instruments. For example,
the parties may include a provision such as the following:
Obligations under this Transaction shall not
be set off against any other obligations of the
parties, whether arising under the Agreement, this
Confirmation, under any other agreement between
the parties hereto, by operation of law or
otherwise, and no other obligations of the parties
shall be set off against obligations under this
Transaction, whether arising under the Agreement,
this Confirmation, under any other agreement
between the parties hereto, by operation of law or
otherwise, and each party hereby waives any such
right of setoff.
Whether such a term is
enforceable is a legal determination that may
require involvement of legal counsel.
Some forward sale contracts
require the issuing entity to settle the contract before the entity’s insolvency
filing. For example, a forward sale contract may give the counterparty the right
to terminate the contract upon the entity’s filing for insolvency. Such a
provision does not have the effect of giving the counterparty a right senior to
that of a holder of the underlying shares. This type of insolvency filing
provision is commonly included in forward sale contracts and exists to ensure
that the counterparty could not find itself in a situation in which it had to
pay for the shares but could not receive them on the date it paid for them (a
situation that could occur in bankruptcy in the absence of this provision).
5.3.8 No Collateral Required
ASC 815-40
25-35 A requirement to post collateral of any kind (other than the entity’s shares underlying the contract, but limited to the maximum number of shares that could be delivered under the contract) under any circumstances is inconsistent with the concept of equity and, therefore, precludes equity classification of the contract.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-35
Paragraph superseded by Accounting Standards
Update No. 2020-06.
Some equity-linked instruments require the entity to post collateral (e.g., if
the stock price falls below a specified price).
Before the adoption of ASU 2020-06, if an
equity-linked instrument requires or could require
the entity to post collateral in a form other than
the shares underlying the instrument (such as cash
or other assets), the instrument cannot be
classified as equity. Further, if the underlying
shares serve as collateral, their number must be
limited to the maximum number of shares that the
entity might be required to deliver under the
instrument. After the adoption of ASU 2020-06, an
entity is no longer required to evaluate whether
this condition is met.
An entity does not need to consider whether the
counterparty might be required to post collateral
under the contract in evaluating this condition.
In addition, in an entity’s evaluation of whether
an equity conversion option embedded in
convertible debt meets this condition, it is
irrelevant whether the debt is backed by
collateral. The entity assesses only whether it
has to post collateral to back the settlement of
the conversion option.
Footnotes
2
Under ASU 2020-06, an equity-linked instrument
can qualify as equity even if it requires settlement in
registered shares unless it explicitly states that the entity
must cash settle the instrument if registered shares are
unavailable.
5.4 Ongoing Reassessment of Classification Requirements
ASC 815-40
35-8 The classification of a contract shall be reassessed at each balance sheet date. If the classification required under this Subtopic changes as a result of events during the period (if, for example, as a result of voluntary issuances of stock the number of authorized but unissued shares is insufficient to satisfy the maximum number of shares that could be required to net share settle the contract [see discussion in paragraph 815-40-25-20]), the contract shall be reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.
Pending Content (Transition Guidance: ASC
815-40-65-1)
35-8 The classification of a contract
(including freestanding financial instruments and
embedded features) shall be reassessed at each
balance sheet date. If the classification required
under this Subtopic changes as a result of events
during the period (if, for example, as a result of
voluntary issuances of stock the number of
authorized but unissued shares is insufficient to
satisfy the maximum number of shares that could be
required to net share settle the contract [see
discussion in paragraph 815-40-25-20]), the
contract shall be reclassified as of the date of
the event that caused the reclassification. There
is no limit on the number of times a contract may
be reclassified.
35-11 If a contract permits
partial net share settlement and the total notional amount
of the contract no longer can be classified as permanent
equity, any portion of the contract that could be net share
settled as of that balance sheet date shall remain
classified in permanent equity. That is, a portion of the
contract shall be classified as permanent equity and a
portion of the contract shall be classified as an asset, a
liability, or temporary equity, as appropriate.
