Deloitte’s Roadmap: Contracts on an Entity’s Own Equity
Preface
Preface
We are pleased to present the 2024 edition of Contracts on an
Entity’s Own Equity. This Roadmap provides an overview of the guidance in
ASC 815-401 as well as insights into and interpretations of how to apply it in practice.
For ease of reference, we have accompanied our discussion with the related
authoritative text.
It is assumed in this edition that an entity has adopted ASU
2020-06. We have therefore removed from the Roadmap discussions of the accounting
before adoption of the ASU’s guidance. The 2024 edition also contains new and
expanded guidance on various topics. Appendix F outlines significant changes made
since the issuance of the 2023 edition of the Roadmap.
Be sure to check out On the Radar (also available
as a stand-alone publication), which briefly
summarizes emerging issues and trends related to the
accounting and financial reporting topics addressed in the
Roadmap.
We hope you will find this Roadmap to be a useful resource in
determining the appropriate accounting for contracts on an entity’s own equity, and
we welcome your suggestions for improvements to it. If you need
assistance applying the guidance or have other questions about this topic, we
encourage you to consider consulting our technical specialists and other professional
advisers.
Footnotes
1
For a list of abbreviations used in this publication, see
Appendix E.
For the full titles of standards, topics, and regulations used in this
publication, see Appendix
D.
On the Radar
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
reporting entity’s accounting for contracts that are potentially 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
|
Embedded Equity-Linked Financial Instruments
|
---|---|
|
|
An equity-linked financial instrument can be classified in equity
only if it (1) is indexed to the 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 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:
-
The effect of the classification on the entity’s credit rating and stock price.
-
Regulatory capital requirements.
-
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 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 entity’s stock, it must be classified as
an asset or a liability. To be considered indexed to the 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 an 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 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 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 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.
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, 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.
Contacts
Contacts
|
Ashley Carpenter
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
|
Jonathan Howard
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3235
|
|
Magnus Orrell
Audit & Assurance
Managing Director
Deloitte & Touche
LLP
+1 203 761 3402
|
For information about Deloitteʼs financial instruments service
offerings, please contact:
|
Jamie Davis
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 0303
|
Chapter 1 — Overview
Chapter 1 — Overview
ASC 815-40
05-1 For a number of business
reasons, an entity may enter into contracts that are indexed
to, and sometimes settled in, its own stock. This Subtopic
provides guidance on accounting for such contracts. Examples
of these contracts include put and call options (both
written and purchased) and forward contracts (for both sales
and purchases). These contracts may be settled using a
variety of settlement methods, or the issuing entity or
counterparty may have a choice of settlement methods. The
contracts may be either freestanding or embedded in another
financial instrument.
ASC 815-40 provides guidance on the accounting for contracts that
are potentially indexed to, and potentially settled in, an entity’s own equity (also
known as contracts on own equity or equity-linked financial instruments). Examples
of contracts and transactions that may require evaluation under ASC 815-40
include:
-
Call options on own stock (both written and purchased).
-
Warrants on own stock.
-
Forward contracts to sell own stock.
-
Purchased put options on own stock.
-
Accelerated share repurchase programs.
-
Contingent consideration arrangements in business combinations.
-
Convertible bond hedges.
-
Equity line facilities that permit an entity to sell own stock.
-
Hybrid equity units.
-
Prepaid forward purchases of own stock.
-
Prepaid written put options on own stock.
While the accounting requirements in ASC 815-40 focus on
freestanding instruments, some of the guidance also applies to features embedded in
other contracts. In particular, the indexation guidance and other conditions for
equity classification in ASC 815-40 apply to both freestanding and embedded
derivative instruments in the evaluation of whether they are exempt from derivative
accounting (see Section
2.2). Examples of embedded derivative features that would be assessed
under the indexation and equity classification guidance in ASC 815-40 include:
-
Equity conversion features embedded in debt or equity securities or lines of credit that are debt hosts.
-
Written put options embedded in the entity’s equity securities (i.e., stock redeemable by the holder).
-
Redemption requirements in equity securities that are not certain to be redeemed (e.g., mandatorily redeemable convertible preferred stock).
ASC 815-40 also provides guidance on
whether a contract on own equity should be classified as equity or as an asset or a
liability. In making this determination, an entity considers the following
questions:
Question
|
Roadmap Discussion
|
---|---|
Is the instrument within the scope of ASC
815-40?
| |
What are the terms of the instrument?
| |
Does the instrument meet the criteria to be
considered indexed to the entity’s own stock?
| |
Does the instrument meet other conditions
for equity classification?
|
Only an equity-linked instrument that is both indexed to the
entity’s own stock and meets all other conditions for equity classification can be
classified as equity. If an instrument either (1) is not considered indexed to the
entity’s own stock (e.g., because it is indexed to an extraneous variable such as
the price of gold) or (2) does not meet other conditions for equity classification
(e.g., because the entity could be forced to net cash settle the contract), the
instrument is classified as an asset or a liability.
In addition, ASC 815-40 provides guidance (other than for embedded
features) on the following aspects of the accounting for freestanding equity-linked
financial instruments (Chapter 6):
-
Initial measurement (i.e., fair value).
-
Subsequent measurement (which depends on the instrument’s classification as equity or an asset or a liability).
-
Reclassification between (1) equity and (2) liabilities or assets (the classification of an equity-linked instrument is subject to continual reassessment).
-
Settlements.
Further, ASC 815-40 includes disclosure requirements for contracts on an
entity’s own equity (Chapter 7).
Some entities are affected by both U.S. GAAP and IFRS®
Accounting Standards. There are significant differences between the guidance in ASC
815-40 and the equivalent guidance under IFRS Accounting Standards (Chapter 8).
The appendixes of this Roadmap include a tabular overview of the FASB’s
examples in ASC 815-40 (Appendix
A), checklists for determining whether a contract or embedded feature
qualifies as equity under ASC 815-40 (Appendix B), and the definitions of selected terms from the ASC master
glossary (Appendix C).
Connecting the Dots
When analyzing equity-linked instruments, entities typically
must also consider the guidance in:
-
ASC 260 (see Deloitte’s Roadmap Earnings per Share).
-
ASC 470 (see Deloitte’s Roadmap Issuer’s Accounting for Debt).
-
ASC 480 (see Deloitte’s Roadmap Distinguishing Liabilities From Equity).
-
ASC 815 (see Deloitte's Roadmap Derivatives).
Chapter 2 — Scope
Chapter 2 — Scope
2.1 Instruments Potentially Indexed to, and Potentially Settled in, the Entity’s Own Equity
ASC 815-40
15-1 The guidance in this Subtopic applies to all entities.
15-2 The guidance in this
Subtopic applies to freestanding contracts that are
potentially indexed to, and potentially settled in, an
entity’s own stock.
15-2A
The scope of this Subtopic includes security price
guarantees or other financial instruments indexed to, or
otherwise based on, the price of the entity’s stock that are
issued in connection with a business combination and that
are accounted for as contingent consideration.
15-4 The guidance in this Subtopic
applies to derivatives embedded in contracts in analyzing the
embedded feature under paragraphs 815-15-25-1(c) and
815-15-25-14 as though it were a freestanding instrument (as
further discussed in paragraphs 815-40-25-39 through
25-40).
ASC 815-40 applies to both public business
entities (including SEC registrants) and private companies. The guidance focuses on
freestanding contracts (see Section 3.2) that
have the following characteristics (ASC 815-40-15-2):
Characteristic | ASC Reference | Roadmap Discussion |
---|---|---|
Potentially indexed to an entity’s own stock | ASC 815-40-15 provides guidance on determining whether an equity-linked
instrument is considered indexed to an entity’s own
stock. | |
Potentially settled in an entity’s own stock | ASC 815-40-25 provides guidance on whether an entity has the ability to settle
an equity-linked instrument in its own stock or could be
forced to net cash settle it. |
Unless a specific scope exception applies, therefore, the following types of
instruments would be within the scope of ASC 815-40:
-
A freestanding call option written by the entity that gives the holder a right to purchase equity shares of the entity.
-
A freestanding call option that gives the entity a right to repurchase outstanding shares.
-
A freestanding warrant issued by the entity to a shareholder giving it the right to subscribe to additional equity shares of the entity.
-
A freestanding put option that gives the entity the right to sell shares to the writer of the option.
-
A freestanding forward contract that commits the entity to issue additional equity shares or the resale of treasury shares.
-
Contracts issued as contingent consideration in a business combination that are indexed to, or otherwise based on, the price of the entity’s stock.
As noted in ASC 815-40-15-4, the indexation and equity classification guidance
in ASC 815-40 also applies to some embedded features that have all the
characteristics of a derivative instrument in an entity’s determination of whether
such features are exempt from bifurcation under ASC 815-15 (see Section 2.2).
ASC 815-40 does not directly apply to outstanding equity shares (e.g., common or
preferred equity securities). Nevertheless, some equity shares contain embedded
features that may require evaluation under the indexation and equity classification
guidance in ASC 815-40 (e.g., an equity conversion option in a convertible preferred
stock contract, provided the option has the characteristics of a derivative
instrument and is not clearly and closely related to the host contract; see Section 2.2).
ASC 815-40 does not apply to the counterparty of an equity-linked financial
instrument. From the counterparty’s perspective, the contract is not on its own
equity. For example, if an entity writes a call option on its own equity to a third
party, the holder of that call option would not apply ASC 815-40 to the contract
because from the counterparty’s perspective, the contract is indexed to another
entity’s equity. (See also ASC 815-10-15-75.) Because ASC 815-40 does not apply to
the counterparty of an equity-linked financial instrument, an “entity” in this
Roadmap refers to the reporting entity whose stock is the underlying instrument in
the contract.
2.2 Derivative Instruments
2.2.1 Interaction With the Derivative Accounting Requirements
ASC 815-40
15-4 The guidance in this Subtopic applies to
derivatives embedded in contracts in analyzing the embedded feature under
paragraphs 815-15-25-1(c) and 815-15-25-14 as though it were a freestanding
instrument (as further discussed in paragraphs 815-40-25-39 through
25-40).
15-5 The guidance in this paragraph through paragraph
815-40-15-8 applies to any freestanding financial instrument or embedded
feature that has all the characteristics of a derivative instrument (see the
guidance beginning in paragraph 815-10-15-83). That guidance applies for the
purpose of determining whether that instrument or embedded feature qualifies
for the first part of the scope exception in paragraph 815-10-15-74(a). That
guidance does not address the second part of the scope exception in paragraph
815-10-15-74(a), which is addressed in Section 815-40-25. The guidance also
applies to any freestanding financial instrument that is potentially settled
in an entity’s own stock, regardless of whether the instrument has all the
characteristics of a derivative instrument for purposes of determining whether
the instrument is within the scope of this Subtopic.
15-9 For guidance on the interaction of this Subtopic and Subtopic 815-10, see paragraphs 815-10-15-74 through 15-78. For guidance on the interaction of this Subtopic and Subtopic 815-15, see paragraph 815-15-25-15.
ASC 815-10
15-74 Notwithstanding the conditions of paragraphs
815-10-15-13 through 15-139, the reporting entity shall not consider the
following contracts to be derivative instruments for purposes of this
Subtopic:
- Contracts issued or held by that reporting entity that
are both:
- Indexed to its own stock (see Section 815-40-15)
- Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25). . . .
15-75 The scope exceptions in paragraph 815-10-15-74
do not apply to either of the following:
-
The counterparty in those contracts. For example, the scope exception in (b) in the preceding paragraph related to share-based compensation arrangements does not apply to equity instruments (including stock options) received by nonemployees as compensation for goods and services.
-
A contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock. That contract can be a derivative instrument for the issuer under paragraphs 815-10-15-13 through 15-139, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Subtopic. For example, a forward contract that is indexed to both an entity’s own stock and currency exchange rates does not qualify for the exception in (a) in the preceding paragraph with respect to that entity’s accounting because the forward contract is indexed in part to something other than that entity’s own stock (namely, currency exchange rates).
15-75A For purposes of evaluating
whether a financial instrument meets the scope exception in paragraph
815-10-15-74(a)(1), a down round feature shall be excluded from the
consideration of whether the instrument is indexed to the entity’s own
stock.
15-76 Temporary equity
is considered stockholders' equity for purposes of the scope exception in
paragraph 815-10-15-74(a) even if it is required to be displayed outside of
the permanent equity section.
15-83 A derivative instrument is a financial instrument or other contract with all of the following characteristics:
- Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both.
-
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Some freestanding equity-linked instruments have the characteristics of a
derivative instrument under ASC 815-10-15-83. In accordance with ASC 815, such instruments
must be accounted for as derivatives at fair value, with changes in fair value reported in
earnings, unless they meet a scope exception in ASC 815.1 Under ASC 815-10-15-74(a), certain contracts on an entity’s own equity are exempt
from derivative accounting. In assessing whether an equity-linked instrument qualifies for
this scope exception, an entity applies the indexation and equity classification guidance
in ASC 815-40. A contract that qualifies as equity under the indexation and equity
classification guidance in ASC 815-40 would meet that scope exception and therefore would
be exempt from the derivative accounting requirements in ASC 815.
A freestanding equity-linked instrument that does not meet the definition of a
derivative instrument is outside the scope of ASC 815 but is nevertheless within the scope
of ASC 815-40. For example, a freestanding warrant that requires physical settlement in
private-company stock may not meet the net settlement characteristic in the definition of
a derivative instrument. The issuer of a warrant that does not meet the definition of a
derivative instrument would assess it under ASC 815-40 but not under ASC 815. If the
instrument does not meet the indexation and equity classification guidance in ASC 815-40,
it must be classified as an asset or liability and recognized at fair value, with changes
in fair value reported in earnings. This accounting is required even though the instrument
does not have all the characteristics of a derivative instrument in ASC 815-10-15-83.
Connecting the Dots
Because ASC 815-40 must be applied to all freestanding equity-linked
instruments, the classification and measurement of such instruments is the same
irrespective of whether they meet the characteristics of a derivative instrument in
ASC 815-10-15-83. However, if an equity-linked instrument does not qualify for equity
classification, the disclosures in ASC 815 apply only if the instrument meets the
definition of a derivative instrument.
