Chapter 6 — Initial and Subsequent Accounting
Chapter 6 — Initial and Subsequent Accounting
This chapter discusses the initial and subsequent
accounting for equity-linked instruments, as follows:
-
Freestanding equity-classified instruments (see Section 6.1), including:
-
Initial and subsequent measurement (see Section 6.1.1).
-
Reclassifications (see Section 6.1.2).
-
Settlements (see Section 6.1.3).
-
Modifications or exchanges (see Section 6.1.4).
-
Down-round features (see Section 6.1.5).
-
Own-share lending arrangements entered into on an entity’s own equity in connection with a convertible debt issuance (see Section 6.1.6).
-
-
Freestanding instruments indexed to own equity and classified as assets or liabilities (see Section 6.2), including:
-
Initial and subsequent measurement (see Section 6.2.1).
-
Reclassifications (see Section 6.2.2).
-
Settlements (see Section 6.2.3).
-
Modifications or exchanges (see Section 6.2.4).
-
Standby equity purchase agreements (see Section 6.2.5).
-
-
Freestanding instruments not indexed to own equity (see Sections 6.2 and 6.3).
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Embedded features (see Section 6.4).
-
Fair value measurements (see Section 6.5).
6.1 Freestanding Equity-Classified Instruments
6.1.1 Initial and Subsequent Measurement
ASC 815-40
30-1 All contracts within the
scope of this Subtopic shall be initially measured at
fair value.
35-1 All contracts shall be subsequently accounted for based on the current classification and the assumed or required settlement method in Section 815-40-25 as follows.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-1 All contracts shall
be subsequently accounted for based on the current
classification and the assumed or required
settlement method in Section 815-40-15 or Section
815-40-25 as follows.
Equity Instruments — Permanent Equity
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.
Subsequent changes in fair value shall not be recognized
as long as the contracts continue to be classified as
equity . . . .
If an entity concludes that a freestanding equity-linked instrument qualifies as
equity under ASC 815-40, the entity recognizes the instrument by recording an
entry to additional paid-in capital (APIC) in stockholders’ equity in its
balance sheet. Such an instrument would be initially measured at its fair value.
If the instrument is issued as part of a larger transaction (i.e., one involving
multiple units of account), allocation of the transaction proceeds may be
necessary. ASC 470-20 requires allocation of proceeds on a relative fair value
basis when a debt instrument is issued with equity-classified detachable stock
purchase warrants. ASC 470-20-25-2 states:
Proceeds from the
sale of a debt instrument with stock purchase warrants (detachable call
options) shall be allocated to the two elements based on the relative fair
values of the debt instrument without the warrants and of the warrants
themselves at time of issuance. The portion of the proceeds so allocated to
the warrants shall be accounted for as paid-in capital. The remainder of the
proceeds shall be allocated to the debt instrument portion of the
transaction. This usually results in a discount (or, occasionally, a reduced
premium), which shall be accounted for under Topic 835.
Example 6-1
Initial and Subsequent Measurement
Entity A issues a debt security with a detachable equity-classified warrant for
total proceeds of $19.5 million. Entity A does not elect
to account for the debt at fair value under the fair
value option in ASC 825-10. At the time of issuance, a
third-party valuation specialist estimates the fair
value of the debt to be $18 million and the fair value
of the warrant to be $2 million. In this case, A
allocates $17.55 million of the proceeds to the debt, or
$18 million ÷ ($18 million + $2 million) × $19.5
million, and $1.95 million of the proceeds to the
warrant, or $2 million ÷ ($18 million + $2 million) ×
$19.5 million. Accordingly, the initial carrying amount
of the debt is $17.55 million and the initial carrying
amount of the warrant is $1.95 million.
A relative fair value allocation approach is also appropriate for other types of
freestanding equity-classified instruments that are issued together with debt or
stock that is not accounted for at fair value on a recurring basis (e.g., a
detachable warrant issued with preferred stock). For example, if debt contains
an embedded derivative that is required to be separated under ASC 815-15 (e.g.,
certain embedded put or call options), the allocation of proceeds between the
contract on the entity’s own equity and the debt is performed on a relative fair
value basis before the allocation of proceeds between the debt host contract and
the embedded derivative.
However, if an entity issues a freestanding equity-classified instrument
together with another financial instrument that is subsequently measured at fair
value, with changes in fair value recognized in earnings (e.g., debt for which
the fair value option in ASC 825-10 is elected), the entity should allocate (1)
an amount of the proceeds equal to the fair value of the instrument subsequently
measured at fair value and (2) the remaining amount to the equity-classified
freestanding instrument. The initial carrying amount assigned to the
equity-classified instrument would then be the difference between the total
proceeds received and the fair value of the instrument subsequently measured at
fair value. This method of allocating proceeds, sometimes referred to as a
“with-and-without” method, avoids the recognition of a gain or a loss caused
solely by the allocation model. It is similar to the method of allocating the
basis of a hybrid instrument between a host contract and an embedded derivative
under ASC 815 (see ASC 815-15-30-2). See further discussion in Section 6.2.1.
The initial carrying amount of a freestanding equity-classified
instrument includes the associated issuance costs. When a freestanding
equity-classified instrument is issued as part of a transaction that includes
the issuance of other financial instruments that are not measured at fair value
on a recurring basis, the issuance costs may be allocated on a relative fair
value basis in a manner consistent with the allocation of proceeds. Section 6.2.1 further
discusses the concept of issuance costs and the accounting when a freestanding
equity-classified instrument is issued in conjunction with another financial
instrument that is subsequently measured at fair value, with changes in fair
value recognized in earnings.
The initial carrying amount of a freestanding equity-classified instrument is
not subsequently adjusted to fair value unless, in subsequent periods, the
instrument no longer qualifies for equity classification (e.g., the issuing
entity no longer has sufficient authorized and unissued shares) and so must be
reclassified as an asset or a liability. Special recognition and measurement
requirements apply when a down-round feature has been triggered in an
equity-classified instrument (see Section 6.1.5).
Changing Lanes
Before ASU 2020-06, freestanding equity-linked
instruments that are both (1) indexed to the reporting entity’s stock
and (2) meet the equity classification conditions are classified within
permanent equity. With the elimination of three of the equity
classification conditions in ASU 2020-06 (see Section 1.2), it is possible that
entities that have adopted ASU 2020-06 will classify a freestanding
equity-linked instrument within temporary equity. In those situations,
the classification, measurement, and EPS guidance in ASC 480-10-S99-3A
must be applied. See Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity for
more information.
6.1.2 Reclassifications
ASC 815-40
35-9 If a contract is reclassified from permanent or temporary equity to an asset or a liability, the change in fair value of the contract during the period the contract was classified as equity shall be accounted for as an adjustment to stockholders’ equity. The contract subsequently shall be marked to fair value through earnings.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-9 If a contract is
reclassified from permanent or temporary equity to
an asset or a liability, the change in fair value
of the contract during the period the contract was
classified as equity shall be accounted for as an
adjustment to stockholders’ equity. The contract
subsequently shall be marked to fair value through
earnings. If an embedded feature no longer
qualifies for the derivatives scope exception
under this Subtopic, the feature shall be
separated from its host contract and accounted for
as a derivative instrument in accordance with
Subtopic 815-10 and Subtopic 815-15 (if all of the
criteria in paragraph 815-15-25-1 are met).
An entity is required to reassess its classification of each freestanding
equity-linked instrument as of each reporting date (see Section 5.4). Reclassification of a
freestanding equity-classified instrument is required if the instrument ceases
to meet all the criteria for equity classification. If reclassification of a
freestanding equity-classified instrument is required, the instrument is
reclassified as of the date of the event or change in circumstance that caused
the reclassification at its then-current fair value. If an instrument is no
longer eligible for equity classification, the entity recognizes the adjustment
to its current fair value within stockholders’ equity before the
reclassification. Subsequent adjustments to fair value while the instrument is
an asset or a liability are recognized in the income statement.
6.1.3 Settlements
ASC 815-40
40-1 If contracts classified as permanent equity are ultimately settled in a manner that requires that the entity deliver cash, the amount of cash paid or received shall be reported as a reduction of, or an addition to, contributed capital.
If an entity settles a freestanding equity-classified instrument by delivering
or receiving shares in accordance with its original terms, the entity recognizes
the shares issued or received within equity in a manner similar to other
transactions in its own stock (see ASC 505-10 and ASC 505-30).
Sometimes an entity settles an equity-classified instrument net in cash. For
example, a written call option on the entity’s own equity may give the entity
the right to settle the instrument either net in shares or net in cash. If an
entity settles an equity-classified instrument in accordance with its original
terms through a net cash settlement by delivering cash, the amount of cash paid
is deducted from APIC. If an entity settles the instrument by receiving cash,
the amount is added to APIC.
If an entity repurchases an equity-classified instrument, the repurchase price
is generally equal to its fair value. However, if the entity pays an amount
significantly in excess of the instrument’s fair value, the excess consideration
must be associated with something other than the repurchase. If no other element
is identified for which accounting is required under GAAP, the excess
consideration is recognized either as a dividend paid to the holder or as an
expense. In determining how to recognize the excess consideration, an entity
must use judgment and consider the facts and circumstances associated with the
repurchase (such as the purpose of the excess payment) and the relationship
between the entity and the holder. If an entity is in doubt about how to treat
the excess amount, accounting for it as an expense is generally appropriate. For
further discussion, see Sections 3.2.4.3 and 3.2.5.2 of Deloitte’s Roadmap Earnings per
Share.