35-12 If an entity has more than one contract subject to this Subtopic, and partial reclassification is required, there may be different methods that could be used to determine which contracts, or portions of contracts, shall be reclassified. Methods that would comply with this Section could include any of the following:
- Partial reclassification of all contracts on a proportionate basis
- Reclassification of contracts with the earliest inception date first
- Reclassification of contracts with the earliest maturity date first
- Reclassification of contracts with the latest inception or maturity date first
- Reclassification of contracts with the latest maturity date first.
35-13 The method of reclassification shall be systematic, rational, and consistently applied.
5.4.1 Overview
An entity is required to reassess its classification of both freestanding
equity-linked instruments and embedded features as of each reporting date.
Reclassification is required if an instrument either begins or ceases to meet
all the conditions for equity classification. If reclassification is required,
the entity reclassifies the instrument as of the date of the event that caused
the reclassification at its then-current fair value, and the new classification
is applied prospectively. For this reason, the entity may need to determine the
fair value of the instrument as of the date that reclassification is required,
even if that date is not a reporting date. Prior fair value gains and losses
recognized in earnings are not reversed.
Any of the following could affect an entity’s conclusion about whether an
equity-linked instrument qualifies as equity:
-
The counterparty exercises an option or warrant in such a way that the settlement amount becomes fixed for fixed (e.g., if a strike-price adjustment feature ceases to apply upon exercise of the contract).
-
A modification of one of the instrument’s terms or conditions (e.g., the parties amend the terms of a contract to specify that the entity is not required to net cash settle the contract in case it does not have an effective registration statement).
-
A lapse in one of the instrument’s terms or conditions (e.g., immediately after an IPO if the terms provide for an adjustment to the settlement terms upon an IPO).
-
A change in the reporting entity’s functional currency.
-
Before the adoption of ASU 2020-06, a change in securities law that affects whether the entity is able to deliver registered shares without any further timely filing or registration requirements.
-
Before the adoption of ASU 2020-06, a change in securities law that affects whether the entity is able to deliver unregistered shares.
-
The number of authorized shares increases or decreases as a result of a vote by shareholders.
-
The entity issues previously authorized equity shares.
-
The entity enters into commitments that could require it to deliver equity shares (e.g., warrants, options, forwards, share-based payment awards, or convertible instruments).
-
The entity has an option to settle the instrument either in shares or net in cash and elects to settle the instrument net in cash.
-
An event that is within the entity’s control occurs and triggers a requirement to net cash settle the instrument.
Example 5-6
Reassessment
Entity X issues a warrant on its own common stock. The warrant meets all
conditions for equity classification in ASC 815-40
except for the requirement that the entity has
sufficient authorized and unissued shares to settle the
instrument in shares (see Section 5.3.3).
Accordingly, the warrant is classified as a liability
and accounted for at fair value with changes in fair
value recognized in earnings.
Subsequently, X’s shareholders vote to approve an amendment to its certificate
of incorporation to increase the number of authorized
shares of common stock. Entity X files a certificate of
amendment with its state of incorporation. As a result,
X reassesses its prior conclusion and determines that it
now has sufficient authorized and unissued shares to
cover all its outstanding commitments to issue shares.
Entity X should therefore determine the fair value of
the warrant as of the date that the number of authorized
and unissued shares increased and recognize through
earnings any change in the fair value of the instrument
that had not been previously recognized up to that date.
The updated fair value carrying amount would be
reclassified from liabilities to equity.
A reassessment is required irrespective of whether the event that causes an equity classification condition to be met or no longer met is within the entity’s control (i.e., a reassessment is required once such an event occurs).
At the 2005 AICPA Conference on Current SEC and PCAOB Developments, the SEC
staff reiterated the requirement to continually reassess the classification of
equity-linked instruments. The staff presented an example of a contract that
requires settlement in a variable number of shares and in which the number of
shares to be delivered upon settlement is not limited. The staff concluded that
a company could not classify this uncapped contract within equity and that the
issuance of the uncapped contract could cause other instruments to fail the
criteria to be classified within equity.
Example 5-7
Continual Reassessment
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 have a 10-year term and are
exercisable at any time. However, the terms of the
warrants specify that if there is a change in control of
X at any time during the 18-month period after the
warrants’ issuance date, the exercise price of the
warrants is reduced to $1 per share.