2.2.2 Hybrid Instruments and Embedded Features
ASC 815-15
25-1 An embedded derivative shall be separated from
the host contract and accounted for as a derivative instrument pursuant to
Subtopic 815-10 if and only if all of the following criteria are met:
-
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
-
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
-
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
ASC 815-40
15-4 The guidance in
this Subtopic applies to derivatives embedded in contracts in analyzing the
embedded feature under paragraphs 815-15-25-1(c) and 815-15-25-14 as though it
were a freestanding instrument (as further discussed in paragraphs
815-40-25-39 through 25-40).
An entity may issue a hybrid nonderivative instrument that contains an embedded
equity-linked instrument (e.g., convertible securities or redeemable equity securities).
Although the guidance in ASC 815-40 does not directly address hybrid financial
instruments, its requirements related to indexation and equity classification may apply in
the determination of whether the embedded feature must be bifurcated under ASC
815-15-25-1. Bifurcation of an embedded feature is required if the three conditions in ASC
815-15-25-1 are met. If the first two conditions in ASC 815-15-25-1 are met, the entity
must determine whether the embedded feature qualifies as a derivative instrument on a
stand-alone basis (i.e., under ASC 815-15-25-1(c)).
An embedded feature that does not contain all the characteristics of a
derivative instrument in ASC 815-10-15-83 does not meet the third condition in ASC
815-15-25-1; therefore, bifurcation of the feature is not required, and the entity does
not need to evaluate the embedded feature under the indexation and equity classification
guidance in ASC 815-40. However, if the embedded feature does meet all the characteristics
of a derivative instrument in ASC 815-10-15-83, the entity must evaluate whether the
feature is eligible for the scope exception in ASC 815-10-15-74(a).2 To do so, the entity applies the indexation and equity classification guidance in
ASC 815-40. An embedded feature that does not qualify as equity under ASC 815-40 and meets
the three bifurcation conditions in ASC 815-15-25-1 is removed from its host contract and
accounted for separately as a derivative instrument. If the feature meets the indexation
and equity classification requirements, however, it is not bifurcated because the
exception in ASC 815-10-15-74(a) applies.
Connecting the Dots
ASC 815-40 only applies to an embedded feature in the determination
of whether it qualifies for the scope exception in ASC 815-10-15-74(a). The
recognition, measurement, and disclosure guidance in ASC 815-40 does not apply to an
embedded feature irrespective of whether the feature has all the characteristics of a
derivative instrument in ASC 815.3 Instead, the embedded feature is subject to the recognition, measurement, and
disclosure guidance in ASC 470-20, ASC 505-10, and ASC 815.
Under ASC 480-10-S99-3A and other SEC guidance, registrants are required to classify
certain redeemable equity securities in temporary equity outside of permanent equity. (For
a comprehensive discussion of the application of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.) In the evaluation of
whether an item meets the scope exception for an entity’s own equity in ASC
815-10-15-74(a), temporary equity is considered equity (ASC 815-10-15-76).
Connecting the Dots
ASC 815-10-15-76 indicates that in the evaluation of whether an item meets the scope
exception in ASC 815-10-15-74(a) for an entity’s own equity, temporary equity is
considered equity. This guidance is relevant to the evaluation of embedded derivatives
in a hybrid contract; however, it is not relevant to the evaluation of a freestanding
equity-linked instrument. As noted in the example below, the guidance in ASC
815-10-15-76 is relevant to the evaluation of a put option embedded in a share because
the share (host contract) would be classified in temporary equity as a result of the
embedded equity-linked instrument. However, this guidance does not permit a
freestanding option on a redeemable equity security (i.e., an equity security that is
redeemable for cash) to meet the equity classification requirements in ASC 815-40-25.
Rather, such an equity-linked instrument would be considered a net-cash-settled
instrument that does not qualify for equity classification under ASC 815-40-25.
Example 2-1
Scope Exception — Temporary Equity
An SEC registrant issues
shares that contain an embedded written put option that permits the holder to
put the shares back to the registrant in exchange for a cash payment. In
accordance with ASC 480-10-S99-3A, the registrant may be required to classify
the shares in temporary equity. When evaluating whether the embedded put option
qualifies for the scope exception in ASC 815-10-15-74(a) under the equity
classification guidance in ASC 815-40 (e.g., in assessing whether the contract
permits the issuer to settle in shares), the registrant would consider the
shares to be equity shares even though they are presented outside of permanent
equity.A feature that is commonly subject to evaluation under ASC 815-40 is an equity conversion
option embedded in a debt instrument. If it meets all the characteristics of a derivative
instrument in ASC 815-10-15-83, such feature must be bifurcated under ASC 815-15 unless
either of the following apply:
- The convertible debt instrument is recognized at fair value, with changes in fair value reported in earnings (e.g., the issuer has elected the fair value option in ASC 825-10).
-
The embedded conversion option meets the indexation and equity classification guidance in ASC 815-40. (Note that features embedded in certain convertible debt instruments are exempt from some of the equity classification conditions in ASC 815-40-25 [see Section 5.5].)
Example 2-2
Embedded Derivatives
An entity has issued a debt security that gives the counterparty the right to
convert the security into the entity’s common stock. The equity conversion
feature (1) meets all the characteristics of a derivative in ASC 815-10-15-83
(e.g., because the stock is publicly traded and the number of shares received
upon conversion can be rapidly absorbed by the market) and (2) otherwise meets
the conditions for separation as an embedded derivative in ASC 815-15-25-1
(e.g., it is not clearly and closely related to its host debt contract, and
the debt is not being remeasured at fair value with changes in fair value
recognized in earnings). The entity would assess the conversion feature under
the indexation and equity classification guidance in ASC 815-40 to determine
whether the scope exception to the derivative accounting guidance in ASC
815-10-15-74(a) applies. If the conversion feature qualifies as equity under
ASC 815-40, it would be exempt from derivative accounting. If it does not
qualify as equity under ASC 815-40, it would be bifurcated as a derivative
instrument under ASC 815-15 unless another scope exception applies.
Connecting the Dots
For further discussion of the issuer’s accounting for equity conversion features
embedded in debt instruments, see Deloitte’s Roadmap Issuer’s Accounting for Debt.
Footnotes
1
While ASC 815 requires certain changes in the fair value of
derivative instruments designated in qualifying cash flow hedges to be recognized in
other comprehensive income, ASC 815-20-25-15(h) does not permit an entity to designate
a transaction involving the entity’s own equity instruments as a hedged item in a cash
flow hedge.
2
This evaluation would be unnecessary if the embedded feature met
another exception to the derivative accounting guidance in ASC 815-10 or ASC 815-15.
However, in practice, embedded equity-linked instruments generally only potentially
qualify for the scope exception in ASC 815-10-15-74(a).
3
ASC 815-40 does, however, apply to the evaluation of whether an
embedded feature that meets the definition of a derivative instrument qualifies
for the scope exception in ASC 815-10-15-74(a) (see ASC 815-40-15-4).
2.3 Certain Repurchase Obligations and Variable-Share Contracts
ASC 815-40
15-3 The guidance in this Subtopic does not apply to any of the following: . . .
e. Financial instruments that are within the scope of Topic 480 (see paragraph 815-40-15-12).
15-12 Paragraph
480-10-15-5 explains that Topic 480 does not apply to a
feature embedded in a financial instrument that is not a
derivative instrument in its entirety (for example, a
written put option embedded in a nonderivative host
contract) in analyzing the embedded feature as though it
were a separate instrument as required by paragraph
815-15-25-1(c). Therefore, this Subtopic applies in
evaluating those embedded features under Subtopic
815-15.
Financial instruments that must be accounted for as liabilities or assets under
ASC 480 are outside the scope of ASC 815-40. Therefore, an entity does not apply ASC
815-40 to an equity-linked instrument unless it has first determined that ASC 480 is
not applicable.
ASC 480 applies to three types of freestanding financial instruments that
contain obligations of the issuer (see Chapter
4 of Deloitte’s Roadmap Distinguishing
Liabilities From Equity as well as Sections 2.3.1 and 2.3.2
below). The scope of ASC 480 is limited to freestanding financial instruments and
does not include embedded features (e.g., an embedded written put option in an
equity share issued by the entity). The applicability of ASC 815-40 to embedded
features is discussed in Section
2.2.2.
2.3.1 Obligations to Repurchase Shares by Transferring Assets
ASC 480-10
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
As discussed in more detail in Chapter 5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity, contracts other than outstanding shares that require
— or could require — the issuer to repurchase its equity shares (or are indexed
to such an obligation) by transferring assets are accounted for as liabilities
(or potentially as assets) under ASC 480. For example, a forward purchase
contract on an entity’s own equity shares or a written put option on the
entity’s own equity shares is classified as a liability if the issuer could be
required to physically settle the contract by delivering cash in exchange for
the issuer’s equity shares. Similarly, a forward purchase or written put option
contract that permits the counterparty to net cash settle the contract would be
classified as an asset or a liability. These requirements apply even if the
purchase obligation is contingent on the occurrence or nonoccurrence of an event
(unless it is solely within the entity’s control) or upon the counterparty’s
exercise of an option.
ASC 480 applies to contracts that require or could require delivery of the
entity’s redeemable equity securities (e.g., warrants, written call options, and
forward sales) if the entity could ultimately be forced to redeem those
securities by transferring assets. This is the case even if the redeemable
equity securities would be classified within equity (including temporary equity)
when issued. For example, if an entity issues a warrant that permits the holder
to purchase the entity’s equity shares, that warrant is classified as a
liability if the underlying equity shares contain a redemption requirement that
is not solely within the entity’s control (e.g., an investor put option embedded
in preferred stock). Although the warrant is required to be classified as a
liability, the redeemable equity securities may qualify for classification as
equity or temporary equity once issued. Similarly, a written call option or a
forward sale contract on redeemable equity securities would be classified as a
liability under ASC 480 if the entity could be required to transfer assets even
if the obligation to transfer assets is embedded in the shares underlying the
option or forward.
If, under the redemption feature, the entity could be required to transfer
assets, a contract on redeemable stock is classified as a liability under ASC
480 regardless of the timing of the potential redemption requirement (e.g.,
immediately after exercise of a warrant or at some date in the future) or the
redemption price (e.g., fair value or a fixed price). In addition, such a
contract is classified as a liability even if the redemption feature is
conditional on a defined contingency (such as a change of control, a reduction
in the issuer’s credit rating, a conversion, or a failure to have a registration
statement declared effective by the SEC by a designated date), unless the
contingency is solely within the control of the issuer.
If an entity could not be required to transfer assets under a freestanding contract on redeemable equity securities, the contract may be within the scope of ASC 815-40. For example, the following types of contracts on redeemable equity securities would potentially be within the scope of ASC 815-40 unless another scope exception applies:
- A purchased call option that permits the entity to repurchase redeemable equity securities, at its option (because the entity has no obligation to repurchase the redeemable equity securities).
- A purchased put option that permits the entity to issue (sell) redeemable equity securities, at its option (because the entity has no obligation to issue redeemable equity securities).
2.3.1.1 Put Warrants
ASC 815-40
55-16 Put warrants are
frequently issued concurrently with debt securities
of the entity, are detachable from the debt, and may
be exercisable only under specified conditions. The
put feature of the instrument may expire under
varying circumstances, for example, with the passage
of time or if the entity has a public stock
offering. Under Subtopic 470-20, a portion of the
proceeds from the issuance of debt with detachable
warrants must be allocated to those warrants.
55-17 Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to do any of the following:
- Exercise the warrant feature to acquire the common stock of the entity at a specified price
- Exercise the put option feature to put the instrument back to the entity for a cash payment
- Exercise both the warrant feature to acquire the common stock and the put option feature to put that stock back to the entity for a cash payment.
55-18 Because the contract
gives the counterparty the choice of cash settlement
or settlement in shares, entities should report the
proceeds from the issuance of put warrants as
liabilities and subsequently measure the put
warrants at fair value with changes in fair value
reported in earnings as required by Topic 480. That
is, a put warrant that embodies an obligation to
repurchase the issuer’s equity shares, or is indexed
to such an obligation, and that requires or may
require a transfer of assets is within the scope of
that Topic and therefore is to be recognized as a
liability.
A put warrant is an example of an instrument that is required to be classified
as a liability under ASC 480. Even though the warrant gives the counterparty
an option to purchase the entity’s stock, the warrant is classified as a
liability in its entirety under ASC 480 if the entity could be forced to
repurchase the warrant for cash or other assets because it represents an
obligation that is indexed to an obligation to repurchase the entity’s
equity shares, and the entity may be required to transfer cash or other
assets (see Section
5.1 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Alternatively, the counterparty may have the
right to put the stock it received upon exercise of the warrant back to the
entity for cash. In that case, the warrant embodies an obligation to
repurchase equity shares for cash (see Section 5.2.1 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity). Because put warrants fall
within the scope of ASC 480, they are outside the scope of ASC 815-40.
2.3.2 Contracts to Issue a Variable Number of Shares
ASC 480-10
25-14 A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).
See paragraph 480-10-55-21 for related implementation guidance.
Sometimes entities use their own shares as “currency” to settle an obligation in
which the number of shares delivered depends on the value of the obligation. If
a financial instrument embodies an obligation that the entity must or may settle
in shares, the entity could be required to classify the contract as a liability
(or, potentially, an asset) even if the instrument does not contain an
obligation to transfer cash or other assets. As discussed in more detail in
Chapter 6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity, ASC 480
identifies three circumstances in which a share-settleable contract would be
classified as a liability. A contract that embodies an obligation that the
issuer must or may settle in a variable number of equity-classified shares is
classified as a liability if, at inception, the obligation’s monetary value is
based solely or predominantly on:
-
A fixed monetary amount known at inception.
-
Variations in something other than the issuer’s equity shares.
-
Variations inversely related to changes in the fair value of the entity’s equity shares.
This guidance applies not only to contracts that require share settlement but also to contracts that the issuer may elect to settle in either assets or a variable number of shares. For financial instruments other than outstanding shares, this guidance applies irrespective of whether the obligation is conditional or unconditional.
The following are examples of contracts that would be accounted for as liabilities or assets under this guidance:
- A net-share-settled forward repurchase contract whose value is inversely related to the entity’s stock price (e.g., because the forward price is fixed).
- A net-share-settled written put option whose value is inversely related to the entity’s stock price (e.g., because the strike price is fixed).