If an entity settles an equity-classified instrument under an inducement offer,
it should treat as a dividend or expense the additional value provided as a
result of the inducement offer, which is calculated as the fair value of all
securities and other consideration transferred in the transaction over the fair
value of the stock issuable according to the original terms of the contract. For
further discussion, see Section 3.2.5.2 of Deloitte’s Roadmap Earnings per Share and Section 12.3.4 of
Deloitte’s Roadmap Issuer’s
Accounting for Debt.
Special considerations are necessary in the accounting for redemptions of
equity-classified instruments indexed to an entity’s preferred stock. For
further discussion, see Section 3.2.5.2.2 of Deloitte’s Roadmap Earnings per
Share.
Connecting the Dots
The Inflation Reduction Act of 2022, which was signed into law on August
16, 2022, imposes a 1 percent excise tax on stock repurchases that occur
after December 31, 2022, by publicly traded companies. Specifically, a
covered corporation would be subject to a tax equal to 1 percent of (1)
the fair market value of any of its stock that it (or certain
affiliates) repurchased during any taxable year, with limited
exceptions, minus (2) the fair market value of any of its stock that it
(or certain affiliates) issued during the taxable year (including
compensatory stock issuances). The 1 percent excise tax would also be
imposed on acquisitions of stock in certain mergers or acquisitions
involving covered corporations.
Because the excise tax is not based on a measure of
income, it is not an income tax and thus is outside the scope of ASC
740. While the accounting for taxes paid in connection with the
repurchase of stock is not specifically addressed in U.S. GAAP, entities
may consider the guidance in AICPA Technical Q&As Section 4110.09,
which indicates that direct and incremental legal and accounting costs
associated with the acquisition of treasury stock may be added to the
cost of the treasury stock. Therefore, it is acceptable for an entity to
account for an excise tax obligation that results from the repurchase of
common stock classified within permanent equity as a cost of the
treasury stock transaction.
Any reductions in such excise tax obligation arising from share issuances
would also be recognized as part of the original treasury stock
transaction regardless of the nature of the share issuances. Additional
considerations are necessary when redemptions of preferred stock result
in an excise tax obligation, which would be recognized as a cost of
redeeming the preferred stock. The accounting for redemptions of
preferred stock differs depending on the classification of the preferred
stock as permanent equity, temporary equity, or a liability. An entity
that has repurchased both common stock and preferred stock during a
taxable period would need to use a systematic and rational allocation
approach to account for the effect of share issuances on the excise tax
obligation.
6.1.4 Modifications or Exchanges
6.1.4.1 Freestanding Equity-Linked Instruments That Are Classified in Equity Before and After a Modification or Exchange
6.1.4.1.1 Written Call Options
ASC 815-40
Issuer’s
Accounting for Modifications or Exchanges of
Freestanding Equity-Classified Written Call
Options
35-14 The guidance in
paragraphs 815-40-35-15 through 35-18 applies to
an issuer’s accounting for a modification of the
terms or conditions or an exchange of a
freestanding equity-classified written call option
(for example, a warrant) that remains equity
classified in accordance with this Subtopic after
the modification or exchange and is not within the
scope of another Topic. An entity shall account
for the effects of a modification or an exchange
in accordance with paragraphs 815-40-35-15 through
35-18. The disclosure requirements in paragraphs
815-40-50-5 through 50-6 and 505-10-50-3 shall
apply to a modification or an exchange of a
freestanding equity-classified written call
option. The guidance in paragraphs 815-40-35-16
through 35-17 does not apply to freestanding
equity-classified written call options that are
modified or exchanged to compensate grantees in a
share-based payment arrangement. An entity shall
recognize the effect of such modifications of
freestanding equity-classified written call
options by applying the requirements in Topic 718;
however, classification of the instrument will
remain subject to the requirements in this
Subtopic.
35-15 An entity shall
consider the circumstances of the modification or
exchange of a freestanding equity-classified
written call option to determine whether the
modification or exchange is related to a financing
or other arrangement or a multiple-element
arrangement (for example, an arrangement involving
both debt financing and equity financing). In
making that determination, an entity shall
consider all of the terms and conditions of the
modification or exchange, other transactions
entered into contemporaneously or in contemplation
of the modification or exchange, other rights and
privileges obtained or obligations incurred
(including services) as a result of the
modification or exchange, and the overall economic
effects of the modification or exchange. If the
modification or exchange is not within the scope
of another Topic, an entity shall apply the
guidance in paragraphs 815-40-35-16 through
35-18.
35-16 An entity shall treat a
modification of the terms or conditions or an
exchange of a freestanding equity-classified
written call option as an exchange of the original
instrument for a new instrument. In substance, the
entity repurchases the original instrument by
issuing a new instrument. For transactions
recognized in accordance with paragraph
815-40-35-17(c), the effect of a modification or
an exchange shall be measured as the difference
between the fair value of the modified or
exchanged instrument and the fair value of that
instrument immediately before it is modified or
exchanged. For all other transactions recognized
in accordance with paragraph 815-40-35-17, the
effect of a modification or an exchange shall be
measured as the excess, if any, of the fair value
of the modified or exchanged instrument over the
fair value of that instrument immediately before
it is modified or exchanged. In a multiple-element
transaction, the total effect of the modification
or exchange shall be allocated to the respective
elements in the transaction.
35-17 An entity shall
recognize the effect of a modification or an
exchange (calculated in accordance with paragraph
815-40-35-16) in the same manner as if cash had
been paid as consideration, as follows:
- Equity issuance. An entity shall recognize the effect of a modification or an exchange that is directly attributable to a proposed or actual equity offering as an equity issuance cost. For additional guidance see SAB Topic 5.A, Expenses of Offering (paragraph 340-10-S99-1).
- Debt origination. An entity shall recognize the effect of a modification or an exchange that is a part of or directly related to an issuance of a debt instrument as a debt discount or debt issuance cost in accordance with the guidance in Topic 835 on interest.
- Debt modification. An entity shall recognize the effect of a modification or an exchange that is a part of or directly related to a modification or an exchange of an existing debt instrument in accordance with the guidance in Subtopic 470-50 on debt modifications and extinguishments and Subtopic 470-60 on troubled debt restructurings by debtors.
- Other. An entity shall recognize the effect of a modification or an exchange that is not related to a financing transaction in (a) through (c) and is not within the scope of any other Topics (such as Topic 718) as a dividend. Additionally, for an entity that presents earnings per share (EPS) in accordance with Topic 260, that effect shall be treated as a reduction of income available to common stockholders in basic earnings per share in accordance with the guidance in paragraph 260-10-45-15.
35-18 Example 22 (see
paragraphs 815-40-55-49 through 55-52) illustrates
the application of the guidance in paragraphs
815-40-35-14 through 35-17.
A modification or exchange of a freestanding
equity-classified written call option that remains equity classified
after the modification or exchange is accounted for by recognizing “the
excess, if any, of the fair value of the modified or exchanged
instrument over the fair value of that instrument immediately before it
is modified or exchanged . . . on the basis of the substance of the
transaction, in the same manner as if cash had been paid as
consideration.” Accordingly, an entity accounts for any incremental fair
value provided to the counterparty in a modification or exchange of an
equity-classified written call option. The accounting applied depends on
the reason for the modification or exchange (e.g., whether other
transactions were entered into contemporaneously or in contemplation of
the modification or exchange of the option, and whether any other rights
or privileges were exchanged). An entity therefore accounts for the
effect of the modification or exchange in the same manner as if cash had
been paid as consideration. Such effect is measured as the difference
between the option’s fair value immediately before and immediately after
the modification or exchange. The table below summarizes how to apply
this guidance in different scenarios.