The warrants are not considered indexed to X’s stock
because the adjustment in the event of a change in
control is inconsistent with the inputs used in the
pricing (fair value measurement) of a fixed-for-fixed
option on equity shares. However, when the provision
that may result in an adjustment to the exercise price
lapses (i.e., 18 months after the issuance date), X
should reconsider, as of that date, whether the warrants
should be treated as indexed to its own stock.
5.4.2 Sequencing Policy
One of the conditions for equity classification is that the entity have
sufficient authorized and unissued shares available after considering all other
commitments that may require it to deliver shares during the maximum period the
instrument could remain outstanding (see Section 5.3.3). Therefore, the entity may need
to reassess its classification of existing equity-linked instruments if it
issues shares, enters into new commitments to deliver shares, or reduces the
number of authorized shares. To determine whether the entity has sufficient
authorized and unissued shares available to share settle equity-linked
instruments being evaluated under ASC 815-40-25, the entity should adopt a
“sequencing policy” (also known as “reclassification policy” or “contract
ordering policy”) as an accounting policy election and disclose such policy
under ASC 235. The sequencing policy should be systematic and rational (i.e.,
understandable and reasonable) as well as consistently applied (i.e., the entity
must use the same sequencing policy for all instruments within the scope of the
guidance).
One acceptable sequencing policy would be for an entity to perform the following
two steps to evaluate whether equity-linked instruments, or portions of such
instruments, should be initially classified as equity or later reclassified from
equity to an asset or a liability:
-
Step 1 — Determine whether outstanding equity-linked instruments have overlapping settlement opportunities with respect to their exercise periods or settlement dates.In step 1, the entity determines whether the outstanding commitments to deliver shares have overlapping settlement opportunities with respect to their exercise periods or settlement dates. (For commitments with early settlement date provisions, the entity should consider the earliest possible settlement date.) If the settlement opportunities in the commitments do not overlap, the instrument with the earlier exercise date or settlement date would be considered first with regard to the availability of shares for settlement. If an entity determines in step 1 that two or more commitments have overlapping exercise periods or settlement dates, the entity should proceed to step 2.
-
Step 2 — Apply a sequencing policy to determine which equity-linked instruments, or portions of such instruments, if any, qualify as equity.In step 2, the entity applies a sequencing policy under ASC 815-40-35-11 through 35-13 to determine which equity-linked instruments, or portions of such instruments, qualify as equity.ASC 815-40-35-12 lists several permissible methods of reclassification:
-
Partial reclassification of all contracts on a proportionate basis.
-
Reclassification of contracts with the earliest inception date first (i.e., first in, first out).
-
Reclassification of contracts with the earliest maturity date first.
-
Reclassification of contracts with the latest inception or maturity date first.
-
Reclassification of contracts with the latest maturity date first.
-
An entity should also consider any legal priority specified in the contracts’
terms. If an instrument has dedicated shares under a legally enforceable share
reservation clause, the instrument may be exempt from the sequencing exercise if
the dedicated shares would have highest priority, thereby ensuring share
settlement of the contract. In this case, the entity should subtract shares
related to the reservation clause from shares available for equity-settled
instruments before assessing share sufficiency for all remaining instruments.
Because this is a legal, rather than an accounting, consideration, it may
require the involvement of a legal specialist.
5.4.3 Commitments to Deliver a Potentially Unlimited Number of Shares
Some commitments may not explicitly limit the potential number of shares an entity could be required to deliver. In this case, the commitment could result in an obligation to deliver a potentially unlimited number of equity shares upon settlement. Examples of such commitments, which may fall outside the scope of ASC 815-40, include:
- A net-share-settled written put option or forward repurchase contract on an entity’s own stock (see ASC 480).
- An obligation to issue a variable number of shares worth a fixed monetary amount (see ASC 480).
- An obligation to issue a variable number of shares indexed to something other than the entity’s own stock (e.g., the price of gold) (see ASC 480 and ASC 815-40-15-7F).
- Share-settled interest deferral features in certain hybrid debt securities.