- A contract to issue a variable number of equity shares whose value is based solely or predominantly on variations in something other than the entity’s equity shares (e.g., the S&P 500 Index).
- A prepaid variable share forward on the entity’s stock that obligates the entity to deliver shares with a monetary value that is predominantly a fixed monetary amount known at inception.
- Stock-settled debt.
2.3.3 Application of ASC 480 to Freestanding Written Puts and Forward Purchase Contracts
ASC 480-10
55-63 The following table
addresses classification of freestanding written put options
and forward purchase contracts within the scope of this
Subtopic.
If a forward contract requires physical settlement by repurchase of
a fixed number of the issuer’s equity shares for cash, it is classified as a
liability under ASC 480-10-25-8 and accounted for in accordance with ASC 480-10-30-3
and ASC 480-10-35-3 in a manner similar to a treasury stock repurchase with borrowed
funds (see Section
5.3.1 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Other forward purchase contracts and written put options
that require or may require the issuer to settle its obligation under the contract
by transferring assets are classified as assets or liabilities under ASC 480-10-25-8
and accounted for at fair value under ASC 480-10-30-7, ASC 480-10-35-1, ASC
480-10-35-4A, or ASC 480-10-35-5 (see Sections 5.1 and 5.3.2 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Such contracts include those that require net cash
settlement, permit the issuer to choose between net cash or physical settlement (but
not net share settlement), and give the counterparty a settlement choice if at least
one of the options is physical settlement or net cash settlement. Forward purchase
contracts and written put options that require or permit the issuer to settle its
obligation under the contract net in shares are classified as assets or liabilities
under ASC 480-10-25-14(c) and accounted for at fair value in accordance with ASC
480-10-30-7 as well as ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5 (see
Sections 6.1.4 and
6.3 of Deloitte’s
Roadmap Distinguishing
Liabilities From Equity).
2.4 Share-Based Payments
ASC 815-40 — Glossary
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
Also called share-based compensation arrangements.
ASC 815-40
15-3 The guidance in this Subtopic
does not apply to any of the following: . . .
b. Contracts that are issued to compensate grantees
in a share-based payment arrangement within the
scope of Topic 718 . . . .
15-5A The guidance in this
paragraph through paragraph 815-40-15-8 does not apply to
share-based payment awards within the scope of Topic 718 for
purposes of determining whether instruments are classified
as liability awards or equity awards under that Topic.
Equity-linked financial instruments issued to investors for
purposes of establishing a market-based measure of the
grant-date fair value of employee stock options are not
within the scope of Topic 718 themselves. Consequently, the
guidance in this paragraph through paragraph 815-40-15-8
applies to such market-based share-based payment stock
option valuation instruments for purposes of making the
determinations described in paragraph 815-40-15-5.
ASC 718-10
15-5 The guidance in this Topic
does not apply to transactions involving share-based payment
awards granted to a lender or an investor that provides
financing to the issuer. However, see paragraphs
815-40-35-14 through 35-15, 815-40-35-18, 815-40-55-49, and
815-40-55-52 for guidance on an issuer’s accounting for
modifications or exchanges of written call options to
compensate grantees. . . .
Awards May Become
Subject to Other Guidance
35-9 Paragraphs 718-10-35-10
through 35-14 are intended to apply to those instruments
issued in share-based payment transactions with employees
and nonemployees accounted for under this Topic . . . .
35-10 A freestanding financial
instrument or a convertible security issued to a grantee
that is subject to initial recognition and measurement
guidance within this Topic shall continue to be subject to
the recognition and measurement provisions of this Topic
throughout the life of the instrument, unless its terms are
modified after any of the following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
35-10A Only for
purposes of paragraph 718-10-35-10, a modification does not
include a change to the terms of an award if that change is
made solely to reflect an equity restructuring provided that
both of the following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of that
instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12 Once the classification of an
instrument is determined, the recognition and measurement
provisions of this Topic shall be applied until the
instrument ceases to be subject to the requirements
discussed in paragraph 718-10-35-10. Topic 480 or other
applicable GAAP, such as Topic 815, applies to a
freestanding financial instrument that was issued under a
share-based payment arrangement but that is no longer
subject to this Topic. This guidance is not intended to
suggest that all freestanding financial instruments shall be
accounted for as liabilities pursuant to Topic 480, but
rather that freestanding financial instruments issued in
share-based payment transactions may become subject to that
Topic or other applicable GAAP depending on their
substantive characteristics and when certain criteria are
met.
35-14 An entity may modify
(including cancel and replace) or settle a fully vested,
freestanding financial instrument after it becomes subject
to Topic 480 or other applicable GAAP. Such a modification
or settlement shall be accounted for under the provisions of
this Topic unless it applies equally to all financial
instruments of the same class regardless of the holder of
the financial instrument. Following the modification, the
instrument continues to be accounted for under that Topic or
other applicable GAAP. A modification or settlement of a
class of financial instrument that is designed exclusively
for and held only by grantees (or their beneficiaries) may
stem from the employment or vendor relationship depending on
the terms of the modification or settlement. Thus, such a
modification or settlement may be subject to the
requirements of this Topic. See paragraph 718-10-35-10 for a
discussion of changes to awards made solely to reflect an
equity restructuring.
ASC 815-40 does not apply to a share-based payment arrangement that
is within the scope of ASC 718. For example, it does not apply to a share-based
payment award granted to (1) an employee as compensation for rendering service, (2)
a nonemployee as compensation for the acquisition of goods or services by the
entity, or (3) a customer in conjunction with the entity’s sale of goods or services
that are within the scope of ASC 606. The entity would instead apply ASC 718 to
determine (1) whether the share-based payment arrangement should be classified as
equity or as a liability and (2) the appropriate accounting. However, ASC 815-40
does apply to equity-linked freestanding financial instruments that are issued to
nonemployee investors to establish a market-based measure of the grant-date fair
value of stock options because such arrangements are not within the scope of ASC 718
(see ASC 815-40-15-5A).
ASC 815-40 may also apply to an instrument that was originally
issued to a grantee in a share-based payment arrangement subject to ASC 718 if the
terms of the instrument are subsequently modified. If the terms of a share-based
payment award originally subject to ASC 718 are modified and the holder is no longer
an employee, or, for awards granted to nonemployees, a vested award is modified and
the grantee is no longer providing goods or services or is no longer a customer, ASC
718 ceases to apply unless the modification is made solely to reflect an equity
restructuring and the two conditions in ASC 718-10-35-10A are met. If an instrument
originally issued to a grantee in a share-based payment arrangement subject to ASC
718 becomes subject to ASC 480 or ASC 815-40, the classification of the instrument
may change.
ASC 718-10-15-5 exempts from the scope of ASC 718 transactions
involving equity instruments granted to a lender or an investor that provides
financing to the issuer. For example, if an entity obtains a loan in exchange for
issuing a contract on its own equity, that contract would not be within the scope of
ASC 718, but it would be evaluated under ASC 815-40 and any other applicable
guidance (including ASC 480).
2.5 Business Combinations
2.5.1 Contingent Consideration
ASC 815-40
15-2A The
scope of this Subtopic includes security price
guarantees or other financial instruments indexed
to, or otherwise based on, the price of the
entity’s stock that are issued in connection with
a business combination and that are accounted for
as contingent consideration.
ASC Master Glossary
Contingent Consideration
Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
In business combinations, the parties may agree to the contingent issuance of
additional shares in the future or to a contingent
return of shares. Contingent consideration is part
of the total consideration transferred for the
acquiree and therefore must be measured and
recognized at fair value as of the acquisition
date. Such arrangements permit the parties to
proceed with a business combination without
agreeing on the final purchase price. For example,
the acquirer may agree to deliver a specified
number of its own equity shares if the earnings of
the acquired entity exceed a specified target in
the year following the combination. Other examples
of events that may trigger contingent
consideration payments include reaching a
specified stock price or reaching a milestone on a
research and development project.
There is no scope exception in ASC 815-40 for equity-linked financial
instruments that represent contingent consideration in a business
combination. Accordingly, the acquirer determines whether contingent
consideration should be classified as equity or as an asset or a
liability in accordance with ASC 815-40 and any other applicable
guidance (including ASC 480).
ASC 805-30-35-1 discusses how to recognize changes in fair value of contingent consideration other than measurement-period adjustments. Contingent consideration classified as equity is not remeasured, and its settlement is recognized in equity. Contingent consideration classified as an asset or a liability is remeasured to fair value in each reporting period, with changes in fair value recognized in earnings unless the consideration qualifies for recognition in other comprehensive income under the hedge accounting guidance in ASC 815.
Under ASC 805, adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date are recognized as adjustments to goodwill. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information was based on events that occurred after the acquisition date. For example, earnings targets that are met, changes in share prices, and FDA approvals are all changes that occur after the acquisition date. Changes in fair value resulting from these items are recognized in earnings and not as adjustments to goodwill.
2.5.2 Lock-Up Options
ASC 815-40
15-6 The guidance in this paragraph applies to both the issuer and the holder of the instrument. Outstanding instruments within the scope of the guidance in paragraphs 815-40-15-5 through 15-8 shall always be considered issued for accounting purposes, except as discussed in the next sentence. Lock-up options shall not be considered issued for accounting purposes unless and until the options become exercisable.
ASC Master Glossary
Lock-Up Options
Contingently exercisable options to purchase equity securities of another party to a business combination, at favorable prices, to encourage successful completion of that combination. If the merger is consummated as proposed, the options expire unexercised. If, however, a specified event occurs that interferes with the planned business combination, the options become exercisable.
Unless a scope exception applies, contracts that are only contingently
exercisable (e.g., equity-linked financial
instruments that become issuable or exercisable
upon an initial public offering [IPO] or other
contingent event) are not exempt from ASC 815-40.
One scope exception applies to lock-up options in
business combinations. ASC 815-40-15-6 specifies
that such options are “not . . . considered issued
for accounting purposes unless and until [they]
become exercisable.” Effectively, this means that
no accounting recognition is given to such options
before they become exercisable.
As defined in the ASC master glossary, lock-up options are limited to certain
contingent options exchanged by parties to a contemplated business
combination. The purpose of such options is to promote the completion
of the business combination between the parties. The options are meant
to “lock up” the acquiree and prevent it from being sold to other
potential buyers. For instance, lock-up options might give the
potential acquirer in a business combination the right to purchase
additional equity of the target company at a favorable price in the
event a third party purchases a large interest in the target company.
In this case, the options are designed to discourage third parties
from buying a large interest in the target company. If the business
combination proceeds as planned, however, the options never become
exercisable.
In addition, lock-up options are not specifically limited to those arrangements
for which no consideration is exchanged or firmly
committed. Further, the guidance on lock-up
options applies not only to freestanding financial
instruments but also to embedded features (e.g., a
lock-up option in a loan commitment).
2.5.3 Share-Settleable Earn-Out Arrangements
A special-purpose acquisition company (SPAC) is a newly formed company
that raises cash in an IPO and uses that cash or the equity of the SPAC, or both, to fund
the acquisition of a target. After a SPAC IPO, the SPAC’s management looks to complete an
acquisition of a target within the period specified in its governing documents (e.g., 24
months). In many cases, the SPAC and target may need to secure additional financing to
facilitate the transaction. For example, they may consider funding through a private
investment in public equity, which will generally close contemporaneously with the
consummation of the transaction. If an acquisition cannot be completed within the required
time frame, the cash raised by the SPAC in the IPO must be returned to the investors and
the SPAC is dissolved (unless the SPAC extends its timeline via a proxy process).
As part of the merger negotiations, the SPAC and target may agree to
enter into what is often referred to as an “earn-out” arrangement. Share-settleable
earn-out arrangements may be established with the target’s shareholders, the SPAC’s
sponsors, or both. Generally, share-settleable earn-out arrangements have the following
characteristics:
- The combined company is required to issue additional shares of common stock if, during a specified period after the merger date, its stock price equals or exceeds a stated amount or amounts.
- Some or all of the shares not previously issued will become issuable upon the occurrence of a specific event (e.g., a change of control of the combined company).
- The settlement must occur in shares (i.e., the combined company or holder cannot elect cash settlement).
Example 2-3
SPAC Earn-Out Arrangement
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will be issued to the target’s
shareholders for each of the following share price levels achieved over the
next five years:
- Level 1 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $10 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $10 per share.
- Level 2 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $15 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $15 per share.
- Level 3 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $20 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $20 per share.
- Level 4 — (1) The volume-weighted average price of the combined company’s common stock over any 20 trading days in a 40-day trading period is equal to or greater than $25 per share or (2) the combined company is acquired in a change of control at a price equal to or greater than $25 per share.
If Level 4 is achieved, an aggregate of 4 million common
shares of the combined company (i.e., 1 million shares for each level) will be
issued pro rata to the target’s shareholders on the basis of their
pretransaction ownership interests.
For share-settleable earn-out arrangements such as those in the example
above, the accounting treatment of the shares awarded depends on the arrangements’ terms.
In cases in which these types of earn-out arrangements are entered into with the SPAC’s
sponsor, the shares are generally issued before the transaction; however, at the time of
the SPAC transaction, they become subject to either transfer restrictions or forfeiture on
the basis of one or more share price levels or the occurrence of a specific event (e.g., a
change of control). Such shares may or may not be held in escrow. In either case, if the
holder of the shares is subject to losing those shares (i.e., they would be forfeited if
one or more conditions are not met), for accounting purposes, those arrangements are
treated in the same manner as share-settleable earn-out arrangements that involve the
conditional issuance of shares (i.e., they are treated as equity-linked instruments as
opposed to outstanding shares). If, however, the owner legally owns the shares and is
subject only to transfer restrictions that lapse upon the earlier of (1) meeting one or
more specific conditions or (2) a stated date, such shares are considered to be
outstanding shares of stock subject to transferability restrictions rather than
equity-linked instruments. In other words, share-settleable earn-out arrangements that
contain vesting-type conditions are treated as equity-linked instruments (regardless of
whether the related shares have been issued), whereas earn-out arrangements that subject
the holder only to transfer restrictions are treated as outstanding shares.
Share-settleable earn-out arrangements that represent equity-linked
instruments are classified as either liabilities or equity instruments on the basis of ASC
815-40 unless such arrangements are within the scope of ASC 480 or ASC 718.4 Contracts that are classified in equity under ASC 815-40 are not remeasured.