Transaction
|
Accounting for Incremental Fair
Value
|
Guidance
|
---|---|---|
Financing transaction to issue
equity (ASC 815-40-35-17(a))
|
Treat the amount as equity
issuance cost.
|
ASC 340-10-S99-1
|
Financing transaction to issue
debt (ASC 815-40-35-17(b))
|
If the instrument is held by the
creditor, treat the amount as a debt discount. If
the instrument is held by a third party, treat the
amount as a debt issuance cost.
|
ASC 835-30
|
Nontroubled debt modification or
exchange (ASC 815-40-35-17(c))
|
If the instrument is held by the
creditor, treat the amount as day 1 cash flow in
the performance of the 10 percent test and as a
fee paid to the creditor in the accounting for the
modification or exchange. If the instrument is
held by a third party, treat the amount as a
third-party cost in the accounting for the
modification or exchange.
|
ASC 470-50
|
Troubled debt restructuring (ASC
815-40-35-17(c))
|
If the instrument is held by the
creditor, treat the amount as a fee paid to the
creditor. If the instrument is held by a third
party, treat the amount as a third-party cost.
|
ASC 470-60
|
Other
|
Treat the amount in accordance
with other GAAP (e.g., ASC 606 or ASC 718). If the
transaction is not within the scope of other GAAP,
recognize as a dividend under ASC 260-10.
|
Other relevant topics or
subtopics
|
ASC 815-40-35-17 specifies that an entity should
recognize as a dividend the effect of a modification or exchange that is
not related to a financing transaction and is not within the scope of
other GAAP (e.g., ASC 606 or ASC 718). However, an entity cannot assume
that dividend recognition is appropriate for a transaction that is not
specifically mentioned in ASC 815-40-35-17. Rather, it must carefully
consider the related facts and circumstances and the substance of the
transaction. Generally, the recognition of an expense is appropriate if
the modification or exchange of the option represents compensation for
other stated or unstated transaction elements (e.g., a standstill
agreement or settlement of litigation). Paragraph BC19 of ASU 2021-04
states:
Additionally, the Task Force noted that if
a modification or an exchange is executed in exchange for an
agreement by the holder of the written call option to abandon
certain acquisition plans, forgo other planned transactions, settle
litigation, settle employment contracts, or voluntarily restrict its
purchase of shares of the issuing entity or the issuing entity’s
affiliates within a stated time period, those rights and privileges
obtained, both stated and unstated, or other elements of the
transaction should be accounted for according to their substance
(that is, as a cost to the issuing entity) rather than as a dividend
distribution.
If the modification or exchange involves more than one
of the categories identified above (i.e., it involves multiple
elements), the amount is allocated among those categories.
6.1.4.1.2 Other Instruments
ASC 815-40 only addresses the accounting for a modification or exchange
of a freestanding equity-classified written call option that remains
classified in equity after the modification or exchange. In the absence
of other directly applicable guidance, when a freestanding equity-linked
instrument other than a written call option is modified or exchanged,
and such instrument is classified in equity before and after the
modification or exchange, an entity would analogize to the guidance in
ASC 815-40 to determine whether it is necessary to reflect the
modification or exchange for accounting purposes.1 That is, an entity calculates the difference between (1) the fair
value of the instrument immediately before the modification or exchange
and (2) the fair value of the instrument immediately after the
modification or exchange. If the change in fair value is unfavorable to
the entity, the entity recognizes such change as an adjustment to the
carrying amount of the equity-classified instrument. The entity does not
recognize a fair value change that is favorable to it. Thus, the entity
does not recognize a gain if either (1) there is a fair value increase
and the instrument is a purchased call option on the entity’s own stock
or (2) there is a fair value decrease and the instrument is a written
call option on the entity’s own stock. However, the entity does
recognize any fair value change that is unfavorable to it. For example,
if the fair value of a purchased call option declines as a result of a
modification or exchange, the entity recognizes that fair value decline
in the same manner as a fair value increase that is unfavorable to the
entity.
If no other element is identified for which accounting
is required under GAAP, the entity must recognize the unfavorable change
in fair value either as a deemed dividend paid to the holder or as an
expense. In determining how to recognize the unfavorable change in fair
value, the entity must use judgment and consider the facts and
circumstances associated with the modification or exchange (such as its
purpose) and the relationship between the entity and the holder. Such
consideration is consistent with the guidance in ASC 815-40 that applies
to modifications or exchanges of equity-classified written call options.
For further discussion, see Section 3.2.6.4 of Deloitte’s
Roadmap Earnings
per Share.
Special considerations are necessary in the accounting
for modifications or exchanges of equity-classified instruments indexed
to an entity’s preferred stock. For more information, see Section 3.2.6.4
of Deloitte’s Roadmap Earnings per Share.
6.1.4.2 Freestanding Equity-Linked Instruments Whose Classification Changes as a Result of a Modification or Exchange
The table below discusses the accounting for a freestanding equity-linked
instrument when the classification of the instrument changes in conjunction
with a modification or exchange.
Classification
|
Accounting
| |
---|---|---|
Before Modification or Exchange
|
After Modification or Exchange
| |
Equity
|
Asset/liability
|
The entity recognizes an asset or a
liability for the fair value of the instrument
immediately after the modification or exchange
(i.e., taking into account the modification or
exchange). The offsetting entry (or entries) will
depend on whether any incremental value was
transferred to the counterparty as a result of the
modification or exchange (i.e., whether any fair
value change as a result of the modification or
exchange is unfavorable to the entity). The guidance
in Section
6.1.4.1 is applied as follows:
If no incremental
value was transferred to the counterparty, the
entity recognizes the offsetting entry in equity and
recognizes the following entry:
If incremental value
that must be expensed was transferred to the
counterparty, the entity recognizes the following
entry:
If incremental value
that represents a dividend was transferred to the
counterparty, the entity recognizes the following
entry:
If incremental value that represents something other
than an expense or a dividend was transferred to the
counterparty, the entity accounts for that element
in accordance with the facts and circumstances
(i.e., it replaces the amount recognized as an
expense or in retained earnings in the above entries
with an entry that reflects the substance of the
transaction).
In all situations, the entity records the asset or
liability at fair value and takes into account the
impact of the modification or exchange.
|
Asset/liability
|
Equity
|
The entity first adjusts the fair value of the asset
or liability immediately before the modification or
exchange (i.e., ignoring the impact of the
modification or exchange) and recognizes the
offsetting entry in earnings.
Next, the entity evaluates whether
any incremental value was transferred to the
counterparty as a result of the modification or
exchange (i.e., whether any fair value change as a
result of the modification or exchange is
unfavorable to the entity). The guidance in
Section
6.1.4.1 is applied as follows:
If no incremental
value was transferred to the counterparty, the
entity reclassifies the fair value of the asset or
liability to equity and recognizes the following
entry:
If incremental value
that must be expensed was transferred to the
counterparty, the entity recognizes the following
entry:
If incremental value
that represents a dividend was transferred to the
counterparty, the entity recognizes the following
entry:
If incremental value that represents something other
than an expense or a dividend was transferred to the
counterparty, the entity accounts for that element
in accordance with the facts and circumstances
(i.e., it replaces the amount recognized as an
expense or in retained earnings in the above entries
with an entry that reflects the substance of the
transaction).
In all situations, the amount of the asset or
liability that is derecognized is equal to the fair
value of such instrument immediately before the
modification or exchange.
|
Section 6.2.4 addresses the accounting
for a modification or exchange of an equity-linked instrument that is
classified as an asset or a liability before and after a modification or
exchange.
6.1.5 Down-Round Features
ASC Master Glossary
Down Round Feature
A feature in a financial instrument that
reduces the strike price of an issued financial
instrument if the issuer sells shares of its stock for
an amount less than the currently stated strike price of
the issued financial instrument or issues an
equity-linked financial instrument with a strike price
below the currently stated strike price of the issued
financial instrument.
A down round feature may reduce the
strike price of a financial instrument to the current
issuance price, or the reduction may be limited by a
floor or on the basis of a formula that results in a
price that is at a discount to the original exercise
price but above the new issuance price of the shares, or
may reduce the strike price to below the current
issuance price. A standard antidilution provision is not
considered a down round feature.
ASC 260-10
05-1A An entity may issue a
freestanding financial instrument (for example, a
warrant) with a down round feature that is classified in
equity. This Subtopic provides guidance on earnings per
share and recognition and measurement of the effect of a
down round feature when it is triggered.
25-1 An entity that presents
earnings per share (EPS) in accordance with this Topic
shall recognize the value of the effect of a down round
feature in an equity-classified freestanding financial
instrument (that is, instruments that are not
convertible instruments) when the down round feature is
triggered. That effect shall be treated as a dividend
and as a reduction of income available to common
stockholders in basic earnings per share, in accordance
with the guidance in paragraph 260-10-45-12B. See
paragraphs 260-10-55-95 through 55-97 for an
illustration of this guidance.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
Financial Instruments That
Include a Down Round Feature
25-1 An entity that presents earnings
per share (EPS) in accordance with this Topic
shall recognize the value of the effect of a down
round feature in an equity-classified freestanding
financial instrument and an equity-classified
convertible preferred stock (if the conversion
feature has not been bifurcated in accordance with
other guidance) when the down round feature is
triggered. That effect shall be treated as a
dividend and as a reduction of income available to
common stockholders in basic earnings per share,
in accordance with the guidance in paragraph
260-10-45-12B. See paragraphs 260-10-55-95 through
55-97 for an illustration of this guidance.
30-1 As of the date that a down
round feature is triggered (that is, upon the occurrence
of the triggering event that results in a reduction of
the strike price) in an equity-classified freestanding
financial instrument, an entity shall measure the value
of the effect of the feature as the difference between
the following amounts determined immediately after the
down round feature is triggered:
-
The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
-
The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
30-1 As of the date that a
down round feature is triggered (that is, upon the
occurrence of the triggering event that results in
a reduction of the strike price) in an
equity-classified freestanding financial
instrument and an equity-classified convertible
preferred stock (if the conversion feature has not
been bifurcated in accordance with other
guidance), an entity shall measure the value of
the effect of the feature as the difference
between the following amounts determined
immediately after the down round feature is
triggered:
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
30-2 The fair values of the
financial instruments in paragraph 260-10-30-1 shall be
measured in accordance with the guidance in Topic 820 on
fair value measurement. See paragraph 260-10-45-12B for
related earnings per share guidance and paragraphs
505-10-50-3 through 50-3A for related disclosure
guidance.