When an entity enters into a commitment that may require it to deliver a
potentially unlimited number of shares, it is possible that other equity-linked
instruments no longer meet the condition that the entity has sufficient
authorized and unissued shares to share settle the instrument. Nevertheless, an
entity is not necessarily precluded from classifying any or all of its other
instruments as equity. To determine whether share settlement is within the
entity’s control for equity-linked instruments other than the unlimited
contract, the entity should apply its sequencing policy. Such a policy may
indicate that sufficient authorized and unissued shares are available to share
settle some or all of the equity-linked instruments other than the contract that
does not limit the number of shares.
If the entity issues an uncapped contract, it would need to reevaluate the
classification of all its other outstanding equity-linked instruments classified
within equity. To do so, the entity may apply the two-step approach described in
Section 5.4.2 to
evaluate whether those other equity-linked instruments, or portions of such
instruments, should be reclassified from equity to an asset or a liability.
(Note that this Roadmap does not take a view on whether an entity is permitted
to use an approach other than this two-step approach when it has issued one or
more uncapped contracts.)
Under the two-step approach, if a commitment that might require delivery of a
potentially unlimited number of shares has an earlier exercise period or
settlement date than the equity-linked instrument being evaluated, then the
instrument being evaluated does not qualify as equity until the contract with
the potentially unlimited number of shares has been settled. If several
equity-linked instruments are currently exercisable and the entity could not be
forced to settle the uncapped contract first, the entity should apply its
sequencing policy to determine which equity-linked instruments, or portions of
such instruments, qualify as equity.
However, equity classification of other equity-linked instruments may be
appropriate under the two-step approach if the other instruments will be settled
before the earliest possible date that the uncapped contract can be settled
(provided that these instruments meet all the criteria for equity
classification), or upon expiration of the uncapped contract. For example, if an
entity has an accounting policy of reclassifying contracts with the latest
inception or maturity date first, equity-linked instruments with an inception or
maturity date earlier than the unlimited contract would remain classified in
equity as long as the entity has a sufficient number of authorized and unissued
shares available to allow delivery under those instruments.
Example 5-8
Two-Step Approach: Latest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the latest maturity date first. Thus, any available shares are allocated first to contracts with the earliest maturity date. Entity A has two million shares of common stock authorized, with 200,000 shares unissued and a stock price of $25.
On January 1, 20X7, A acquires assets from Entity B and, as consideration, enters into a contract to provide a variable number of common shares of its stock to B in the amount of $2.5 million on December 31, 20X7.
On April 1, 20X7, A enters into a written call option contract to sell 150,000 shares of its stock to Entity C at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement, as determined by A. The call option expires on June 30, 20X7.
While the contract with B could require a potentially unlimited number of shares to be delivered by A, if A applies its sequencing policy only to contracts with overlapping settlement opportunities with respect to their exercise periods or settlement dates (as discussed in Section 5.4.2), it does not need to consider the contract with B in determining whether the call option qualifies for equity classification because the contract with B can be settled only after the entire term of the call option.
Under a sequencing policy that reclassifies contracts with the latest maturity date first, available shares are
allocated to contracts in order of increasing maturity dates. That is, the 200,000 available shares are first
compared with the potential share delivery requirement of 150,000 under the written call option contract
that matures on June 30, 20X7, since that contract has the earliest maturity date. Given the greater number
of available shares compared with the share delivery requirement (200,000 vs. 150,000), A would be able to
conclude that there are sufficient shares available to share settle the written call option contract and that it
has 50,000 remaining shares available to share settle other contracts with a later maturity date. Because of
the unlimited contract with B that matures on December 31, 20X7, however, A would be unable under this
sequencing policy to assert that it has any shares available to share settle contracts with a maturity date after
December 31, 20X7. The contract with B is not eligible for equity classification because of the unlimited share
exposure; nor is it eligible for partial classification in equity.
Example 5-9
Two-Step Approach: Earliest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the earliest maturity date first. Thus, any available shares are allocated first to contracts with the latest maturity date. Entity A has two million shares of common stock authorized with 200,000 shares unissued and a stock price of $25.
On January 1, 20X4, A enters into a six-month written call option contract to sell 150,000 shares of its stock to Entity B at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement as determined by A. The call option can be exercised at any time and expires on June 30, 20X4.