However, contracts classified as liabilities must be subsequently remeasured at fair
value, with changes in fair value recognized in earnings.
To be classified as an equity instrument under ASC 815-40, a
share-settleable earn-out arrangement must meet the indexation and equity classification
requirements in ASC 815-40. The application of ASC 815-40 to these arrangements can be
very complex. Before beginning the analysis, entities must ensure that they have a
complete understanding of all the relevant terms. For example, in some cases, the main
provisions are included in a separate section of the merger agreement, but there could be
other agreements or “side letters” that modify or expand upon such terms. In addition, the
terms of such arrangements may be affected by definitions that are difficult to interpret.
Entities may need to consult with their legal advisers to obtain an understanding of such
definitions.
Several considerations, including those related to the following, are
relevant in the determination of how ASC 815-40 applies to an equity-linked instrument
such as a share-settleable earn-out arrangement.
- The unit of account — The arrangement may be a single unit of account, or it may contain multiple units of account, depending on whether (1) the arrangement as a whole represents a freestanding financial contract or (2) there are multiple freestanding financial contracts within the overall arrangement. (See Section 3.2 for further discussion of the unit of account.)
- Whether the equity-linked instrument is indexed to the combined company’s stock under ASC 815-40-15 — Only share-settleable earn-out arrangements that are indexed to the issuing entity’s stock may be classified in equity. (See Sections 4.2.3.2 and 4.3.7.4 for further discussion of indexation requirements.)
- Whether the equity-linked instrument satisfies the conditions for equity classification under ASC 815-40-25 — Only share-settleable earn-out arrangements for which the entity controls settlement in shares may be classified in equity. (See Chapter 5 for further discussion of these classification requirements.)
- Whether the earn-out arrangement gives the holder nonforfeitable rights to dividends irrespective of the arrangement’s classification as an equity or liability instrument — If this is the case, the instrument is a participating security regardless of whether the combined company actually declares or pays dividends. (See Deloitte’s Roadmap Earnings per Share for discussion of participating securities and the two-class method of calculating EPS.)
Footnotes
4
Generally, a share-settleable earn-out arrangement would be subject
to ASC 718 if the holder must provide service to the combined company after the merger
date and one or more share-price levels are reached or other conditions are met.
Therefore, entities should consider whether the counterparty to the arrangement must
provide services to the combined company to earn the award.
2.6 Consolidation and the Equity Method
2.6.1 Contracts on the Stock of Consolidated Subsidiaries
ASC 810-10
45-17A An equity-classified
instrument (including an embedded feature that is
separately recorded in equity under applicable GAAP)
within the scope of the guidance in paragraph
815-40-15-5C shall be presented as a component of
noncontrolling interest in the consolidated financial
statements whether the instrument was entered into by
the parent or the subsidiary. However, if such an
equity-classified instrument was entered into by the
parent and expires unexercised, the carrying amount of
the instrument shall be reclassified from the
noncontrolling interest to the controlling interest.
ASC 815-40
15-5C Freestanding financial
instruments (and embedded features) for which the payoff
to the counterparty is based, in whole or in part, on
the stock of a consolidated subsidiary are not precluded
from being considered indexed to the entity’s own stock
in the consolidated financial statements of the parent
if the subsidiary is a substantive entity. If the
subsidiary is not a substantive entity, the instrument
or embedded feature shall not be considered indexed to
the entity’s own stock. If the subsidiary is considered
to be a substantive entity, the guidance beginning in
paragraph 815-40-15-5 shall be applied to determine
whether the freestanding financial instrument (or an
embedded feature) is indexed to the entity’s own stock
and shall be considered in conjunction with other
applicable GAAP (for example, this Subtopic) in
determining the classification of the freestanding
financial instrument (or an embedded feature) in the
financial statements of the entity. The guidance in this
paragraph applies to those instruments (and embedded
features) in the consolidated financial statements of
the parent, whether the instrument was entered into by
the parent or the subsidiary. The guidance in this
paragraph does not affect the accounting for instruments
(or embedded features) that would not otherwise qualify
for the scope exception in paragraph 815-10-15-74(a).
For example, freestanding instruments that are
classified as liabilities (or assets) under Topic 480
and put and call options embedded in a noncontrolling
interest that is accounted for as a financing
arrangement under Topic 480 are not affected by this
guidance. For guidance on presentation of an
equity-classified instrument (including an embedded
feature that is separately recorded in equity under
applicable GAAP) within the scope of the guidance in
this paragraph, see paragraph 810-10-45-17A.
In consolidated financial statements, contracts potentially indexed to, and
potentially settled in, the equity shares of a consolidated subsidiary are analyzed in a
manner similar to contracts on the parent entity’s own stock unless the subsidiary is not
a substantive entity. Thus, a contract on subsidiary stock could be within the scope of
ASC 815-40 and qualify for equity classification in the consolidated financial statements
even though it is not on the parent entity’s own stock. This is the case irrespective of
whether the parent or the subsidiary entered into the contract. An equity-classified
contract on the stock of a consolidated subsidiary is presented as a component of
noncontrolling interest in the consolidated financial statements.
If the subsidiary is not a substantive entity, a contract on that subsidiary’s
stock is outside the scope of ASC 815-40 and does not qualify for equity classification
regardless of whether the contract otherwise meets the conditions for equity
classification in ASC 815-40. However, since ASC 815-40 does not define “substantive
entity,” judgment must be used in the determination of whether an entity is substantive.
For example, a shell entity that holds commodities or stocks might not be a substantive
entity.
2.6.2 Contracts on the Stock of a Parent or Other Entity That Is Not Consolidated
In the subsidiary’s separate financial statements, the equity of its parent
would not be considered part of the subsidiary’s equity. Therefore, a contract potentially
indexed to, and potentially settled in, the parent’s stock would be outside the scope of
ASC 815-40 and could not be classified within equity in the subsidiary’s separate
financial statements. For the same reason, a contract on the stock of an affiliated entity
that is not consolidated by the reporting entity (e.g., a sister company within a group)
would be outside the scope of ASC 815-40. Such a contract would not qualify as equity in
the reporting entity’s financial statements, although it might qualify as equity in the
reporting entity’s parent’s financial statements if the parent consolidates the affiliated
entity. See Section 5.2.7 for
further discussion about the analysis under ASC 815-40-25 of contracts indexed to an
entity’s own equity that can be settled in the shares of another entity within a
consolidated group.
Connecting the Dots
The discussion above focuses on a subsidiary’s accounting for an equity-linked
instrument that is indexed to the stock of its parent or to the stock of an affiliate
that is not consolidated by the subsidiary. As noted previously, in the application of
ASC 815-40, the stock of a subsidiary’s parent or its affiliate is not considered
equity of the subsidiary; therefore, an equity-linked instrument on the stock of the
subsidiary’s parent or its affiliate may not be classified in equity. However, this
does not mean that a subsidiary should classify an ownership interest in the stock of
its parent or its affiliate as an asset. Rather, it is presumed that such ownership is
established to facilitate a treasury stock transaction on behalf of the subsidiary’s
parent or its affiliate and that the ownership interest should therefore be classified
in equity within the subsidiary’s separate financial statements. See further
discussion in Section 4.3.2.1 of Deloitte’s
Roadmap Noncontrolling Interests.
2.6.3 Contracts on the Stock of an Equity Method Investee
Equity shares issued by an equity method investee are not considered part of the
entity’s own equity. Therefore, contracts potentially indexed to, and potentially settled
in, the equity shares of an equity method investee would be outside the scope of ASC
815-40.
2.6.4 Certain Option Combinations Involving Noncontrolling Interests
ASC 815-40
15-3 The guidance in this Subtopic does not apply to any of the following: . . .
d. A written put option and a purchased call option embedded in the shares of a noncontrolling
interest of a consolidated subsidiary if the
arrangement is accounted for as a financing under
the guidance beginning in paragraph 480-10-55-53 .
. . .
ASC 480-10
55-53 A controlling majority owner (parent) holds 80 percent of a subsidiary’s equity shares. The remaining 20 percent (the noncontrolling interest) is owned by an unrelated entity (the noncontrolling interest holder). Simultaneous with the acquisition of the noncontrolling interest, the noncontrolling interest holder and the parent enter into a derivative instrument that is indexed to the subsidiary’s equity shares. The terms of the derivative instrument may be any of the following: . . .
b. The parent has a call option to buy the other 20 percent at a fixed price at a stated future date, and the
noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those
same terms, that is, the fixed price of the call is equal to the fixed price of the put option. (Derivative 2) . . .
55-55 Depending on how Derivative 2 was issued, one
of three different accounting methods applies. If Derivative 2 was issued as a
single freestanding instrument, under this Subtopic it would be accounted for
in its entirety as a liability (or an asset in some circumstances), initially
and subsequently measured at fair value. If the written put option and the
purchased call option in Derivative 2 were issued as freestanding instruments,
the written put option would be accounted for under this Subtopic as a
liability measured at fair value, and the purchased call option would be
accounted for under Subtopic 815-40. Under both of those situations, the
noncontrolling interest is accounted for separately from the derivative
instrument under applicable guidance. However, if the written put option and
purchased call option are embedded in the shares (noncontrolling interest) and
the shares are not otherwise classified as liabilities under the guidance in
this Subtopic, the instrument shall be accounted for as discussed in paragraph
480-10-55-59 with the parent consolidating 100 percent of the subsidiary.
55-57 In applying paragraphs 480-10-25-4 through 25-14 to determine classification, a freestanding financial instrument within this Subtopic’s scope is precluded from being combined with another freestanding financial instrument, unless combination is required under the provisions of Topic 815; therefore, unless under the particular facts and circumstances that Topic provides otherwise, freestanding derivative instruments in the scope of this Subtopic would not be combined with the noncontrolling interest.
55-58 This guidance is limited to circumstances in which the parent owns a majority of the subsidiary’s outstanding common stock and consolidates that subsidiary at inception of the derivative instrument. This guidance is limited to the specific derivative instruments described.
Written Put Option and Purchased Call Option Embedded in Noncontrolling Interest
55-59 If the derivative instrument in Derivative 2 is
embedded in the shares (noncontrolling interest) and the shares are not
otherwise classified as liabilities under the guidance in this Subtopic, the
combination of options should be viewed on a combined basis with the
noncontrolling interest and accounted for as a financing of the parent’s
purchase of the noncontrolling interest.
55-60 Under that approach, the parent would consolidate 100 percent of the subsidiary and would attribute the stated yield earned under the combined derivative instrument and noncontrolling interest position to interest expense (that is, the financing would be accreted to the strike price of the forward or option over the period until settlement). No gain or loss would be recognized on the sale of the noncontrolling interest by the parent to the noncontrolling interest holder at the inception of the derivative instrument.
55-61 The risks and rewards
of owning the noncontrolling interest have been retained
by the parent during the period of the derivative
instrument, notwithstanding the legal ownership of the
noncontrolling interest by the counterparty. Combining
the two transactions in this circumstance reflects the
substance of the transactions; that the counterparty is
financing the noncontrolling interest. Upon such
combination, the resulting instrument is not a
derivative instrument subject to Subtopic 815-10.
55-62 This accounting applies even if the exercise prices of the put and call options are not equal, as long as those exercise prices are not significantly different.
ASC 480-10-55-53 through 55-62 require certain embedded option combinations
involving a noncontrolling interest of a consolidated subsidiary to be accounted for on a
combined basis with the noncontrolling interest as a financing of the parent’s purchase of
the noncontrolling interest. Such option combinations are exempt from the scope of ASC
815-40. This accounting treatment applies when:
-
The parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary.
-
The remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest) are held by a third party.
-
Simultaneously with the acquisition of the noncontrolling interest, the parent and the holder of the noncontrolling interest enter into the following option combination:
-
The parent has a call option to purchase the noncontrolling interest at a fixed price on a stated future date.
-
The noncontrolling interest holder has a put option to sell the noncontrolling interest to the parent under the same terms. (ASC 480-10-55-62 suggests that the exercise prices do not need to be equal as long as they are not significantly different.)
-
-
The options are embedded in the shares representing the noncontrolling interest (i.e., they are not considered freestanding instruments).
-
The noncontrolling interest shares do not meet the definition of a mandatorily redeemable financial instrument (see Chapter 4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).
This guidance applies irrespective of whether the noncontrolling interest is in
the form of common stock or preferred stock. Further, the guidance applies even if the
relative ownership interests of the parent and the holder of the noncontrolling interest
differ from the levels assumed in the fact pattern described in ASC 480 (i.e., 80 percent
and 20 percent), provided that the parent owns a majority of the subsidiary’s outstanding
common stock and consolidates the subsidiary at the inception of the arrangement (ASC
480-10-55-58). The guidance does not apply, however, if the option strike prices are based
on a formula (e.g., EBITDA) that is not simply an indexation to interest rates rather than
being fixed or if the options are contingent on the satisfaction of certain conditions
(for further discussion, see Section
7.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).
If a parent and the holder of a noncontrolling interest enter into put and call
options on the noncontrolling interest and either the option combination or each option is
considered to be a freestanding financial instrument (see Section 3.2.1) that is separate from the
noncontrolling interest, the noncontrolling interest and the options would not be
accounted for on a combined basis as a financing of the parent’s purchase of the
noncontrolling interest. Instead, the accounting for the options depends on whether they
represent a single freestanding financial instrument (in which case the option combination
is accounted for as an asset or a liability under ASC 480-10-25-8) or two separate
freestanding financial instruments (in which case the put option is accounted for as a
liability under ASC 480-10-25-8, and the call option is evaluated under ASC 815-40).
Either way, the accounting differs from that specified for noncontrolling interests with
embedded options in ASC 480-10-55-59 through 55-62, because the noncontrolling interest
would be reflected in equity by the parent.
2.7 Guarantee Contracts
ASC 815-40
15-10 Topic 460 provides an exception from its initial recognition and initial measurement requirements, but not its disclosure provisions, for a guarantee for which the guarantor’s obligation would be reported as an equity item (rather than a liability) under generally accepted accounting principles (GAAP).
15-11 If
a contract under this Subtopic is required to be accounted
for as a liability under this Subtopic and also meets the
definition of a guarantee under Topic 460 (for example, a
physically settled written put option), both this Subtopic
and that Topic are consistent with respect to requiring the
issuer to account for the contract at fair value at the
initial measurement date. In that situation, the guarantee
would also be subject to the disclosure requirements of
Topic 460.