35-1 An entity shall recognize
the value of the effect of a down round feature in an
equity-classified freestanding financial instrument each
time it is triggered but shall not otherwise
subsequently remeasure the value of a down round feature
that it has recognized and measured in accordance with
paragraphs 260-10-25-1 and 260-10-30-1 through 30-2. An
entity shall not subsequently amortize the amount in
additional paid-in capital arising from recognizing the
value of the effect of the down round feature.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-1 An entity shall
recognize the value of the effect of a down round
feature in an equity-classified freestanding
financial instrument and an equity-classified
convertible preferred stock (if the conversion
feature has not been bifurcated in accordance with
other guidance) each time it is triggered but
shall not otherwise subsequently remeasure the
value of a down round feature that it has
recognized and measured in accordance with
paragraphs 260-10-25-1 and 260-10-30-1 through
30-2. An entity shall not subsequently amortize
the amount in additional paid-in capital arising
from recognizing the value of the effect of the
down round feature.
45-12B For a freestanding
equity-classified financial instrument with a down round
feature, an entity shall deduct the value of the effect
of a down round feature (as recognized in accordance
with paragraph 260-10-25-1 and measured in accordance
with paragraphs 260-10-30-1 through 30-2) in computing
income available to common stockholders when that
feature has been triggered (that is, upon the occurrence
of the triggering event that results in a reduction of
the strike price).
Pending Content (Transition
Guidance: ASC 815-40-65-1)
45-12B For a freestanding
equity-classified financial instrument and an
equity-classified convertible preferred stock (if
the conversion feature has not been bifurcated in
accordance with other guidance) with a down round
feature, an entity shall deduct the value of the
effect of a down round feature (as recognized in
accordance with paragraph 260-10-25-1 and measured
in accordance with paragraphs 260-10-30-1 through
30-2) in computing income available to common
stockholders when that feature has been triggered
(that is, upon the occurrence of the triggering
event that results in a reduction of the strike
price).
Special recognition and measurement requirements apply each time a down-round
feature in a freestanding equity-classified instrument is triggered (i.e., the
entity sells shares of its stock for an amount less than the currently stated
strike price or issues an equity-linked financial instrument with a strike price
below the currently stated strike price); see Section 4.3.7.2 for a discussion of the
definition of a down-round feature. Before the adoption of ASU 2020-06, these
requirements do not apply to convertible instruments (e.g., convertible
preferred stock) that are subject to other GAAP (e.g., if a convertible
instrument is subject to the BCF guidance in ASC 470-20, the accounting model
for contingent BCFs would be applied upon the trigger of a down-round feature).
After the adoption of ASU 2020-06, these requirements also apply to
equity-classified convertible preferred stock but not to convertible debt.
Further, issuers that do not present EPS in accordance with ASC 260 are not
required to apply the guidance. If an entity that is not required to present EPS
elects voluntarily to disclose EPS in its financial statements, however, the
guidance applies.
When the strike price of an equity-classified instrument is reduced in
accordance with the terms of a down-round feature, the issuer is required to
determine the amount of value that was transferred to the holder through the
strike price adjustment, but the issuer does not use the change in the fair
value of the entire instrument to compute that amount. Instead, the issuer
calculates the amount of value transferred by comparing the fair values of two
hypothetical instruments whose terms are consistent with the actual instrument,
except that the instruments do not contain a down-round feature. The strike
price of the first hypothetical instrument equals the strike price of the actual
instrument immediately before the strike price reduction. The strike price of
the second hypothetical instrument equals the strike price immediately after the
down-round feature is triggered. The value transferred is the difference between
the fair values of the two hypothetical instruments. The issuer determines those
fair values on the basis of the conditions immediately after the down-round
feature is triggered by using the fair value measurement guidance in ASC
820.
Further, the issuer recognizes the value transferred as a reduction of retained
earnings and as an increase in APIC (i.e., as a deemed dividend). The transfer
of value is reflected as a deduction to income available to common stockholders
in the basic EPS calculation.
In addition, an entity that applies the special recognition and measurement
guidance in ASC 260-10 to a down-round feature that was triggered during the
reporting period must, under ASC 505-10-50-3A, disclose (1) the fact that the
down-round feature has been triggered and (2) the amount of value
transferred.
Example 6-2
Down-Round
Feature
On January 1, 2017, Entity A grants warrants to Investor X to acquire A’s common shares. The warrants have an exercise price of $3.00 per share, subject to adjustment if A issues new shares of its common stock. If A issues new shares of its common stock for less than $3.00 per share, the exercise price is adjusted to that issue price. In accordance with ASC 815-40, A evaluated the warrants and concluded that they should be classified in equity since (1) they are considered indexed to the entity’s own stock if the down-round provision is disregarded and (2) settleable in the issuer’s shares. On July 1, 2017, A issues new shares of its common stock to Investor Y at a price of $2.50 per share. Accordingly, the exercise price of the warrants is adjusted from $3.00 to $2.50.
On July 1, 2017, A would determine the value transferred to X as the difference
between the fair values of two hypothetical instruments
with terms similar to those of the actual warrants,
except that the instruments contain no down-round
feature. The only difference between the two
hypothetical instruments is that one has an exercise
price of $2.50 and the other has an exercise price of
$3.00. Entity A would recognize the value transferred as
a reduction in retained earnings, with an offsetting
increase to the carrying value of the warrants in APIC.
The amount would also be reflected as a reduction to the
income available to common stockholders in the basic EPS
calculation.
Because the amount of the value transferred reduces income available to common
stockholders in the basic EPS calculation, an entity may be required to adjust
the diluted EPS calculation. In computing diluted EPS, an entity applies the
treasury stock method if the option or warrant is dilutive. Under the treasury
stock method, options and warrants are assumed to be exercised as of the
beginning of the period. An entity therefore assumes that options or warrants
are exercised before the trigger of the down-round feature. Accordingly, as
noted in ASC 260-10-55-97, the amount of value transferred that has been
deducted from basic EPS is added back to income available for common
stockholders in the calculation of diluted EPS if the option or warrant is
dilutive. ASC 260-10-45-25 notes that warrants or options have a dilutive effect
under the treasury stock method if the options or warrants are in-the-money
(i.e., “the average market price of the common stock during the period exceeds
the exercise price of the options or warrants”).
ASC 260-10
Example 16:
Equity-Classified Freestanding Financial
Instruments That Include a Down Round
Feature
55-95 Assume Entity A issues
warrants that permit the holder to buy 100 shares of its
common stock for $10 per share and that Entity A
presents EPS in accordance with the guidance in this
Topic. The warrants have a 10-year term, are exercisable
at any time, and contain a down round feature. The
warrants are classified as equity by Entity A because
they are indexed to the entity’s own stock and meet the
additional conditions necessary for equity
classification in accordance with the guidance in
Subtopic 815-40 on derivatives and hedging—contracts in
entity’s own equity (see paragraphs 815-40-55-33 through
55-34A for an illustration of the guidance in Subtopic
815-40 applied to a warrant with a down round feature).
Because the warrants are an equity-classified
freestanding financial instrument, they are within the
scope of the recognition and measurement guidance in
this Topic. The terms of the down round feature specify
that if Entity A issues additional shares of its common
stock for an amount less than $10 per share or issues an
equity-classified financial instrument with a strike
price below $10 per share, the strike price of the
warrants would be reduced to the most recent issuance
price or strike price, but the terms of the down round
feature are such that the strike price cannot be reduced
below $8 per share. After issuing the warrants, Entity A
issues shares of its common stock at $7 per share.
Because of the subsequent round of financing occurring
at a share price below the strike price of the warrants,
the down round feature in the warrants is triggered and
the strike price of the warrants is reduced to $8 per
share.
55-96 In accordance with the
measurement guidance in paragraphs 260-10-30-1 through
30-2, Entity A determines that the fair value of the
warrants (without the down round feature) with a strike
price of $10 per share immediately after the down round
feature is triggered is $600 and that the fair value of
the warrants (without the down round feature) with a
strike price of $8 per share immediately after the down
round feature is triggered is $750. The increase in the
value of $150 is the value of the effect of the
triggering of the down round feature.
55-97 The $150 increase is the
value of the effect of the down round feature to be
recognized in equity in accordance with paragraph
260-10-25-1, as follows:
Additionally, Entity A reduces income
available to common stockholders in its basic EPS
calculation by $150 in accordance with the guidance in
paragraph 260-10-45-12B. Entity A applies the treasury
stock method in accordance with paragraphs 260-10-45-23
through 45-27 to calculate diluted EPS. Accordingly, the
$150 is added back to income available to common
stockholders when calculating diluted EPS. However, the
treasury stock method would not be applied if the effect
were to be antidilutive.
6.1.6 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
ASC 470-20
25-20A
At the date of issuance, a share-lending arrangement
entered into on an entity’s own shares in contemplation
of a convertible debt offering or other financing shall
be measured at fair value (in accordance with Topic 820)
and recognized as an issuance cost, with an offset to
additional paid-in capital in the financial statements
of the entity.
30-26A
At the date of issuance, a share-lending arrangement
entered into on an entity’s own shares in contemplation
of a convertible debt offering or other financing shall
be measured at fair value in accordance with Topic
820.