On April 1, 20X4, A issues a hybrid convertible debt instrument to Entity C with interest payments due quarterly. Entity A has the option to defer its scheduled interest payment, but such a deferral triggers an obligation to share settle all deferred interest after five years unless previously paid. Since any deferred interest will result in a fixed-dollar payable settled in a variable number of shares, this feature has the potential to result in the issuance of an unlimited number of shares.
Because the exercise period of the written call option (January 1, 20X4, to June 30, 20X4) does not overlap with the earliest possible settlement date of the share-settled interest payment (April 1, 20X9), the 200,000 available shares would first be allocated to the written call option before consideration of the potentially unlimited number of shares associated with the hybrid convertible debt instrument. Entity A would apply its sequencing policy only if the exercise periods or settlement dates overlap.
5.5 Application of the Equity Classification Conditions to Certain Convertible Debt Instruments
ASC 815-40
25-39 For purposes of evaluating under paragraph 815-15-25-1 whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the requirements of paragraphs 815-40-25-7 through 25-35 and 815-40-55-2 through 55-6 do not apply if the hybrid contract is a conventional convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-39
For purposes of evaluating under paragraph
815-15-25-1 whether an embedded derivative indexed
to an entity’s own stock would be classified in
stockholders’ equity if freestanding, the
requirements of paragraphs 815-40-25-7 through
25-30 and 815-40-55-2 through 55-6 do not apply if
the hybrid contract is a convertible debt
instrument in which the holder may only realize
the value of the conversion option by exercising
the option and receiving the entire proceeds in a
fixed number of shares or the equivalent amount of
cash (at the discretion of the issuer).
25-40 However, the requirements of paragraphs 815-40-25-7 through 25-35 and 815-40-55-2 through 55-6 do apply if an issuer is evaluating whether any other embedded derivative is an equity instrument and thereby excluded from the scope of Subtopic 815-10.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-40 However, the requirements of
paragraphs 815-40-25-7 through 25-30 and
815-40-55-2 through 55-6 do apply if an issuer is
evaluating whether any other embedded derivative
is an equity instrument and thereby excluded from
the scope of Subtopic 815-10.
25-41 Instruments that provide
the holder with an option to convert into a fixed number of
shares (or equivalent amount of cash at the discretion of
the issuer) for which the ability to exercise the option is
based on the passage of time or a contingent event shall be
considered conventional for purposes of applying this
Subtopic. Standard antidilution provisions contained in an
instrument do not preclude a conclusion that the instrument
is convertible into a fixed number of shares.
Pending Content (Transition Guidance: ASC
815-40-65-1)
25-41 Instruments that provide the
holder with an option to convert into a fixed
number of shares (or equivalent amount of cash at
the discretion of the issuer) for which the
ability to exercise the option is based on the
passage of time or a contingent event shall
qualify for the exceptions included in paragraph
815-40-25-39. Standard antidilution provisions
contained in an instrument do not preclude a
conclusion that the instrument is convertible into
a fixed number of shares.
25-42 Convertible preferred
stock with a mandatory redemption date may qualify for the
exception included in paragraph 815-40-25-39 if the economic
characteristics indicate that the instrument is more akin to
debt than equity. An entity shall consider the guidance in
paragraph 815-15-25-17 in assessing whether the instrument
is more akin to debt or equity. That paragraph explains
that, if the preferred stock is more akin to equity than
debt, an equity conversion feature would be clearly and
closely related to that host instrument.
ASC 815-40 — Glossary
Equity Restructuring
A nonreciprocal transaction between an entity and its shareholders that causes
the per-share fair value of the shares underlying an option
or similar award to change, such as a stock dividend, stock
split, spinoff, rights offering, or recapitalization through
a large, nonrecurring cash dividend.
Standard Antidilution Provisions
Standard antidilution provisions are those that result in adjustments to the
conversion ratio in the event of an equity restructuring
transaction that are designed to maintain the value of the
conversion option.