A contract potentially indexed to, and potentially settled in, an entity’s own
stock might fall within the scope of both ASC
815-40 and ASC 460. ASC 460-10-15-4 states that
with certain exceptions, ASC 460 applies to the
following types of guarantee contracts:
-
Contracts that contingently require a guarantor to make payments [including cash, financial instruments, other assets, shares of its stock, or provision of services] to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. . . .
-
Contracts that contingently require a guarantor to make payments . . . to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees). . . .
-
Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
-
Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
ASC 460-10-25-1(d) and ASC 460-10-30-1 exempt from the scope of the recognition
and initial measurement guidance on guarantee contracts in ASC 460 “[a] guarantee
for which the guarantor’s obligation would be reported as an equity item” (e.g.,
under ASC 815-40) rather than as a liability. However, the disclosure requirements
for guarantees in ASC 460 would apply to such contracts unless they are eligible for
a scope exception in ASC 460-10-15-7 (e.g., guarantees of an entity’s own future
performance are excluded from the scope of ASC 460).
Example 2-4
Guarantee Contracts
Assume:
- An entity writes a call option that gives the holder the right to purchase equity securities of the option issuer in exchange for payment of cash by the holder.
- The entity knows that the holder of the call option is purchasing the option to cover a short position in the entity’s equity securities.
In this example, the entity may conclude that the contract is within the scope of ASC 460 on the basis of ASC 460-10-15-4(a) since the issuer is required to transfer an equity security to the option holder as a result of the changes in a liability of the option holder (the underlying short position).
However, if the issuer has no factual basis on which to conclude that the holder
of the call option is purchasing the option to cover a short
position in the asset, the written call option is not within
the scope of ASC 460 since the issuer does not have the
information necessary to conclude that the option holder has
an underlying short position.
2.8 Contingently Issuable Contracts
ASC 815-40
15-6 The guidance in this paragraph applies to both the issuer and the holder of the instrument. Outstanding instruments within the scope of the guidance in paragraphs 815-40-15-5 through 15-8 shall always be considered issued for accounting purposes, except as discussed in the next sentence. Lock-up options shall not be considered issued for accounting purposes unless and until the options become exercisable.
Unless a scope exception applies (such as the one for lock-up options [see Section 2.5.2]), contracts on an
entity’s own equity that are only contingently issuable, exercisable, or settleable
are not exempt from ASC 815-40. Thus, a freestanding equity-linked instrument that
becomes issuable, exercisable, or settleable only upon the occurrence or
nonoccurrence of a specified event (e.g., an IPO, a debt draw, or the meeting of a
revenue target) is considered issued for accounting purposes and evaluated under ASC
815-40. ASC 815-40 applies even if the specified event is within the entity’s
control. This is illustrated in the example in ASC 815-40-55-26, which implies that
a warrant that is exercisable solely upon the occurrence of an IPO (which is an
event that an entity typically has the ability to avoid) is within the scope of ASC
815-40. Further, ASC 815-40 applies even if no consideration is exchanged at
inception.
A contingency that affects the exercisability or settlement of an equity-linked
instrument influences its measurement but not the fact that the instrument is issued
for accounting purposes. Since one party has agreed to give up an asset (e.g.,
cash), perform a service, or do some combination of both, the instrument must be
considered issued for accounting purposes. That is, if a contract or any other
enforceable arrangement is established as a result of one party’s performance, the
instrument must be recognized for accounting purposes regardless of the nature of
the contingencies that affect the exercisability or settlement of the instrument.
All instruments that are considered issued for accounting purposes contain value
since there would be no reason for two parties to enter into an arrangement that
does not have value.
Freestanding equity-linked instruments that become issuable,
exercisable, or settleable only upon the occurrence or nonoccurrence of a specified
event are often executed in connection with the issuance of preferred stock, debt,
or loan commitments. For example, in conjunction with the issuance of convertible
preferred stock, entities often enter into agreements to issue additional shares of
the preferred stock if certain milestones are met in the future. (Such transactions
are often referred to as issuances of “tranche preferred stock.”) In addition,
entities commonly issue warrants that are exercisable on the basis of the amount of
debt draws made under a loan commitment. These types of freestanding equity-linked
instruments are considered issued and outstanding for accounting purposes regardless
of whether they are deemed legally issued before the specified event occurs or fails
to occur. Entities must therefore apply the guidance in ASC 815-40 to determine
whether to classify such instruments as liabilities or equity. The unit of account
identified for an instrument may significantly affect its classification (see
Section 3.2).
Although less common, there may be situations in which equity-linked
instruments that become issuable, exercisable, or settleable only upon the
occurrence or nonoccurrence of a specified event represent embedded features in a
hybrid financial instrument. In these cases, the embedded features must be evaluated
for bifurcation in accordance with ASC 815-15.
Example 2-5
Warrant That Vests on
the Basis of Debt Draw
Company A executes a credit facility with
Bank B, which permits, but does not require, A to borrow $15
million. As part of the agreement, A provides B with a
warrant, which becomes exercisable (vested) only if A elects
to draw on the credit facility. Once vested, the warrant
permits B to purchase 1 million shares of A’s common stock.
The warrant is viewed as outstanding under ASC 815-40 before
the vesting condition has been met even though the
contingency underlying the exercisability of the warrant is
within the entity’s control. Accordingly, A should evaluate
the warrant under ASC 815-40 to determine whether it should
account for it as a liability or equity instrument even if A
has not yet drawn on the credit facility. (Note that before
A draws on the credit facility, this warrant would be
outside the scope of ASC 480 even if the underlying shares
were to include a deemed liquidation feature or other
redemption provision outside of A’s control, provided that A
has discretion to avoid a transfer of assets or equity
shares by electing not to make any draw; see Section
2.2.1.3 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.)
Note that in this example, the warrant is considered a
freestanding financial instrument, which is generally the
case for these types of arrangements. If, however, the
warrant was considered embedded in the loan commitment, the
warrant would be bifurcated from the loan commitment host
contract and recognized as a derivative liability unless it
(1) does not meet the definition of a derivative or (2)
qualifies for equity classification under ASC 815-40. An
entity would not be able to apply the loan commitment scope
exception to the warrant because this scope exception could
only be applied to the host contract.
Example 2-6
Warrants That Vest on
the Basis of Debt Draws
Company A executes a credit facility with
Bank B, which permits, but does not require, A to borrow up
to $10 million. As part of the agreement, A provides B with
warrants, which become exercisable (vested) only if A elects
to draw specified amounts on the credit facility. The
warrants permit B to purchase the following number of
shares:
-
200,000 shares for the first $2.5 million of debt drawn.
-
300,000 shares for the second $2.5 million of debt drawn.
-
500,000 shares for the remaining $5 million of debt drawn.
The warrants are viewed as outstanding under
ASC 815-40 even if no amounts have been drawn. Accordingly,
A should evaluate the warrants under ASC 815-40 to determine
whether it should account for them as liabilities or equity
instruments. Note that if the warrants are determined to be
one unit of account (see Section 3.2), they
would not be considered indexed to the entity’s own stock
under ASC 815-40-15, because the amount of debt draws
affects the settlement amount. Since this underlying is not
an input into the pricing of a fixed-for-fixed option on
equity shares (see Sections 4.2.2.3 and
4.3.3), the warrants would be accounted for
as liabilities under ASC 815-40.
Note that in this example, the warrants are
considered freestanding financial instruments, which is
generally the case for these types of arrangements. If,
however, the warrants were considered embedded in the loan
commitment, the warrants would be bifurcated from the loan
commitment host contract and recognized as derivative
liabilities unless they do not meet the definition of a
derivative. An entity would not be able to apply the loan
commitment scope exception to the warrants because this
scope exception could only be applied to the host
contract.
Nevertheless, if an arrangement is not contractually binding or legally
enforceable, it is not recognized. For example, an arrangement would generally not
be recognized if both parties have an unconditional right to cancel it (i.e., to
“walk away”) without any penalty or right to recover damages. An entity should
consult its legal advisers for assistance in determining whether an arrangement is
contractually binding or legally enforceable.
Example 2-7
Nonbinding Accelerated Share Repurchase Transaction
On June 15, 20X0, Company A entered into an accelerated share repurchase (ASR)
agreement with Bank B that clearly defined all significant
terms of the transaction (see Section 3.2.5 for a description of an ASR
transaction). The agreement included a cancellation
provision under which both A and B had the right to
terminate the ASR at any time before the settlement of the
initial treasury stock repurchase on July 1, 20X0 (the
prepayment date), by written notice to the other party,
without any penalty or recourse for the other party to
recover damages. The ASR should be initially recognized on
the prepayment date when the cancellation right expired and
the contract became binding.
Example 2-8
Nonbinding Plan of
Reorganization in Bankruptcy
An entity has filed for bankruptcy
protection and has filed a proposed plan of reorganization
that includes the issuance of shares and warrants to
specified investors after approval by the bankruptcy court.
The investors have made commitments to purchase the shares
and warrants at specified prices. However, the bankruptcy
court is under no legal obligation to accept the plan and
has full discretion regarding whether to accept or reject
it. In these circumstances, the entity would not recognize
the capital commitments and warrants since they are not
binding on the entity.
2.9 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
ASC 470-20
05-12A An entity for which the cost to an investment banking firm (investment bank) or third-party investors
(investors) of borrowing its shares is prohibitive (for example, due to a lack of liquidity or extensive open
short positions in the shares) may enter into share-lending arrangements that are executed separately but
in connection with a convertible debt offering. Although the convertible debt instrument is ultimately sold to
investors, the share-lending arrangement is an agreement between the entity (share lender) and an investment
bank (share borrower) and is intended to facilitate the ability of the investors to hedge the conversion option in
the entity’s convertible debt.
05-12B The terms of a share-lending arrangement require the entity to issue shares (loaned shares) to
the investment bank in exchange for a nominal loan processing fee. Although the loaned shares are legally
outstanding, the nominal loan processing fee is typically equal to the par value of the common stock, which is
significantly less than the fair value of the loaned shares or the share-lending arrangement. Generally, upon
maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to
the entity for no additional consideration.
05-12C Other terms of a share-lending arrangement typically require the investment bank to reimburse the
entity for any dividends paid on the loaned shares. Typically, the arrangement precludes the investment bank
from voting on any matters submitted to a vote of the entity’s shareholders to the extent the investment bank
is the owner of the shares.
ASC 470-20 provides recognition, measurement, EPS, and disclosure guidance
related to an issuer’s accounting for equity-classified share-lending arrangements
that are executed in contemplation of a convertible debt issuance. This guidance is
designed for arrangements that have the following terms and characteristics:
-
The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
-
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
-
The counterparty will return the loaned shares to the issuer by the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
-
The arrangement qualifies as equity under GAAP.
-
The arrangement was executed in contemplation of a convertible debt issuance or other financing.
In evaluating whether the contract qualifies as equity under GAAP, the issuer
should consider the requirements in ASC 480 and ASC 815-40 (see Sections 4.3.5.12, 5.2.3.6, and 6.1.6).
Own-share lending arrangements usually derive their fair value from the difference between the
contractual processing fee and a market-based rate that would typically be charged for lending such
shares, adjusted as necessary to reflect the nonperformance risk of the share borrower. The terms of a
share-lending arrangement issued 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 is not issued in contemplation
of a convertible debt issuance. The issuer may accept less than a market rate on the arrangement to
promote the issuance of the convertible debt.
Example 2-9
Own-Share Lending Arrangement
Issuer A is in the process of issuing convertible debt. Before certain prospective investors agree to buy the
convertible debt, however, they would like to ensure that they are able to economically hedge their exposure
to A’s share price risk associated with the conversion option embedded in the debt. Accordingly, they seek
to enter into derivative contracts on the underlying shares (such as options, forwards, or total return swaps)
with Bank B that offset the “long” position in A’s share price risk that would result from an investment in the
convertible debt. To economically hedge its exposure from writing such derivatives, B in turn seeks to borrow
the underlying shares. By borrowing the shares, B can sell them short in the market to offset its “long” position
in A’s share price risk that would be created by its derivative contracts with the investors.
Because a sufficient amount of underlying shares is not readily available to market participants (or the price
is too high), B borrows the underlying shares by entering into a share-lending arrangement directly with A.
The terms of the share lending arrangement require B to pay a nominal processing fee to A (e.g., the par
value of the shares) that is significantly less than the agreement’s fair value. Issuer A is motivated to enter
into the agreement because the pricing and successful completion of the convertible debt offering depend
on the investors’ ability to enter into derivative contracts to hedge their equity price exposure, which in turn
depend on B’s ability to borrow the shares from A. During the period that the shares are on “loan,” they are
legally outstanding and the holder is legally entitled to dividends paid on them, although it must reimburse
A for any dividends paid on the loaned shares. Upon conversion or maturity of the convertible debt, B must
physically return the loaned shares to A for no consideration. If B defaults in returning the loaned shares, A is
contractually entitled to a cash payment equal to the fair value of the loaned shares.
Chapter 3 — Contract Analysis
Chapter 3 — Contract Analysis
3.1 Identifying and Evaluating Contractual Terms
3.1.1 Document Review
In determining the appropriate accounting for an equity-linked instrument, the
entity should devote adequate time to reading the
underlying legal documents. Terms that could be
significant to the accounting analysis (e.g.,
contingent net cash settlement requirements or
provisions that adjust the settlement amount) may
be buried deep within the contract’s fine print.
To properly apply the applicable accounting
requirements, the entity needs to evaluate all the
contractual terms, the legal and regulatory
framework, and the relevant facts and
circumstances.
In forming a view on the appropriate accounting for a contract, an entity cannot necessarily rely on the name given to the transaction (e.g., “equity derivative” or “accelerated share repurchase program”) or how it is described in summary term sheets, slide-show presentations, and marketing materials. Products with similar economics sometimes go by different names in the marketplace (e.g., products marketed by different investment banks), while products subject to different accounting may go by the same or similar names (e.g., a warrant on own equity can be designed in a variety of ways). Furthermore, the names given to contractual provisions in legal documents, such as conversion features or share settlement provisions, do not necessarily reflect their economics or how they would be identified and analyzed for accounting purposes; for example, certain redemption provisions may permit conversion features to be net settled (see Section 5.2.4.1). Minor variations in the way contractual terms are defined can have major accounting implications.