35-11A
If it becomes probable that the counterparty to a
share-lending arrangement will default, the issuer of
the share-lending arrangement shall recognize an expense
equal to the then fair value of the unreturned shares,
net of the fair value of probable recoveries, with an
offset to additional paid-in capital. The issuer of the
share-lending arrangement shall remeasure the fair value
of the unreturned shares each reporting period through
earnings until the arrangement consideration payable by
the counterparty becomes fixed. Subsequent changes in
the amount of the probable recoveries should also be
recognized in earnings.
Under ASC 470-20-25-20A and ASC 470-20-30-26A, equity-classified own-share
lending arrangements executed in contemplation of a convertible debt issuance
(see Section 2.9)
are recorded initially at fair value and recognized as a debt issuance cost with
an offset to APIC in the entity’s financial statements. The terms of a
share-lending arrangement entered into in contemplation of a convertible debt
issuance typically require an entity to issue its common shares to a
counterparty (e.g., the bank) in exchange for a nominal processing fee. The
processing fee is significantly less than the fair value of the shares and is
typically less than a market fee that would be charged in a share-lending
arrangement that was not entered into in contemplation of a convertible debt
issuance. To promote the issuance of the debt, the issuer may sometimes accept
less than the market rate on the share-lending arrangement. The fair value of
the share-lending arrangement will be determined on the basis of the difference
between the contractual processing fee and a market-based fee that would
typically be charged for lending such shares, adjusted as necessary to reflect
the nonperformance risk of the share borrower.
Example 6-3
Initial Accounting for Own-Share Lending
Arrangement
Issuer A issues convertible debt at par for cash proceeds
of $250 million. The stated interest rate on the debt is
2.5 percent per annum. The debt is due five years from
the issuance date and is convertible into A’s equity
shares at the holder’s option. Issuer A determines that
it is not required to recognize the conversion option in
the debt separately as a liability or in equity.
In contemplation of the convertible debt issuance, A
executes a share-lending arrangement with Bank B to help
ensure the successful completion of the debt offering,
and A receives $100,000 for the arrangement (which is
also the par amount of the shares issued). However, the
fair value of the arrangement is $15 million. Issuer A
evaluates the share-lending arrangement under ASC 470-20
and ASC 815-40 and determines that it qualifies as
equity.
On the date on which both the debt issuance and the
share-lending arrangement occur, A makes the following
journal entry:
Unless the issuer elects to account for the debt at fair value under the fair
value option in ASC 825-10, it amortizes any discount (or reduced premium) on
the debt created by the recognition of the own-share lending arrangement as a
debt issuance cost by using the effective interest method. The amount recognized
in equity is not remeasured as long as (1) the share-lending arrangement
qualifies as equity under ASC 815-40 and (2) it is not probable that the
counterparty to the share-lending arrangement will default in returning the
loaned shares (or an equivalent amount of consideration).
ASC 470-20-35-11A states that if it becomes probable that the counterparty to a
share-lending arrangement will default in returning the loaned shares (or an
equivalent amount of consideration), the issuer must recognize an expense equal
to the fair value of the unreturned shares adjusted for the fair value of any
probable recoveries. The offsetting entry for the expense is to APIC.
Even when a share-lending arrangement is classified in equity, it is appropriate
to record an expense because the issuer is suffering a loss from the
counterparty’s failure to satisfy its obligation to return the loaned shares.
Under the contractual terms, the shares (or an equivalent amount of
consideration) should have been returned to the issuer, but as a result of the
counterparty credit risk, the issuer is instead receiving something of lesser or
no value. The amount of the loss (i.e., the fair value of the unreturned shares
adjusted for probable recoveries) is remeasured in each period (e.g., for
changes in the fair value of the unreturned shares) until the consideration
payable becomes fixed. The issuer recognizes changes in the amount of the loss
in earnings with an offset to APIC. For discussion of the EPS accounting
consequences of own-share lending arrangements, see Section 8.5 of Deloitte’s Roadmap
Earnings per
Share.
Footnotes
1
The guidance in ASC 815-40 is similar to the modification
guidance in ASC 718, which was applied in practice before ASC
815-40 addressed this issue.
6.2 Freestanding Instruments Classified as Assets or Liabilities
6.2.1 Initial and Subsequent Measurement
6.2.1.1 General
ASC 815-40
15-8A If the instrument does
not meet the criteria to be considered indexed to an
entity’s own stock as described in paragraphs
815-40-15-5 through 15-8, it shall be classified as
a liability or an asset.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
15-8A
If the instrument does not meet the criteria to be
considered indexed to an entity’s own stock as
described in paragraphs 815-40-15-5 through 15-8,
it shall be classified as a liability or an asset.
See paragraph 815-40-35-4 for subsequent
measurement guidance for those instruments. See
paragraph 815-40-15-9 for guidance on the
interaction with this Subtopic and Subtopics
815-10 and 815-15 for derivative instruments and
embedded derivatives.
25-5 Paragraph 815-20-55-33
explains that derivative instruments that are
indexed to an entity’s own stock and recorded as
assets or liabilities can be hedging
instruments.
30-1 All contracts within the
scope of this Subtopic shall be initially measured
at fair value.
35-1 All contracts shall be
subsequently accounted for based on the current
classification and the assumed or required
settlement method in Section 815-40-25 . . . .
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-1
All contracts shall be subsequently accounted for
based on the current classification and the
assumed or required settlement method in Section
815-40-15 or Section 815-40-25 . . . .
35-4 All other contracts
classified as assets or liabilities under Section
815-40-25 shall be measured subsequently at fair
value, with changes in fair value reported in
earnings and disclosed in the financial statements
as long as the contracts remain classified as assets
or liabilities (see paragraph 815-40-50-1).
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-4
All other contracts classified as assets or
liabilities under Section 815-40-25 or paragraph
815-40-15-8A shall be measured subsequently at
fair value, with changes in fair value reported in
earnings and disclosed in the financial statements
as long as the contracts remain classified as
assets or liabilities (see paragraph
815-40-50-1).
A freestanding equity-linked instrument that does not
qualify as equity under ASC 815-40 is classified as an asset or a liability.
With one exception, all freestanding equity-linked instruments that are
classified as assets or liabilities must be initially and subsequently
measured at fair value, with changes in fair value recognized in net income.
The one exception to this requirement is related to an issuer’s accounting,
before the adoption of ASU 2020-06, for a freestanding equity-linked
instrument that is classified as an asset or liability that is not indexed
to the entity’s stock under ASC 815-40-15 (see Section 6.3).2
6.2.1.2 Allocation of Proceeds
If a freestanding equity-linked instrument is issued with
debt or stock, the issuance proceeds received need to be allocated between
the items. An entity allocates proceeds first to the items that will be
measured at fair value on a recurring basis; it then allocates any residual
proceeds to those items that will be carried at amortized cost (i.e., a
with-and-without method) to avoid the recognition of a gain or a loss caused
solely as a result of the allocation model. Thus, whether a freestanding
equity-linked instrument that is classified as an asset or a liability is
issued alone or in conjunction with other financial instruments, the
instrument must be initially recognized at fair value.
6.2.1.3 Issuance Costs
Issuance costs are specific incremental costs that are (1) paid to third parties
and (2) directly attributable to the issuance of debt, equity, or a freestanding
equity-linked instrument. Thus, issuance costs represent costs incurred with
third parties that result directly from and are essential to the financing
transaction and would not have been incurred by the issuer had the financing
transaction not occurred. Examples of costs that may qualify as issuance costs
include underwriting fees, professional fees paid to attorneys and accountants,
printing and other document preparation costs, travel costs, and registration
and listing fees directly related to the issuance of the instrument. Amounts
paid to the investor upon issuance, such as commitment fees, origination fees,
and other payments (e.g., reimbursement of the investor’s expenses) represent a
reduction in the proceeds received, not issuance costs.3
Costs that would have been incurred irrespective of whether there is a proposed
or actual issuance transaction do not qualify as issuance costs. For example, in
accordance with SAB Topic 5.A (reproduced in ASC 340-10-S99-1), allocated
management salaries and other general and administrative expenses do not
represent an issuance cost. Similarly, legal and accounting fees that would have
been incurred irrespective of whether the instrument was issued are not issuance
costs (see AICPA Technical Q&As Section 4110.01). Further, the SEC staff
believes that if a proposed issuance is aborted (including the postponement of
an issuance for more than 90 days), its associated costs do not represent
issuance costs of a subsequent issuance.
Issuance costs attributable to a freestanding equity-linked instrument that is
classified in equity should be offset against the associated proceeds in the
determination of the instrument’s initial net carrying amount (see SAB Topic 5.A
and AICPA Technical Q&As Section 4110.01). However, any issuance costs or
other transaction costs attributable to a freestanding equity-linked financial
instrument that is classified as an asset or a liability should be recognized in
earnings in the period incurred. This accounting is consistent with the guidance
in ASC 825-10-25-3 and ASC 820-10-35-9B.