The conditions in ASC 815-40-25-10 (see Section 5.3) do not apply to an embedded
conversion option if the holder is only able to realize the option’s value by
exercising it “and receiving the entire proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of the issuer).” Thus, a conversion
option in such a convertible debt instrument may fail to meet one or more of those
conditions and still qualify for the own-equity scope exception to the derivative
accounting guidance.3 Convertible preferred stock may also qualify under this exception for
convertible debt if it has a mandatory redemption date and its economic
characteristics indicate that the instrument is more akin to debt than equity (ASC
815-40-25-42). Because of the requirement related to a mandatory redemption date,
convertible preferred securities that are redeemable only at the option of the
holder do not qualify.
For an instrument to be exempt from the conditions in ASC 815-40-25-10, the
issuer must have the ability to settle it gross by delivering a fixed number of
shares, although the issuer might alternatively elect to settle the instrument in an
equivalent amount of cash. The holder’s ability to exercise the conversion option
may be “based on the passage of time or a contingent event” (ASC 815-40-25-41).
The following are examples of convertible debt instruments that do not qualify
for the exemption because the number of shares to be delivered upon conversion is
not fixed:
-
A convertible debt instrument that contains a down-round provision that reduces the conversion price if the issuer offers new shares to the market at an issuance price lower than the conversion price in the convertible debt (see Section 4.3.7.2).
-
A convertible debt instrument that contains a make-whole provision (other than a standard antidilution provision) that adjusts the conversion rate so that the issuer is required to deliver additional shares if it fails to meet specified debt covenants.
There is one exception to the rule requiring that the number of shares be fixed. Adjustments to the number of shares are permitted if they are considered to be “standard” antidilution provisions. Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction that are designed to maintain the value of the conversion option (ASC 815-40-20). An equity restructuring transaction is a nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying a contract to change.
Examples of Adjustment to the Conversion Price | Type of Antidilution Provision |
---|---|
Subdivision (stock split, stock dividend) | Standard |
Combination (reverse stock split) of outstanding common shares | Standard |
Issuance of common shares at a lower price than the conversion price in effect immediately before such issuance | Nonstandard |
Recurring quarterly cash dividend to all common shareholders | Nonstandard |
Recapitalization through a large nonrecurring cash dividend | Standard |
In assessing whether a convertible instrument qualifies for this exemption, an
entity does not need to evaluate whether the circumstances that are identified in
ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through 55-6 could cause the issuer
to net cash settle the conversion option. This is because the purpose of the
exception for certain convertible debt is to exempt entities from the requirement to
evaluate whether the conditions in those paragraphs are met. In other words, even if
the conditions specified in one of those paragraphs could result in a cash
settlement outside the issuer’s control, the convertible debt might still qualify
for the exemption. Accordingly, contractual terms that require cash settlement in
the following situations do not preclude a convertible instrument from qualifying
for the exemption:
-
The contract requires settlement in registered shares. If registered shares are unavailable, then the contract is settled in cash. (Note, however, that ASU 2020-06 removes this condition from ASC 815-40-25-10.)
-
The contract requires the issuer to make cash payments to the counterparty in the event the issuer fails to make timely filings with the SEC.
-
The contract includes cash-settled top-off or make-whole provisions that require the issuer to make cash payments to the counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due.
-
The contract requires the issuer to cash settle the contract upon a change in control.
-
The contract requires the issuer to cash settle the contract upon bankruptcy.
Although the equity classification conditions in ASC 815-40-25-10 do not apply
to convertible debt that is eligible for the exemption, an entity still needs to be
satisfied that the other conditions for equity classification are met before it can
conclude that the embedded conversion option qualifies as equity. For example, such
convertible debt is not exempted from the guidance on indexation in ASC 815-40-15
(see Chapter 4). If the entity
could be forced to net cash settle the embedded conversion option upon (1) the
occurrence of an event not discussed in ASC 815-40-25-7 through 25-35 or ASC
815-40-55-2 through 55-6 or (2) only the passage of time, the convertible debt does
not qualify for the exemption, and the conversion option does not qualify as equity
(see Section 5.2). If the
embedded conversion option does not qualify as equity, the entity is generally
required to separate the conversion option as an embedded derivative under ASC
815-15 (see Section 2.2).
Footnotes
3
Before the amendments made by ASU 2020-06, ASC 815-40
described convertible debt that qualifies for this exemption as
“conventional convertible debt.” However, ASU 2020-06 removes this term from
ASC 815-40.