An individual contract may consist of multiple legal documents (e.g., a trade
confirmation that refers to a master agreement and side letters), all of which
an entity should consider in identifying the contract’s terms. In addition, when
identifying the terms of a contract on its own shares, the entity should
consider whether the terms of the underlying shares could affect the accounting
analysis of the contract. In identifying the terms of such underlying shares,
the entity should consider all relevant documents, including the entity’s
certificate of incorporation and any shareholder agreement or side letter that
affects the entity’s rights and obligations vis-à-vis a holder of those shares.
For example, if an entity issues a warrant on its own shares and the entity is
party to a shareholder agreement that includes a provision that allows the
holder to put the warrant or the underlying shares to the issuing entity upon a
change of control or other deemed liquidation event, that “put” provision would
affect the warrant’s classification (i.e., the warrant would be classified as a
liability) even though the provision is not contained within the warrant
agreement itself.
3.1.2 Legal Determinations
Before applying the guidance in ASC 815-40, an entity may need to consider the
legal and regulatory framework within which a
transaction takes place. For example, depending on
such framework, the entity may not be able to
assume that it can share settle a contract, which
is one of the conditions for equity
classification, even if the contract states that
it will be settled in shares. Accordingly, in
evaluating the conditions for equity
classification, the entity may need to seek advice
from legal counsel.
3.1.3 ISDA Standard Documentation
Entities often execute and document contracts on their own equity by using standard documentation issued by the International Swaps and Derivatives Association (ISDA). Use of standard documentation can facilitate the negotiation process and enables the parties to elect contractual terms whose definitions are based on industry-wide conventions.
For example, a trade confirmation may (1) incorporate ISDA equity derivatives definitions and (2) supplement, form a part of, and be subject to an agreement in the form of the ISDA master agreement that sets out general terms between the parties. Further, the confirmation may identify adjustments, settlement methods, early termination provisions, and other terms that must be evaluated within the context of an ISDA master agreement and ISDA’s equity derivatives definitions and specify that the terms of the confirmation govern in the event of any inconsistency between the documents. In this case, the application of the indexation and equity classification guidance in ASC 815-40 depends on the elections and modifications an entity has made and how they are defined within the documents. Adjustment or cancellation provisions or netting arrangements may preclude equity classification unless the contracting parties agree to override them in the transaction confirmation (see Section 5.2.2).
In remarks at the
2007 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting
Fellow Ashley Carpenter said:
The [SEC] staff would like to remind management
of the importance of carefully considering all of
the applicable provisions in the transaction
Confirmation and related ISDA Agreements in
applying [ASC 815-40-25]. Considering the
complexity of the issues, the staff encourages
management and auditors to consult with the Office
of the Chief Accountant when specific questions
arise regarding the application of [ASC
815-40-25].
3.2 Unit of Account
ASC 815-40
15-5B The guidance in
paragraphs 815-40-15-5 through 15-8 shall be applied to the
appropriate unit of accounting, as determined under other
applicable U.S. generally accepted accounting principles.
For example, if an entity issues two freestanding financial
instruments and concludes that those two instruments are
required to be accounted for separately, then the guidance
in paragraphs 815-40-15-5 through 15-8 shall be applied
separately to each instrument. In contrast, if an entity
issues two freestanding financial instruments and concludes
that those two instruments are required to be linked and
accounted for on a combined basis as a single financial
instrument (for example, pursuant to the guidance in
paragraph 815-10-15-8), then the guidance in paragraphs
815-40-15-5 through 15-8 shall be applied to the combined
financial instrument.
ASC Master Glossary
Unit of Account
The level at which an asset or a liability is aggregated or disaggregated in a Topic for recognition purposes.
In applying ASC 815-40, an entity should consider how to appropriately identify units of account (i.e., the “level at which an asset or a liability is aggregated or disaggregated” for accounting purposes). While a single contract may represent a unit of account, this is not always the case. Sometimes a single legal agreement consists of more than one unit of account that should be accounted for separately. Examples include:
- A contract that contains two or more components that individually each meet the definition of a freestanding contract, such as components that are legally detachable and separately exercisable (e.g., debt with a detachable warrant or a contingent consideration arrangement that is included in the terms of an acquisition agreement in a business combination).
- A contract that contains a registration payment arrangement (see Section 3.2.4).
- An accelerated share repurchase program (see Section 3.2.5).
- A hybrid financial instrument with an embedded feature that is required to be bifurcated as a derivative, such as a debt contract with an embedded conversion option that has all the characteristics of a derivative and does not qualify as equity under ASC 815-40 (see Section 2.2).
Conversely, two separate agreements might for accounting purposes have to be combined and treated as a single unit of account (e.g., debt issued with a warrant that is not legally detachable and separately exercisable).
3.2.1 The Concept of a Freestanding Contract
ASC 815-40 — Glossary
Freestanding Contract
A freestanding contract is entered into either:
-
Separate and apart from any of the entity’s other financial instruments or equity transactions
-
In conjunction with some other transaction and is legally detachable and separately exercisable.
ASC 815-40-20 defines a freestanding contract as one entered into either
“[s]eparate and apart from any of the entity’s other financial instruments or
equity transactions” or “[i]n conjunction with some other transaction and is
legally detachable and separately exercisable.”1 Therefore, an entity should consider the following questions in
identifying freestanding contracts:
-
Was the transaction entered into contemporaneously with and in contemplation of another transaction, or was it entered into separately and apart from other transactions?The fact that a transaction was entered into separately and apart from any other transaction suggests that it is a freestanding contract that is separate from any other transaction. If the transaction was entered into contemporaneously and in contemplation of another transaction, the entity should assess whether the transactions represent a single freestanding contract. For example, if warrants are issued in conjunction with a debt issuance of the same issuer, the issuer should consider whether to treat them as being embedded in the debt even if they are subject to a separate contractual agreement.A transaction’s having been entered into contemporaneously or in conjunction with some other transaction, however, would not necessarily result in a conclusion that the two transactions should be viewed on a combined basis as a single freestanding contract. The entity should also consider whether the transactions are legally detachable and separately exercisable (see below) and whether the combination guidance in ASC 815 applies (see Section 3.2.2).A one-week period between transactions may be good evidence that the transactions are not contemporaneous if the entity is exposed to market fluctuations during this time. Even when transactions occur at different times, however, entities should consider all available evidence to ensure that no side agreements or other contracts were entered into that suggest that the transactions were entered into in contemplation of one another.Options written by the acquired entity on its stock as of the date of a business combination are often viewed as effectively modifying previously existing shares. Such options are not considered to have been entered into separately and apart from the shares.
-
Is the item legally detachable?Neither ASC 815-40 nor other GAAP provide guidance on the meaning of “legally detachable.” In practice, an item is considered legally detachable from another item if it is (1) separately transferable from that item or (2) otherwise capable of being separated from that item. If an item is separately exercisable but not considered legally detachable, it would not be a separate freestanding contract under item (b) of the definition of a freestanding contract in ASC 815-40-20. However, in some cases, the separate exercisability of an item results in a conclusion that an item is legally detachable.An item is always considered legally detachable if it can be transferred separately from another item in a single contractual agreement (or from another item in multiple contracts entered into at the same time) at the holder’s discretion (i.e., without limitations imposed by the counterparty). The fact that an item can be transferred independently from another item indicates that it is a separate unit of account even if the two items were entered into contemporaneously and have the same counterparty. This view is supported by the guidance in ASC 815-10-25-9, which states, in part:Derivative instruments that are transferable are, by their nature, separate and distinct contracts.Similarly, ASC 815-10-15-5 states, in part:The notion of an embedded derivative . . . does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.However, a scenario in which two items cannot be transferred independently of one another suggests that each item is not a freestanding contract under (b) in the definition of a freestanding contract in ASC 815-40-20. For example, if a warrant “travels with” a bond and cannot be transferred separately from the bond, it may be an embedded feature in the bond.A contract may be entered into in conjunction with some other item. For such a contract to be considered a freestanding contract, an assessment must be performed of both the form and substance of the transaction, including the substance of the independent transferability of the item. In some circumstances, an item is unconditionally separately transferable by the holder but would have no economic value if the related item were not held, which would suggest that the separate transferability has no substance and the item is embedded in the related item (see further discussion in question 3). Similarly, the holder of shares not readily obtainable in the market may have a separately transferable put option that it can exercise only by delivering the same specific shares. In this case, the shares and the put option may represent a single, combined unit of account on the basis of an assessment of the substance of the transaction.In other circumstances, an item may be separately transferred only with the consent of the counterparty. If an item may be separated from a related contract without any modification to the contractual terms (e.g., the contract specifically permits the item to be transferred if the issuer gives its consent and such consent cannot be unreasonably withheld), the legally detachable condition is, in substance, generally met since the counterparty has agreed to not withhold its consent. If, however, the counterparty can always prevent the separate transfer of the item at its discretion, the legally detachable condition is, in substance, most likely not met and therefore the item is not a freestanding contract.The SEC staff has indicated in informal discussions that it is possible for two items that have been entered into contemporaneously with the same counterparty to be considered freestanding contracts solely on the basis of the items’ ability to be separately exercised (i.e., even though the contractual terms prevent the items from being transferred separately). This would generally be the case when a reasonable conclusion can be reached that the separate exercisability of one item is sufficient to establish that it is legally detachable from the related item. However, when determining whether an item can be transferred separately, an entity must use significant judgment and consider the transaction’s form and substance. We therefore strongly recommend that an entity consult with its independent accounting advisers when performing this assessment.
-
Can the item be exercised separately; or does its exercise result in the termination, redemption, or automatic exercise of a specifically identified item?If an item can be freely exercised without terminating another item (e.g., through redemption, automatic exercise, or expiration), it is considered to be “separately exercisable.” The fact that a warrant remains outstanding if a bond to which it is attached is redeemed, for example, suggests that the warrant is a freestanding contract that is separate from the bond. Similarly, if a bond may remain outstanding after a net-share-settled conversion feature in the bond is exercised, the conversion feature may be a freestanding contract.Conversely, if the exercise of an item results in the termination of a specifically identified item, the first item would not be considered “separately exercisable” from the other item. For example, if a warrant can be exercised only by tendering a specific bond in a physical settlement, it may be a feature embedded in the bond rather than a freestanding contract. ASC 470-20-25-3 states, in part:[I]f stock purchase warrants are not detachable from [a] debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument.Similarly, if a specifically identified share is subject to a redemption requirement, the share and the redemption requirement may represent one freestanding contract even if they are documented in separate agreements. ASC 480-10-15-7C states, in part:Some entities have issued shares that are required to be redeemed under related agreements. If the shares are issued with a redemption agreement and the required redemption relates to those specific underlying shares, the shares are mandatorily redeemable.
-
Does the transaction involve multiple counterparties?Contracts with different counterparties are treated as separate freestanding contracts even if they are issued contemporaneously or are transacted as a package. Thus, ASC 815-10-15-6 suggests that an option added or attached to an existing debt instrument by another party is not an embedded derivative because it does not have the same counterparty. Similarly, ASC 815-15-25-2 indicates that the notion of an embedded derivative in a hybrid instrument does not refer to provisions in separate contracts between separate counterparties.Example 3-1Issuance of a Bond With a WarrantAn entity delivers a bond and a warrant on own equity to an underwriter for cash. The underwriter is a party to the warrant but holds the bond merely as an agent for a third-party investor. The terms and pricing of the bond sold to the third-party investor are not affected by the sale of the warrant to the underwriter. Because they involve different counterparties, the bond and the warrant are two separate freestanding contracts.Under ASC 815-10-25-10, transactions that are entered into with a single party are treated as having the same counterparty even if some of them are structured through an intermediary. In consolidated financial statements, the reporting entity is the consolidated group. Therefore, the parent and its subsidiary would not be considered different parties in the consolidated financial statements. For example, if a parent entity writes a put option on subsidiary shares to the holder of those shares, it is acceptable to view the option as being embedded in the shares in the consolidated financial statements even though the subsidiary technically is not a party to the option.
3.2.2 Combination Guidance
ASC 815 contains additional guidance to help an
entity determine whether two or more separate transactions should be viewed as
separate units of accounting or combined for accounting purposes. ASC
815-10-15-8 states, in part:
In some circumstances, an
entity could enter into two or more legally separate transactions that, if
combined, would generate a result that is economically similar to entering
into a single transaction that would be accounted for as a derivative
instrument under this Subtopic.
Nevertheless, ASC 815 ordinarily does not permit an entity to treat two or more
freestanding financial instruments as a single combined unit of account because
ASC 815 is transaction-based.
ASC 815-10-25-6 states, in part:
This Subtopic generally
does not provide for the combination of separate financial instruments to be
evaluated as a unit.
However, if two or more freestanding contracts have characteristics suggesting
that they were structured to circumvent GAAP, they may need to be combined and
treated as a single unit of account. Specifically, ASC 815 requires two or more
separate transactions to be combined and viewed in combination as a single unit
of account for accounting purposes if they were entered into in an attempt to
circumvent that subtopic’s accounting requirements for derivatives (i.e.,
measured at fair value, with subsequent changes in fair value recognized in
earnings except for qualifying hedging instruments in cash flow or net
investment hedges). ASC 815-10-15-9 states that such combination is required if
the transactions have all of the following characteristics:
-
They “were entered into contemporaneously and in contemplation of one another.”
-
They “were executed with the same counterparty (or structured through an intermediary).”
-
They “relate to the same risk.”
-
“There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those listed above from
ASC 815-10-15-9 and adds the following commentary, in part:
If separate derivative instruments have all of [these] characteristics,
judgment shall be applied to determine whether the separate derivative
instruments have been entered into in lieu of a structured transaction in an
effort to circumvent GAAP: . . . If such a determination is made, the
derivative instruments shall be viewed as a unit.
Note that the SEC staff has indicated that it will challenge the accounting for
transactions that have been structured to circumvent GAAP.
3.2.3 Application of the Unit of Account Guidance
3.2.3.1 Examples
Example 3-2
Units Consisting of Stock and Warrants
An entity undertakes a placement offering, in which common shares and warrants to acquire common shares are issued simultaneously as one unit. If the warrants are legally detachable and can be exercised separately from the common stock after issuance, they are considered units of account separate from the common shares.