Entities should consistently
apply a systematic and rational method for allocating issuance costs among
freestanding financial instruments that form part of the same transaction. In
limited circumstances, a specific allocation method is prescribed for such costs
under U.S. GAAP. Otherwise, the allocation method is based on the specific facts
and circumstances. For example, if an entity uses a with-and-without method to
allocate proceeds between a freestanding equity-linked instrument that is
classified as an asset or liability and another financial instrument that is not
remeasured to fair value on a recurring basis, either of the following two
methods is generally considered appropriate:
- The relative fair value method — The issuer would allocate issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to the allocation of proceeds to debt instruments with detachable warrants in ASC 470-20-25-2 and the guidance in SAB Topic 2.A.6.
- An approach that is consistent with the allocation of proceeds — The issuer would allocate issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments.
The method used should be applied consistently to similar
transactions. Any issuance costs allocated to a freestanding equity-linked
instrument that is classified as an asset or liability and subsequently measured
at fair value through earnings must be expensed as of the issuance date. For
additional discussion of the allocation of issuance costs, see Section
3.3.4.4 of Deloitte's Roadmap: Distinguishing
Liabilities From Equity.
6.2.1.4 Fair Value of Items Measured at Fair Value on a Recurring Basis Exceeds Proceeds
In some circumstances, the
initial fair value of the items required to be subsequently measured at fair
value exceeds the proceeds received. At the 2014 AICPA Conference on Current
SEC and PCAOB Developments, Professional Accounting Fellow Hillary Salo
addressed the allocation of proceeds related to a reporting entity’s
issuance of a hybrid instrument when the initial fair value of the financial
liabilities required to be measured at fair value (such as embedded
derivatives) exceeds the net proceeds received. Her remarks are applicable
by analogy to freestanding instruments (e.g., debt issued with detachable
warrants) when one or both are measured at fair value with changes in fair
value recognized in earnings and the initial fair value of items required to
be remeasured at fair value exceeds the amount of the proceeds received. Ms.
Salo made the following remarks:
[T]he staff believes that when reporting entities
analyze these types of unique fact patterns, they should first, and most
importantly, verify that the fair values of the financial liabilities
required to be measured at fair value are appropriate under [ASC 820].
[Footnote omitted] If appropriate, then the reporting entity should
evaluate whether the transaction was conducted on an arm’s length basis,
including an assessment as to whether the parties involved are related
parties under [ASC 850]. Lastly, if at arm’s length between unrelated
parties, a reporting entity should evaluate all elements of the
transaction to determine if there are any other rights or privileges
received that meet the definition of an asset under other applicable
guidance.
In the fact patterns analyzed by the staff, we
concluded that if no other rights or privileges that require separate
accounting recognition as an asset could be identified, the financial
liabilities that are required to be measured at fair value (for example,
embedded derivatives) should be recorded at fair value with the excess
of the fair value over the net proceeds received recognized as a loss in
earnings. Furthermore, given the unique nature of these transactions, we
would expect reporting entities to provide clear and robust disclosure
of the nature of the transaction, including reasons why the entity
entered into the transaction and the benefits received.
Additionally, some people may wonder whether the staff
would reach a similar conclusion if a transaction was not at arm’s
length or was entered into with a related party. We believe those fact
patterns require significant judgment; therefore, we would encourage
consultation with OCA in those circumstances.
For a freestanding equity-linked instrument classified as an
asset or a liability under ASC 815-40, an entity should determine whether
the instrument also falls within the scope of the derivative accounting
requirements in ASC 815-10. If so, an entity would need to provide the
disclosures required by ASC 815 for derivatives and could designate the
instrument as a hedging instrument in a qualifying hedge relationship if the
criteria for such designation are met.
Before the adoption of ASU 2020-06, ASC 815-40 provides
subsequent accounting guidance only on instruments classified as assets and
liabilities that are also considered indexed to the entity’s own stock. If the
instrument is not considered indexed to the entity’s own stock under ASC
815-40-15, the subsequent measurement guidance in ASC 815-40 only applies after
the adoption of ASU 2020-06 (see Section 6.3).
6.2.2 Reclassifications
ASC 815-40
35-10 If a contract is reclassified from an asset or a liability to equity, gains or losses recorded to account for the contract at fair value during the period that the contract was classified as an asset or a liability shall not be reversed.
Pending Content (Transition
Guidance: ASC 815-40-65-1)
35-10 If a contract is
reclassified from an asset or a liability to
equity, gains or losses recorded to account for
the contract at fair value during the period that
the contract was classified as an asset or a
liability shall not be reversed. The contract
shall be marked to fair value immediately before
the reclassification. An embedded derivative that
qualifies for the derivatives scope exception upon
reassessment under this Subtopic that was
separated from its host contract and accounted for
as a derivative instrument in accordance with
Subtopic 815-10 shall be
reclassified to equity. The previously bifurcated
embedded derivative shall not be recombined with
its host contract.
An entity is required to reassess its classification of each freestanding
equity-linked instrument as of each reporting date (see Section 5.4). Reclassification of an
instrument classified as an asset or a liability is required if the instrument
begins to meet all the criteria for equity classification (e.g., the entity’s
shareholders approve an increase in the number of authorized shares; see Section 5.3.3).
If reclassification is required, the entity reclassifies the instrument as of
the date of the event or change in circumstance that caused the reclassification
at its then-current fair value. If an instrument is reclassified from an asset
or a liability to equity, gains and losses during the period the instrument was
classified as an asset or a liability are not reversed, and the adjustment to
the instrument’s current fair value is recognized in earnings before
reclassification. The reclassification of an embedded equity-linked instrument
is performed in accordance with ASC 815 (see Section 6.4).
6.2.3 Settlements
ASC 815-40
40-2 If contracts classified
as assets or liabilities are ultimately settled in
shares, any gains or losses on those contracts shall
continue to be included in earnings.
An entity should record in earnings all changes in the fair value of an
equity-linked instrument classified as an asset or a liability. The gains and
losses are not reversed upon settlement, even if the instrument is settled in
shares. When a freestanding equity-linked instrument is settled, the entity
should measure it at its current fair value as of the settlement date and
include in earnings any fair value gain or loss that has not been previously
recognized. The entity should then derecognize the asset- or
liability-classified instrument and recognize the cash received (paid) and
shares received (issued), if any. The recognition of these items may also result
in a gain or loss that is reported in earnings.
6.2.4 Modifications or Exchanges
A freestanding equity-linked instrument that is classified as an asset or a
liability is recognized at fair value, with changes in fair value recognized in
earnings. Therefore, a modification or exchange of a freestanding equity-linked
instrument that is classified as an asset or a liability before and after the
modification or exchange is reflected in the change in fair value of the
instrument. Section 6.1.4.2 addresses the accounting for a
modification or exchange of an equity-linked instrument that is (1) classified
as an asset or a liability before the modification or exchange and is classified
in equity after the modification or exchange or (2) classified in equity before
the modification or exchange and is classified as an asset or a liability after
the modification or exchange.
6.2.5 Standby Equity Purchase Agreements
A standby equity purchase agreement (SEPA) is an equity-linked instrument for
which an entity has the right, but not the obligation, to sell the entity’s
common stock to third-party investors over a specified period. The total number
of shares that the entity may issue to the investor is capped by either an
aggregate dollar amount or an aggregate number of shares. Furthermore, the
number of shares that an entity may issue at any particular time during the life
of the SEPA is also limited. The price payable by the investor for each share of
common stock purchased from the entity is generally discounted (e.g., 97 percent
of the volume-weighted average price of the entity’s common stock over a
specified period before issuance of the stock). In exchange for its access to
capital through the SEPA, the entity typically provides up-front consideration
to the investor in the form of cash or shares of the entity’s common stock.
Economically, before the entity has elected to sell shares, a SEPA represents a
purchased put option on the entity’s own equity. However, once the entity
“draws” on the SEPA, the related number of shares issuable constitutes a forward
contract to issue common stock. Thus, SEPAs contain both a purchased put option
element and a forward share issuance element. As discussed in Sections
4.3.5.7 and 5.2.3.1, generally neither
element qualifies for equity classification. Accordingly, entities must
recognize an asset or liability for SEPAs. Such asset or liability must be
measured at fair value, with changes in fair value recognized in net income.
Because SEPAs do not qualify for classification in equity, an entity must expense
as incurred the amount by which any consideration provided to the investor at
the inception of the arrangement exceeds the fair value of the asset recognized
for the SEPA. This accounting is consistent with the guidance in ASC 825-10-25-3
and ASC 820-10-35-9B.
An entity should recognize at fair value the common shares
issued to the investor upon settlement of a SEPA by using the quoted price of
the shares on the date of issuance (i.e., P × Q).4 The then-current fair value of the asset or liability for the associated
forward share issuance contract must be derecognized in conjunction with the
settlement.5 The proceeds received from the investor are reflected and any residual
amount must be charged (or credited) to earnings.6 This accounting is consistent with the guidance in ASC 815-10 that applies
upon the settlement of a derivative instrument. It is also consistent with the
guidance in ASC 815-40. As stated in Section
6.2.3, when an equity-linked instrument classified as an asset or
liability is settled, entities should measure the instrument at its current fair
value as of the settlement date and include in earnings any previously
unrecognized fair value gain or loss.
