On the Radar
Entities raising capital must apply the highly complex, rules-based
guidance in U.S. GAAP to determine whether (1) freestanding contracts such as
warrants, options, and forwards to sell equity shares are classified as liabilities
or equity instruments and (2) convertible instruments contain embedded equity
features that require separate accounting as derivative liabilities. To reach the
proper accounting conclusion, they must consider the following key questions:
All entities are capitalized with debt or equity. The nature and mix
of debt and equity securities that comprise an entity’s capital structure, and an
entity’s decision about the type of security to issue when raising capital, may
depend on the stage of the entity’s life cycle, the cost of capital, the need to
comply with regulatory capital requirements or debt covenants (e.g., capital or
leverage ratios), and the financial reporting implications. For example, early-stage and
smaller-growth companies are often financed with preferred stock and warrants with
complex and unusual features, whereas larger, more mature entities often have a mix
of debt and equity securities with more plain-vanilla common stock
capitalization.
ASC 815-40 provides guidance on the
accounting for contracts that are indexed to, and potentially settled in, an
entity’s own equity (also known as equity-linked financial instruments). The
following are examples of the types of instruments that are within the scope of ASC
815-40:
Freestanding Equity-Linked Financial Instruments
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Embedded Equity-Linked Financial Instruments
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An equity-linked financial instrument can be classified in equity only if it (1) is
indexed to the reporting entity’s own stock and (2) meets all other conditions for
equity classification. If an equity-linked financial instrument either is not
indexed to the reporting entity’s own stock or does not meet the other conditions
for equity classification, it is classified as an asset or a liability. Under the
indexation and equity classification guidance, all terms of a contract must be
analyzed regardless of their significance or likelihood of becoming applicable.
Seemingly inconsequential features in a contract can cause it to fail to qualify for
equity classification.
An equity-linked financial instrument’s classification on the balance sheet will
affect how returns on the instrument are reflected in an entity’s income statement.
Returns on asset- and liability-classified instruments are reflected in net income
because they are subsequently measured at fair value, with changes in fair value
reported in earnings, whereas returns on equity-classified instruments are generally
reflected in equity, without affecting net income.
In addition to the effect on net income and earnings per share, entities often seek
to avoid classifying freestanding or embedded equity-linked financial instruments as
liabilities for other reasons, including:
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The effect of the classification on the entity’s credit rating and stock price.
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Regulatory capital requirements.
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Debt covenant requirements (e.g., leverage or capital ratios).
The SEC staff closely
scrutinizes the appropriate balance sheet classification
of freestanding and embedded equity-linked financial
instruments. This is evident in comment letters on
registrants’ filings and the number of restatements
arising from inappropriate classification.
Balance Sheet Classification
ASC 815-40 applies to each freestanding equity-linked financial instrument
regardless of whether it meets the ASC 815-10 definition of a derivative
instrument. In addition, ASC 815-40 applies to embedded equity-linked financial
instruments in hybrid financial instruments such as convertible debt and
convertible preferred stock unless (1) the embedded feature is clearly and
closely related to the host contract; (2) the hybrid financial instrument is
measured at fair value, with changes in fair value reported in earnings; or (3)
the equity-linked financial instrument does not, on a stand-alone basis, meet
the definition of a derivative instrument.
In some cases, equity-linked contracts are issued on a stand-alone basis and it
is readily apparent that there is only one unit of account. In other financing
transactions, there are two or more components that individually represent
separate units of account (e.g., preferred stock is issued with detachable
warrants). When an entity enters into a financing transaction that includes
equity-linked items that can be legally detached and exercised separately, those
items are separate freestanding financial instruments and ASC 815-40 must be
applied to them individually.
Equity-linked features may be embedded in hybrid financial instruments. If so, an
entity often needs to use judgment to determine the unit of account for the
embedded feature that must be evaluated under ASC 815-40.
Unless a freestanding or embedded equity-linked financial instrument is
considered indexed to the reporting entity’s stock, it must be classified as an
asset or a liability. To be considered indexed to the reporting entity’s stock,
the instrument’s exercise and settlement provisions must meet certain
conditions. While contingent exercise provisions often do not disqualify an
instrument from being indexed to a reporting entity’s stock, the instrument’s
settlement terms may contain adjustments to the exercise price or settlement
amount that can result in the arrangement’s failure to be considered indexed to
the reporting entity’s stock. Any input that could potentially affect an
instrument’s exercise price or settlement amount (i.e., number of shares) that
is not an input into the pricing of a fixed-for-fixed forward or option on
equity shares will result in the instrument’s failure to be considered indexed
to the reporting entity’s stock.
A number of equity classification conditions must be met for freestanding or
embedded equity-linked financial instruments that are indexed to the reporting
entity’s stock to be classified as equity instruments. The general principle is
that if net cash settlement could be required for any event that is not within
the entity’s control, the contract should be classified as an asset or a
liability rather than as equity. ASU 2020-06 (issued in August 2020) eliminates
or amends some of the equity classification conditions that must be met but does
not change the general principle for equity classification in ASC 815-40-25.
Earnings per Share
ASC 260 addresses the EPS accounting for contracts within the scope of ASC 815-40.
Special considerations are necessary for contracts that may be settled in stock or
cash.
Under ASC 260 as amended by ASU 2020-06, an
entity may not overcome the presumption of share settlement
for a contract that may be settled in stock or cash.
Therefore, the shares potentially issuable under such a
contract must be included in the denominator of diluted
EPS.
This Roadmap provides a comprehensive
discussion of the classification, initial and subsequent
measurement, and presentation and disclosure of
equity-linked financial instruments. Entities should also
consider Deloitte’s Roadmap Distinguishing Liabilities
From Equity for guidance on
equity-linked financial instruments as well as Deloitte’s
Roadmap Earnings per
Share for guidance on basic and diluted
EPS.