Example 3-3
Issuance of Shares and Call Options
An entity issues equity shares along with call options that permit the counterparty to acquire additional shares. The issuance of the shares and the options is documented in the same legal agreement. The equity shares and options are not publicly traded. The options cannot be readily settled outside the agreement. The shares remain outstanding upon exercise or expiration of the options. Because the rights associated with the shares extend beyond the term of the options, and the exercise of the options does not result in the termination of the existing shares, they are considered legally detachable and separately exercisable. Accordingly, the shares and the options are separate, freestanding contracts that represent separate units of account.
Example 3-4
Issuance of Warrants and Put Options
An entity issues stock purchase warrants on its stock to third-party investors.
In conjunction with that transaction, the entity
enters into a warrant-holder rights agreement with
each warrant holder under which they receive a put
right allowing them to require the entity to
purchase for cash any or all of the shares issued or
issuable to them under the warrants. The put right
cannot be sold separately from the shares issued or
issuable, and those shares cannot be sold separately
from the put rights. In other words, the put rights
are directly linked to the shares that are issued or
issuable under each warrant and accompany the shares
if sold or transferred to another party. The put
rights cannot be used to put back shares other than
those issued or issuable under the warrants. In this
example, the warrants and put rights are combined
and viewed as one unit of account, even though they
are contained in two separate legal documents. (The
accounting for this instrument is addressed in
Example 3-2 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity.)
Example 3-5
Share Modification
An entity enters into an option agreement that gives the entity a right to call
a specific, outstanding equity security from the
holder of that security. Although the counterparty
maintains its right to transfer the underlying share
to another investor, any future investor would
continue to be bound by the terms of the option
agreement attached to the share. Further, the
investor must satisfy its obligation under the call
feature by transferring back to the entity the
specific underlying share to which the option
agreement is attached. In these circumstances, the
option agreement is not a separate unit of account
and should be analyzed on a combined basis with the
underlying share as a single unit of account. The
entity would treat the option agreement as a
modification of the original share.
Example 3-6
Put Option on Noncontrolling Interest
An entity holds 70 percent of the equity shares of another entity and consolidates that entity (i.e., the entities have a parent-subsidiary relationship). The remaining 30 percent of the shares (the noncontrolling interest) are held by a third party. After the parent acquires its 70 percent of the shares and the third party acquires its 30 percent, the parent entity writes a put option that permits the third party to sell all of its shares to the parent for a fixed price on or before a specified date. Unlike the put option, the shares have no expiration date. Upon exercise, the put option is physically settled. There is no mechanism to net cash or net share settle the option. Given the nature of its terms, the put option cannot be transferred separately from the noncontrolling interest, and the exercise of the put option results in the termination of the noncontrolling interest.
Because it is not legally detachable and separately exercisable, the put option
should be considered embedded in the noncontrolling
interest rather than a freestanding contract.
Because redemption is not certain to occur, the
entity would not classify the instrument (the
combination of the noncontrolling interest and the
put option) as a liability under ASC 480 (see
Chapter 4 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity). In the parent’s
consolidated financial statements, the put option
may be considered embedded in the noncontrolling
interest irrespective of whether the option issuer
is the parent or the subsidiary.
Example 3-7
Issuance of Shares and Put Options
An entity issues equity shares along with put options that give the counterparty
the right to require the entity to redeem the same
number of shares for cash. The options can be
physically settled only through the exchange of
shares for cash. The put options do not require
delivery of any specifically identified shares, and
because shares issued with the put options are
publicly traded, they are not the only shares
available to settle the put option. Therefore, the
put options would not be considered embedded in the
shares. (The accounting for the put options is
addressed in Example 3-4 of
Deloitte’s Roadmap Distinguishing
Liabilities From Equity.)
Example 3-8
Tranche
Preferred Stock Agreement
Entity X enters into a preferred
stock purchase agreement with unrelated investors to
sell two tranches of convertible redeemable
preferred stock (the “preferred stock”). The
purchase agreement stipulates the following:
-
On the first closing date, which is the date of the purchase agreement, the investors will acquire 50,000 shares of preferred stock for $50 million.
-
On the second closing date, the investors will acquire 25,000 additional shares of preferred stock for $25 million subject to a specified condition. The second closing will occur only if (1) a specific milestone related to X’s operations is achieved two years from the first closing date or (2) the specific milestone related to X’s operations is not achieved two years from the first closing date but the holders waive the milestone requirement and elect to purchase the additional shares of preferred stock (the “contingent purchase option”).
The purchase agreement stipulates
that the holders of preferred stock issued in the
first closing cannot transfer their contingent
purchase options separately from the preferred
shares acquired in the first closing (or vice
versa). However, such holders have the right to
convert those preferred shares into common stock
before the date that is two years from the first
closing date. The purchase agreement does not
restrict the holders that convert preferred shares
into common stock from selling those common shares.
The only restrictions on selling common stock stem
from restrictions under U.S. securities laws.
In this example, the contingent
purchase option would be considered a freestanding
contract because it meets the “legally detachable
and separately exercisable” condition. The holders
can “detach” the two instruments because they can
convert the preferred stock into common stock and
sell those shares while retaining the contingent
purchase option (i.e., the two instruments are
capable of being separated). This would be the case
even if the contingent purchase option may not be
separately transferred after the conversion into
common stock of the preferred shares obtained in the
first closing. It would not be appropriate to
consider the preferred shares and the contingent
purchase option a single combined financial
instrument, because the contingent purchase option
would not become embedded in the common shares
received upon conversion of the preferred stock
purchased in the first closing.
Note that the conclusion in this example would not
change even if:
- The holders could not sell the common shares received upon conversion of the preferred stock purchased in the first closing before satisfaction or expiration of the contingent purchase option. At the inception of the arrangement, the two instruments still meet the legally detachable and separately exercisable condition because the contingent purchase option (1) cannot become embedded in the common shares received upon conversion of the preferred stock purchased in the first closing and (2) does not become freestanding only if the preferred stock purchased in the first closing is converted into common stock (instead, the ability to convert the preferred stock purchased in the first closing is evidence that the contingent purchase option is capable of being separated at the inception of the arrangement).
- The preferred stock purchased on the first closing date cannot be transferred or converted before the contingent purchase option is satisfied or expires and the holders have the right to acquire the additional shares related to the contingent purchase option at their option at any time before two years from the closing date. The two instruments still meet the legally detachable and separately exercisable condition because the investor can separate the two components by early exercising the contingent purchase option while retaining the preferred shares acquired on the first closing date.
As this example illustrates, and in a manner
consistent with practice, an option or commitment to
issue additional preferred shares is almost always a
freestanding financial instrument because the
separate exercisability of the option or commitment
is sufficient to demonstrate that the feature is
capable of being separated.
Example 3-9
Transfer Restrictions
An entity issues a bond with a warrant. The agreement specifies that the
counterparty may not transfer the bond or the
warrant without the issuer’s consent. However, the
agreement does not preclude the transfer of the
warrant separately from the bond if the issuer were
to give its consent. Further, the contract specifies
that such consent cannot be unreasonably withheld.
The exercise of the warrant does not result in the
termination of the bond (i.e., the counterparty is
not required to tender the bond as payment of the
exercise price of the warrant). In these
circumstances, the warrant is considered a
freestanding contract because it is both
independently transferable and separately
exercisable. The fact that the warrant contains a
restriction that may preclude the counterparty from
transferring it does not mean that the warrant is
not a freestanding contract since the contract
specifies that the issuer’s consent cannot be
unreasonably withheld.
3.2.3.2 Contingent Consideration Arrangements With Performance Targets
As discussed in Section
2.5.1, freestanding equity-linked financial instruments accounted
for as contingent consideration in a business combination may be within the
scope of ASC 815-40. Contingent consideration arrangements often specify
that the issuance of shares under the arrangement depends on whether
successive or cumulative performance targets (e.g., earnings or revenues)
for the acquired entity are met. For example, an arrangement may require the
entity to deliver (1) 100,000 of its equity shares if the subsidiary’s
revenue exceeds $100 million in the first year after the acquisition and (2)
an additional 50,000 of its equity shares if the subsidiary’s revenue
exceeds $125 million in the second year after the acquisition. In this case,
the entity should evaluate whether the contingent consideration arrangement
contains one or multiple units of account.
The entity’s determination of whether the contingent arrangement contains one or
multiple units of account may affect whether the arrangement qualifies as
equity in whole or in part. As discussed in Section 4.2, a provision that affects
whether a contract becomes exercisable or settleable (e.g., a contract that
provides for the delivery of shares only if a revenue target is met) is an
example of an exercise contingency. An exercise contingency that is based on
an index calculated or measured solely by reference to the operations of a
consolidated subsidiary that is a substantive entity does not preclude
equity classification (see Section 4.2). An adjustment made to the settlement amount on
the basis of revenue, however, precludes equity classification (see Section 4.3). This means
that the contract potentially would qualify as equity if it is settleable
only if a specified earnings target is met; however, it would not qualify as
equity if the number of shares that will be delivered upon settlement is not
fixed but depends on the level of earnings.
If an entity determines that an arrangement includes multiple payment
conditions, triggers, or targets that are independent of one another and if
met would result in the issuance of specified consideration regardless of
whether the other targets were met, each target-based payment may be treated
as a separate freestanding contract (provided that the conditions for the
definition of freestanding contract are met). If the payment conditions or
targets are cumulative or not independent of one another, the arrangement is
considered one contract that requires delivery of a variable number of
shares.
The following are examples that illustrate this
approach to identifying the appropriate units of account for contingent
consideration arrangements:
Contingent Consideration Arrangement | Analysis |
---|---|
The acquirer is required to deliver 10,000 of its equity shares to the seller if the acquired entity has earnings of at least $100 million in the year after the acquisition (otherwise, no shares will be delivered). | One unit of account. There is only one payment condition and target. |
The acquirer is required to deliver 10,000 of its equity shares if the acquired entity has earnings of at least $100 million in the first year after the acquisition (otherwise, no shares will be delivered at the end of the first year). In addition, the acquirer is required to deliver 10,000 of its equity shares if the acquired entity has earnings of at least $100 million in the second year after the acquisition (otherwise, no shares will be delivered at the end of the second year). | Two units of account. There are two independent payment conditions and targets.
It is assumed that the two payment conditions are
capable of being separated. |
The acquirer is required to deliver 10,000 of its equity shares to the seller if the acquired entity has earnings of at least $100 million in the year after the acquisition. The acquirer will deliver an additional 5,000 shares if earnings in that year exceed $125 million. Otherwise, no shares will be delivered. | One unit of account. There are two targets, but they cover the same period, and that period has multiple outcomes. |
The acquirer is required to deliver 10,000 of its equity shares if the acquired entity has earnings of at least $100 million in the first year after the acquisition (otherwise, no shares will be delivered at the end of the first year). In addition, the acquirer is required to deliver 10,000 of its equity shares if the acquired entity has cumulative earnings of at least $200 million in the first two years following the acquisition (otherwise, no shares will be delivered at the end of the second year). | Two units of account. There are two targets that cover different periods. It is
assumed that the two payment conditions are capable
of being separated. |
3.2.4 Registration Payment Arrangements
ASC 815-40
25-43
Subtopic 825-20 requires that an entity recognize and
measure a registration payment arrangement (see
paragraph 825-20-15-3) as a separate unit of account
from the financial instrument(s) subject to that
arrangement. Accordingly, under that Subtopic (see
paragraphs 825-20-25-2 and 825-20-30-2), a financial
instrument that is both within the scope of this
Subtopic and subject to a registration payment
arrangement shall be recognized and measured in
accordance with this Subtopic without regard to the
contingent obligation to transfer consideration pursuant
to the registration payment arrangement.
ASC Master Glossary
Registration Payment Arrangement
An arrangement with both of the following characteristics:
- It specifies that the issuer will endeavor to do either of the following:
- File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
- Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
- It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).
ASC 825-20
15-4 The guidance in this
Subtopic does not apply to any of the following:
-
Arrangements that require registration or listing of convertible debt instruments or convertible preferred stock if the form of consideration that would be transferred to the counterparty is an adjustment to the conversion ratio. See Subtopic 470-20 on debt with conversion and other options or Subtopic 505-10 on equity for related guidance.
-
Arrangements in which the amount of consideration transferred is determined by reference to either of the following:
-
An observable market other than the market for the issuer’s stock
-
An observable index.
For example, if the consideration to be transferred if the issuer is unable to obtain an effective registration statement is determined by reference to the price of a commodity. See Subtopic 815-15 for related guidance. -
-
Arrangements in which the financial instrument or instruments subject to the arrangement are settled when the consideration is transferred (for example, a warrant that is contingently puttable if an effective registration statement for the resale of the equity shares that are issuable upon exercise of the warrant is not declared effective by the SEC within a specified grace period).
25-1 An entity shall recognize a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement.
25-2 The financial instrument(s) subject to the registration payment arrangement shall be recognized in accordance with other applicable generally accepted accounting principles (GAAP) (for example, Subtopics 815-10; 815-40; and 835-30) without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement.
30-1 An entity shall measure a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement.
30-2 The financial instrument(s) subject to the registration payment arrangement shall be measured in
accordance with other applicable generally accepted accounting principles (GAAP) (for example, Subtopics
815-10; 815-40; and 835-30) without regard to the contingent obligation to transfer consideration pursuant to
the registration payment arrangement.
ASC 825-20 contains special unit-of-account guidance applicable to registration
payment arrangements (also known as registration rights agreements). In
connection with issuances of equity shares, debt securities, convertible
instruments, and equity-linked instruments, an issuer may agree to pay amounts
in case it is unable to deliver registered securities or maintain an effective
registration. For example, a warrant or other equity-linked financial instrument
may require the issuer to:
-
Use its “best efforts” to file a registration statement for the resale of shares and have the registration statement declared effective by the end of a specified grace period (e.g., within 90 to 180 days).
-
Maintain the effectiveness of a registration statement for a period.
If the issuer fails to meet these conditions, the contract may require the issuer to make cash payments to the counterparty unless and until a registration statement is declared effective. For example, the contract may require the entity to pay the investor 2 percent of the contract purchase price in each month after the end of a 180-day grace period during which there is no registration statement in effect that covers the shares that will be delivered under the contract.