In summary, upon settlement of a forward issuance contract element of a SEPA, an
entity would recognize in earnings the following amounts:
-
The gain (loss) for the excess (deficit) of (1) the carrying amount of the asset or liability for the forward issuance contract plus the proceeds received and (2) the fair value of the common shares as of the issuance date.
-
Any issuance or transaction costs incurred in conjunction with the issuance of the shares.
Example 6-4
Accounting for a SEPA
On January 1, 20X5, Company A enters into a SEPA with
Investor B under which A has the right, but not the
obligation, to issue up to 1 million common shares to B
over the next 18 months. Company A can elect to sell
shares to B in increments of 250,000. The purchase price
that B pays to A for the shares issued is equal to 97
percent of the VWAP of A’s common stock over the
three-trading-day period before A elects to issue shares
under the SEPA. The shares are issued 30 days
thereafter.
At the SEPA’s inception, A issued 50,000 shares to B
(worth $100,000) and paid a $25,000 structuring fee to B
as consideration for the right to access capital under
the SEPA.
In this example, further assume the following:
- The SEPA does not qualify for equity classification.
- The initial and subsequent fair value for the purchased put option element of the SEPA is zero. (Note that this assumption is made for simplicity. Entities cannot assume that the fair value of the purchased put option element is zero; they should determine the fair value of the SEPA in accordance with ASC 820.)
- On June 30, 20X5, A elects to sell 250,000 shares to B. The purchase price is $533,500 (i.e., VWAP of $2.20 × 250,000 × .97 = $533,500). The initial fair value of the forward contract for this share issuance is a $16,500 liability.
- On July 30, 20X5, the 250,000 shares are issued to B. The quoted price of A’s common stock on the settlement date is $2.10. Company A incurs transaction costs of $10,000 in conjunction with such issuance. Immediately before the settlement, the fair value of the forward contract for this share issuance is a $8,500 asset.
The journal entries to account for the SEPA are as
follows:
January 1, 20X5
To record the SEPA at inception.
June 30, 20X5
To record a liability for the forward contract to issue
shares under the SEPA.
July 31, 20X5
To adjust the forward contract to issue shares under the
SEPA to its fair value immediately before settlement.
To record the settlement of the shares issued under the
SEPA to the investor.
To record transaction costs incurred in conjunction with
settlement.
Note that in this example, before transaction costs,
there is an aggregate gain of $8,500 related to the
forward contract to issue shares under the SEPA. Had the
share price stayed the same or increased between June
30, 20X5, and July 30, 20X5, there would have been an
aggregate loss on the shares issued under the forward
contract. In all cases, any transaction costs incurred
in conjunction with settlement of the forward contract
must be recognized in earnings as incurred.
Footnotes
2
In the discussion hereafter, it is assumed that such
instruments are subsequently measured at fair value, with changes in
fair value recognized in earnings.
3
Depending on the relationship between the issuer and the investor,
amounts paid to the investor could represent a dividend or other
distribution as opposed to an issuance cost. An entity should use
judgment and consider the particular facts and circumstances when
determining what these amounts represent.
4
This represents the settlement amount of the contract
under ASC 815-40. Initial recognition of the shares issued at the quoted
price multiplied by the quantity is consistent with the accounting for
settlements of derivatives under ASC 815-10 and ASC 820.
5
An entity generally initially recognizes a liability for
this element. However, it is possible for the forward share issuance
contract to become an asset before settlement.
6
The amount charged (or credited) to earnings includes
any issuance or transaction costs incurred in conjunction with the
issuance of the shares.
6.3 Freestanding Instruments Not Indexed to an Entity’s Own Stock (Before Adoption of ASU 2020-06)
ASC 815-40
15-8A If the instrument does not meet the criteria to be considered indexed to an entity’s own stock as described in paragraphs 815-40-15-5 through 15-8, it shall be classified as a liability or an asset.
ASC 815-10
S99-4 The following is the text of the SEC Observer Comment: Accounting for Written Options
SEC staff’s longstanding position is that written options that do not qualify for equity classification initially should be reported at fair value and subsequently marked to fair value through earnings.
If a freestanding equity-linked instrument does not meet the conditions in ASC
815-40-15 to be considered indexed to the entity’s stock, ASC 815-40 precludes
classification of the instrument as equity (i.e., the contract must be classified as
an asset or a liability). However, before the adoption of ASU 2020-06, ASC 815-40
does not otherwise address the accounting for the instrument (for a discussion of
the accounting after the adoption of ASU 2020-06, see Section 6.2). An entity should first evaluate
whether it must apply ASC 480-10, ASC 718, or ASC 805-30. If it does not apply that
guidance, the initial and subsequent measurement may depend on whether the
instrument meets the definition of a derivative instrument in ASC 815.
Changing Lanes
ASU 2020-06 expands the scope of the subsequent measurement
guidance in ASC 815-40-35-4 (see Section 6.2) to include freestanding
equity-linked instruments that do not meet the conditions in ASC 815-40-15
to be considered indexed to the entity’s own stock. As discussed in
Section 6.2, all such instruments
are initially measured at fair value and subsequently measured at fair
value, with changes in fair value reported in earnings in each reporting
period.
6.3.1 Instrument Meets the Definition of a Derivative Instrument
If a freestanding equity-linked instrument that is not considered
indexed to the entity’s stock has all the characteristics in ASC 815-10-15-83 of a
derivative and is not excluded from the scope of ASC 815-10, it should be accounted
for both initially and subsequently at fair value, with changes in fair value
recorded immediately through earnings (unless it is designated as a hedging
instrument in a cash flow hedge or net investment hedge).
Not every equity-linked instrument that fails to meet the indexation
requirements in ASC 815-40-15 has all the characteristics of a derivative in ASC
815-10-15-83. The determination of whether a freestanding equity-linked instrument
meets the definition of a derivative instrument generally depends on whether it
possesses the net settlement characteristic in ASC 815-10-15-83(c). For example, a
written call option contract that requires physical settlement in shares that are
not readily convertible to cash may be outside the scope of ASC 815-10 because it
does not have the net settlement characteristic that a derivative must possess. In
evaluating whether a freestanding equity-linked instrument has the net settlement
characteristic, an entity should consider the equity classification conditions in
ASC 815-40-25 (discussed in Chapter 5). An instrument that fails to meet any of the conditions
for equity classification would typically possess the net settlement characteristic
because it would be presumed that the entity would be required to net cash settle
the instrument.
6.3.2 Instrument Does Not Meet the Definition of a Derivative Instrument
Before the adoption of ASU 2020-06, if a freestanding equity-linked
instrument that is not considered indexed to the entity’s stock does not meet the
definition in ASC 815-10-15-83 of a derivative instrument, the subsequent
measurement of the instrument depends on whether it is classified as an asset or a
liability. Purchased options are always classified as assets, and written options
are always classified as liabilities. Forward contracts could be classified as
assets or liabilities depending on the entity’s share price and other relevant
inputs to fair value. Since forward contracts could be classified as liabilities,
they are subject to the guidance below on contracts classified as liabilities.
6.3.2.1 Instruments Classified as Liabilities
6.3.2.1.1 Entity Is an SEC Registrant
The long-standing position of the SEC staff is that if an
instrument is a written option (e.g., a warrant or call option) that does
not qualify for equity classification, and the subsequent accounting is not
specifically addressed in other U.S. GAAP (including ASC 480-10, ASC 718,
ASC 805-30, and ASC 815-10), registrants should account for the instrument
at fair value with changes in fair value recorded in earnings in each
reporting period (ASC 815-10-S99-4).
6.3.2.1.2 Entity Is Not an SEC Registrant
For non-SEC registrants, fair value is the most appropriate
subsequent-measurement attribute for a written option or other
liability-classified equity-linked instrument that is not indexed to the
entity’s stock. In a manner similar to an SEC registrant’s accounting, an
entity would (1) initially measure the instrument at fair value and (2)
subsequently measure it at fair value, with changes in fair value recorded
in earnings in each reporting period. However, before the adoption of ASU
2020-06, it may be appropriate in certain circumstances for the entity to
use an alternative subsequent-measurement attribute. For example, when
measuring its liability-classified share-based payment awards at intrinsic
value or calculated value in accordance with ASC 718-30, it may be
appropriate for the entity to use the same measurement attribute to
subsequently calculate a written option on its shares. Alternatively,
subsequent measurement based on intrinsic value may be appropriate in a
manner similar to how the entity might measure certain indexed debt
instruments at intrinsic value.
Note that if an entity applies a subsequent-measurement
attribute other than fair value before its adoption of ASU 2020-06, it must
still evaluate whether the instrument contains an embedded derivative that
requires separate accounting under ASC 815-15 (e.g., the underlying that
caused the instrument to fail to be considered indexed to the entity’s own
stock). For this reason, entities most often account for these types of
instruments at fair value.
6.3.2.2 Instruments Classified as Assets
Before the adoption of ASU 2020-06, if an instrument is a
purchased option and the subsequent accounting is not specifically addressed in
other U.S. GAAP (including ASC 480-10, ASC 718, ASC 805-30, and ASC 815-10), the
entity could use either of the following methods to subsequently account for
it:
- Cost method, subject to adjustment for impairment and observable price changes — ASC 321-10-35-2 provides a measurement alternative that entities may apply to investments in equity securities that do not have readily determinable fair values. While the scope of this guidance does not include equity-linked instruments, it may be applied by analogy to a freestanding equity-linked instrument that is not indexed to the entity’s own stock if the accounting for the instrument is not otherwise addressed in U.S. GAAP. However, an entity should apply the guidance analogously only if the equity shares underlying the purchased option do not have a readily determinable fair value. Under this method, the entity would initially recognize the purchased option at cost and subsequently adjust its carrying amount for any impairment plus or minus changes resulting from observable price changes in orderly transactions.
- Fair value method — Entities commonly remeasure at fair value other instruments that do not qualify for equity classification and for which the subsequent accounting is not specifically addressed by U.S. GAAP. ASC 825-10-25-1 permits entities to elect, on specified election dates, to measure at fair value eligible financial instruments such as instruments that are classified as assets under ASC 815-40-15-8A.
Note that if an entity applies a subsequent-measurement attribute other than fair
value before it adopts ASU 2020-06, it must evaluate whether the instrument
contains an embedded derivative that must be accounted for separately under ASC
815-15 (e.g., the underlying that caused the instrument not to be considered
indexed to the entity’s own stock). For this reason, entities most often account
for these types of instruments at fair value.
6.4 Embedded Features
While ASC 815-40 applies in the determination of whether an embedded feature qualifies as equity, it does not address the recognition, measurement, and presentation of a feature embedded in another contract (e.g., an equity conversion option embedded in a debt security or in a preferred stock instrument).
Under ASC 815-15-25-1, an entity is required to bifurcate — that is, separately account for — a feature embedded within another contract when the following three conditions are met:
- The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not being measured at fair value with changes in fair value recorded immediately through earnings.
- The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers the definition of a derivative in ASC 815-10 and the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15.
- The economic characteristics and risks of the embedded feature are not clearly and closely related to those of the host contract (e.g., an embedded feature with characteristics and risks of equity would not be considered clearly and closely related to a debt host contract).
If the feature is required to be separated under ASC 815-15, the feature is recognized as a derivative asset or liability and measured at fair value with changes in fair value recognized in earnings. For example, an equity conversion feature embedded in a debt security would be separated from its host contract and accounted for as a derivative if the feature does not qualify as equity under ASC 815-40 and the shares to be delivered are readily convertible to cash.
If the embedded feature qualifies as equity under ASC 815-40 or does not
otherwise have to be separated as an embedded derivative, it is excluded from the
scope of the derivative accounting guidance in ASC 815-10 and ASC 815-15 in
accordance with ASC 815-10-15-74(a). For such a feature, the entity should consider
whether other accounting guidance applies, including:
-
Before the adoption of ASU 2020-06, the requirement to separate an equity component from a convertible instrument subject to the cash conversion guidance in ASC 470-20 (see Chapter 6 of Deloitte’s Roadmap Convertible Debt (Before Adoption of ASU 2020-06)).
-
Before the adoption of ASU 2020-06, the requirement to recognize certain BCFs in equity under ASC 470-20 (see Chapter 7 of Deloitte’s Roadmap Convertible Debt (Before Adoption of ASU 2020-06)).
-
The requirement to allocate an amount to equity if a convertible debt instrument is issued at a substantial premium (ASC 470-20-25-13) (see Section 7.6.3 of Deloitte’s Roadmap Issuer’s Accounting for Debt).
The determination of whether an embedded feature qualifies as equity is
reassessed in each period unless reassessment is unnecessary because the feature
does not meet the other criteria for bifurcation in ASC 815-15-25-1. If an embedded
feature ceases to meet the conditions in ASC 815-40 for equity classification after
the initial recognition of the hybrid instrument (e.g., because the entity no longer
has sufficient authorized and unissued shares to share settle the feature; see Section 5.3.3), it no longer
meets the scope exception in ASC 815-10-15-74(a). Accordingly, the entity would need
to evaluate whether the feature should be separated as an embedded derivative under
ASC 815-15.
If separation is required after the initial recognition of the hybrid
instrument, the embedded derivative is bifurcated and recognized at fair value at
the time it ceases to meet the conditions for classification in equity. If no amount
was previously allocated to equity, a portion of the current carrying amount of the
hybrid instrument equal to the current fair value of the feature is allocated to the
embedded derivative (in accordance with ASC 815-15-30-2). Alternatively, before the
adoption of ASU 2020-06, if an amount attributable to the equity feature was
previously allocated to equity under the cash conversion guidance in ASC 470-20 the
difference between the amount previously recognized in equity and the fair value of
the conversion option as of the date of reclassification is accounted for as an
adjustment to equity (ASC 470-20-35-19).
If an embedded feature that was bifurcated from its host contract subsequently meets the conditions for equity classification in ASC 815-40 (e.g., because the entity now has sufficient authorized and unissued shares to share settle the feature), the embedded derivative no longer meets the bifurcation criteria in ASC 815-15. Therefore, the embedded feature should no longer be classified as an asset or a liability. However, any previously recognized gains and losses should not be reversed (ASC 815-40-35-10). Instead, the carrying amount of the embedded derivative (i.e., the fair value of the feature as of the date of the reclassification) should be reclassified to shareholders’ equity. Any remaining debt discount (that arose from the original bifurcation) should continue to be amortized (ASC 815-15-35-4). The entity also should provide the disclosures required by ASC 815-15-50-3, as applicable:
An issuer shall disclose both of the following for the period in which an embedded conversion option previously accounted for as a derivative instrument under [ASC 815-15] no longer meets the separation criteria under [ASC 815-15]:
- A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
- The amount of the liability for the conversion option reclassified to stockholders’ equity.
Example 6-5
Embedded Features
On January 1, 20X5, Company ABC issues a 10-year note that has a $1,000 par value, accrues interest at an annual rate of 4 percent, and is convertible into 100 shares of ABC’s common stock. The fair value of one share of ABC’s common stock is $8.50 on the issue date. Upon conversion, ABC must settle the accreted value of the note in cash and has the option to settle the conversion spread in either cash or common stock (commonly referred to as Instrument C). In accordance with ASC 815-40, Instrument C is not a “conventional convertible” instrument in ABC’s application of ASC 815-40 to the conversion option (i.e., ASC 815-40-25-7 through 25-35 do apply). After ABC considers its potential share requirements for other existing commitments, it concludes that it cannot assert that it has a sufficient number of authorized but unissued common shares available to share settle the conversion option; accordingly, the conversion option does not qualify for equity classification under ASC 815-40. After applying ASC 815-40 and ASC 815-15-25-1, ABC concludes that the conversion option must be bifurcated and accounted for as a separate derivative.
At inception, on January 1, 20X5, ABC records the following entry to bifurcate the embedded derivative (assume that the fair value of the conversion option on that date is $50):
Journal Entry: January 1, 20X5
As of each quarterly reporting date during 20X5, ABC determines that continued bifurcation of the conversion option is required. For each quarterly reporting period, the derivative (which is not designated as a hedging instrument) is marked to fair value, with the changes in fair value recognized in earnings (the conversion option has a fair value of $200 on December 31, 20X5). Company ABC also recognizes its contractual interest expense on the note, and it amortizes to interest expense the debt discount created by the bifurcation of the embedded conversion option. The following journal entries reflect the cumulative activity booked during the year ended December 31, 20X5 (each journal entry represents the sum of the quarterly journal entries):
Journal Entry: Year Ended December 31, 20X5
As of December 31, 20X5, the carrying amounts of the debt host contract and the conversion liability are $954 and $200, respectively.
Embedded Features
On January 1, 20X6, ABC obtains shareholder approval to increase the number of its authorized common shares to a level sufficient for it to assert that it has the ability to share settle the conversion option. On the basis of this approval, ABC concludes that the conversion option now qualifies for equity classification under ASC 815-40 and that the bifurcated derivative liability no longer needs to be accounted for as a separate derivative under ASC 815-15-25-1.
No modification of terms occurred. Rather, an event extraneous to the note (obtaining shareholder approval to increase authorized common shares) has caused the embedded conversion option to no longer meet the conditions for bifurcation.
Company ABC records the following entry on January 1, 20X6 (assume no changes in fair value from December 31, 20X5, to January 1, 20X6):
Journal Entry: January 1, 20X6
Note that the debt discount will continue to be amortized over the remaining term of the debt since this discount reflects the issuer’s economic borrowing costs related to the convertible debt instrument.
Company ABC also is required to provide the disclosures described in ASC 815-15-50-3.
6.5 Fair Value Measurements
ASC 815-40 — Glossary
Fair Value
The price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market
participants at the measurement date.
Because ASC 815-40 requires certain fair value measurements and disclosures
(e.g., equity-linked instruments classified as assets or liabilities
under ASC 815-40-25 are subsequently measured at fair value), ASC
815-40-20 includes definitions related to fair value. In determining
fair value under ASC 815-40, an entity should apply the guidance in
ASC 820. In the absence of a specific exception, ASC 820 applies
whenever fair value measurement or disclosures are permitted or
required under U.S. GAAP (ASC 820-10-15-1). There is no specific
scope exception in ASC 820 for fair value measurements under ASC
815-40. See Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value
Option) for more information about the fair
value measurement and disclosure requirements of ASC 820.