A registration payment arrangement, as defined in the ASC master glossary, is treated as a unit of account that is separate from any related contract on an entity’s own equity. This is the case even if the registration payment arrangement is included in the contract on own equity itself. This means that a contract could qualify for equity classification under ASC 815-40 even if it includes provisions that require the issuer to pay cash to the holder if the issuer is unable to deliver registered shares or maintain an effective registration statement, unless the contract itself would be net cash settled (see Section 5.2). Those provisions would instead be accounted for separately as a registration payment arrangement in accordance with ASC 825-20, provided that the arrangement meets the definition of a registration payment arrangement.
A registration payment arrangement that is within the scope of ASC 825-20 is treated as a contingent liability (ASC 825-20-30-3). This means that proceeds from the related financing transaction are allocated to the registration payment arrangement upon initial recognition only if there is a probable obligation to make payments under the arrangement that can be reasonably estimated (ASC 825-20-30-4). If the obligation becomes probable and can be reasonably estimated after inception, a contingent liability is recognized at that point with an offset to earnings. Any subsequent change in the amount of the contingent liability is also recognized in earnings (ASC 825-20-35-1). If the entity is required to deliver shares under the arrangement, the number of shares can be reasonably estimated, and the transfer is probable, the entity measures the contingent liability by using the issuer’s stock price as of the reporting date (ASC 825-20-30-5).
An arrangement that contains any of the following provisions would not be accounted for as a separate unit of account under ASC 825-20:
- The form of consideration transferred is a contingently adjustable conversion ratio in a convertible instrument.
- The payment is adjusted by reference either to an observable market other than the issuer’s stock (e.g., a commodity price) or to an observable index.
- The payment is made when the contract subject to the arrangement is settled (e.g., a payment that is made upon the exercise of an option on own stock that is subject to the arrangement).
Accordingly, an entity would consider such provisions in its analysis of the contract under ASC 815-40.
3.2.5 Accelerated Share Repurchase Programs
ASC 505-30
25-5 An accelerated share
repurchase program is a combination of transactions that
permits an entity to repurchase a targeted number of
shares immediately with the final repurchase price of
those shares determined by an average market price over
a fixed period of time. An accelerated share repurchase
program is intended to combine the immediate share
retirement benefits of a tender offer with the market
impact and pricing benefits of a disciplined daily open
market stock repurchase program.
25-6 An entity shall account for such an accelerated share repurchase program as the following two separate transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date
- As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock.
Example 1 (see paragraph 505-30-55-1) provides an illustration of an accelerated share repurchase program that is addressed by this guidance.
Example 1: Accelerated Share Repurchase Program
55-1 This Example illustrates the guidance in paragraph 505-30-25-5 by identifying the two separate transactions, namely a treasury stock purchase and a forward contract, that are present in what is sometimes described as an accelerated share repurchase program.
55-2 The treasury stock purchase is as follows.
55-3 Investment Banker, an
unrelated third party, borrows 1,000,000 shares of
Company A common stock from investors, becomes the owner
of record of those shares, and sells the shares short to
Company A on July 1, 1999, at the fair value of $50 per
share. Company A pays $50,000,000 in cash to Investment
Banker on July 1, 1999, to settle the purchase
transaction. The shares are held in treasury. Company A
has legal title to the shares, and no other party has
the right to vote those shares.
55-4 The forward contract is as follows.
55-5 Company A simultaneously enters into a forward contract with Investment Banker on 1,000,000 shares of its own common stock. On the October 1, 1999, settlement date, if the volume-weighted average daily market price of Company A’s common stock during the contract period (July 1, 1999, to October 1, 1999) exceeds the $50 initial purchase price (net of a commission fee to Investment Banker), Company A will deliver to Investment Banker cash or shares of common stock (at Company A’s option) equal to the price difference multiplied by 1,000,000. If the volume-weighted average daily market price of Company A’s common stock during the contract period is less than the $50 initial purchase price (net of a commission fee to Investment Banker), Investment Banker will deliver to Company A cash equal to the price difference multiplied by 1,000,000.
55-6 Under the guidance in paragraph 505-30-25-5, an entity would account for this accelerated share repurchase program as two separate transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the July 1, 1999, acquisition date
- As a forward contract indexed to its own common stock.
ASC 505-30-25 contains unit-of-account guidance for ASR programs. Under ASC
505-30-25-6, an entity accounts for an ASR as two separate units of account: a
treasury stock repurchase and a separate forward contract on the entity’s
shares. An entity should analyze the treasury stock repurchase and forward
contract separately to determine how to account for each unit of account.
Because ASC 815-40 contains an exception for financial instruments that are
within the scope of ASC 480 (see Section 2.3), an entity should determine
whether one or both units of account are within the scope of ASC 480 before
considering whether ASC 815-40 applies.
The terms of ASRs vary. In a traditional ASR, an entity (1) repurchases a targeted number of its own shares at the current stock price immediately for cash and (2) simultaneously enters into a net-share-settled forward sale of the same number of shares indexed to the average stock market price over the contract period. Economically, the forward serves as a true-up mechanism for adjusting the price ultimately paid for the shares purchased. Its purpose is to reduce the number of outstanding shares immediately at a repurchase price that on a combined basis reflects the average stock market price over an extended period (e.g., the volume-weighted average price on each trading day during the contract period). On a combined basis, the initial share repurchase and the forward sale put the issuer in an economic position similar to that of having conducted a series of open market purchases of its own stock over a specified period.
Example 3-10
ASR Analysis
An entity makes an up-front cash payment and receives a specific number of shares from the counterparty (usually an investment bank). Upon settlement of the forward contract (typically within three to six months), the entity either (1) pays the counterparty an amount equal to any excess of the volume-weighted average daily market price (VWAP) of the entity’s shares over the initial purchase price or (2) receives from the counterparty an amount equal to any excess of the initial purchase price over the VWAP. Often, the entity can choose to settle the forward contract with the counterparty in either cash or a variable number of shares. Under ASC 505-30, this transaction is analyzed as two units of account: a treasury stock repurchase and a net settled forward contract to sell the entity’s stock over the contract period.
In practice, the settlement of the treasury stock repurchase often takes place
one or a few days after the execution of the ASR (e.g., the initial share
delivery date may be three business days after the transaction date), at which
time the issuer pays cash and receives an initial number of shares. In such
cases, the obligation to repurchase shares in exchange for cash is classified as
a liability under ASC 480-10-25-8 (see Chapter 5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity) during the period between the ASR transaction
date and the settlement date of the treasury stock repurchase (sometimes
described as the “initial share delivery date” or the “prepayment date”). Note
that in some ASR transactions, the payment of cash in the treasury stock
repurchase occurs before the receipt of the initial shares, in which case ASC
480 may cease to apply once the obligation to pay cash has been settled.
In evaluating whether the forward component of an ASR is within the scope of ASC
480, the issuer should consider whether it embodies an obligation to transfer
assets or a variable number of shares that meet the criteria in ASC 480-10-25-8
or ASC 480-10-25-14 (see Chapters 5 and 6 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Usually, an issuer is not required to classify as a
liability under ASC 480 the forward contract component in a traditional ASR
because it does not embody an obligation to repurchase shares for assets and
does not involve an obligation to deliver a variable number of shares with a
monetary value that moves inversely with — or is based on something other than —
the price of the issuer’s stock. However, an issuer cannot assume that the
forward contract component of an ASR is outside the scope of ASC 480 without
analyzing its specific terms and features.
In some ASR transactions, a portion of the prepayment amount on the initial share delivery date represents a premium paid by the issuer to increase the forward sale price that the issuer will receive in the forward component of the transaction (relative to an at-market forward) rather than a payment for the shares to be received in the initial treasury stock repurchase. For example, the issuer may apply 20 percent of the prepayment amount to the forward component to reduce the likelihood that the forward component will ever dilute EPS. In that case, the issuer may be required to account for the forward component as an asset or a liability under ASC 480-10-25-8 in the period between the transaction date and the initial share delivery date if the forward component permits net share settlement. This is because the forward component embodies an obligation to pay cash (on the initial share delivery date) to repurchase shares (the issuer will receive shares on the forward settlement date if the stock price is less than the forward price).
If the forward component is outside the scope of ASC 480, the issuer considers
the guidance in ASC 815-40 when it determines whether the forward should be
accounted for as an asset or liability. The terms of an ASR often include rights
for the counterparty to end the ASR early upon termination events defined by
reference to ISDA’s equity derivatives definitions (e.g., merger events, tender
offers, nationalization, insolvency, delisting, change in law, failure to
deliver, insolvency filing, loss of stock borrow, increased cost of stock
borrow, extraordinary dividends). Further, the contractual provisions often
specify or permit the counterparty to make adjustments to the settlement terms
upon the occurrence of such events (e.g., calculation agent adjustments,
cancellation, and payment) and might require the entity to settle the contract
net in cash. In evaluating an ASR’s forward-contract component under ASC 815-40,
therefore, the entity should be mindful of the need to assess such terms under
the indexation guidance and other equity classification conditions in ASC 815-40
(see Chapters 4 and 5).
Example 3-11
ASR Analysis — Accounting Between Trade Date and
Settlement Date
On December 30, an issuer enters into an ASR transaction that requires it to transfer a fixed amount of cash (a prepayment amount of $500 million) in exchange for a fixed number of its common shares (10 million initial shares) on the initial share delivery date (January 2). The issuer will either deliver or receive shares on the transaction’s final settlement date (March 31). If the VWAP of the issuer’s common shares exceeds $50, the issuer will deliver shares; if the VWAP is less than $50, the issuer will receive shares. The number of shares that will be received or delivered is calculated as the prepayment amount ($500 million) divided by the VWAP over the contract period less the initial shares (10 million) already delivered.
In these circumstances, the treasury stock repurchase must be accounted for as a liability under ASC 480-10-25-8. In accordance with ASC 480-10-30-3, the issuer recognizes the liability on the ASR transaction date, which was initially measured “at the fair value of the shares at inception, adjusted for any consideration or unstated rights or privileges.” Simultaneously, in accordance with ASC 480-10-30-5, equity is “reduced by an amount equal to the fair value of the shares at inception.” Because under ASC 480-10-35-3(a) both the amount to be paid — $500 million — and the settlement date — January 2 — are fixed, the liability is measured at the present value of the amount to be paid at settlement — $500 million — with interest cost accruing at the rate implicit at inception during the period from the transaction date to the initial share delivery date. (Further, if any part of the prepayment amount represents a premium payment for the forward component of the accelerated share repurchase transaction, that portion would be accounted for separately as a liability measured at fair value under ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5 between the transaction date and the initial share delivery date, as discussed above.)
On the initial share delivery date, the liability for the treasury stock
repurchase is extinguished by delivery of the prepayment
amount. After the initial share delivery date, the
transaction is outside the scope of ASC 480 and is
therefore evaluated under other GAAP (including ASC 815
and ASC 815-40).
Footnotes
1
Note that the ASC master glossary definitions of
“freestanding contract” and “freestanding financial instrument” are
interpreted in practice as being the same.
Chapter 4 — Indexation Guidance
Chapter 4 — Indexation Guidance
4.1 Overview
ASC 815-40
15-7 An entity shall evaluate
whether an equity-linked financial instrument (or embedded
feature), as discussed in paragraphs 815-40-15-5 through
15-8 is considered indexed to its own stock within the
meaning of this Subtopic and paragraph 815-10-15-74(a) using
the following two-step approach:
-
Evaluate the instrument’s contingent exercise provisions, if any.
-
Evaluate the instrument’s settlement provisions.
15-8 Examples 2–21 (see paragraphs 815-40-55-26 through 55-48) illustrate the application of the guidance in paragraphs 815-40-15-5 through 15-7. These examples do not address whether an instrument (or embedded feature) is classified in equity (or would be classified in equity if freestanding). These examples also do not address whether the instrument is within the scope of Topic 480 or whether the instrument would be subject to the two-class method under Topic 260.
55-25A The Examples in paragraphs
815-40-55-26 through 55-48 illustrate the application of the
guidance beginning in paragraph 815-40-15-5.
One of the conditions that must be met for an equity-linked instrument to
qualify as equity is that the instrument is considered indexed to the entity’s own
stock in accordance with ASC 815-40-15. This condition must be met because:
-
If a freestanding equity-linked instrument is not considered indexed to the entity’s own equity, it cannot be accounted for in equity but must be accounted for as an asset or a liability (irrespective of whether it meets the definition of a derivative).
-
If a freestanding or embedded equity-linked instrument that meets the definition of a derivative is not considered indexed to the entity’s own equity, it does not qualify for the own-equity scope exception to the derivative accounting guidance in ASC 815-10-15-74(a).
To determine whether an equity-linked instrument is considered indexed to the
issuer’s own equity, an entity performs a two-step analysis:
-
Step 1 — Evaluate whether the instrument contains any exercise contingencies and, if so, whether they disqualify the instrument from being classified as equity (see Section 4.2).
-
Step 2 — Assess whether the settlement terms are consistent with equity classification (see Section 4.3).
If an entity concludes that an equity-linked instrument is considered indexed to
its own stock under ASC 815-40-15, the entity would also need to determine whether
the equity classification conditions in ASC 815-40-25 are met (see Chapter 5).
Contracts on an entity’s own equity that are prepared in accordance with
standard ISDA documentation often include adjustments and termination events defined
by reference to ISDA standard terms and definitions (see Section 3.1.3). When the EITF developed the
indexation guidance that was later incorporated into ASC 815-40-15, the Task Force
was mindful of such ISDA terms and definitions (e.g., ISDA’s 2002 equity derivatives
definitions). Nevertheless, without analyzing the contract’s terms, an entity cannot
assume that a contract prepared in accordance with standard ISDA documentation meets
the indexation guidance in ASC 815-40-15. For example, an entity should assess
whether the contract specifies any alterations to the ISDA definitions.
Example 4-1
ASR Adjustments
An ASR agreement may give the counterparty (e.g., an investment bank) the right to early terminate the ASR if certain contingent events occur that are defined by reference to ISDA’s equity derivatives definitions. Examples of termination events defined by ISDA include merger events, tender offers, nationalization, insolvency, delisting, change in law, insolvency filing, hedging disruption, increased cost of hedging, loss of stock borrow, and increased cost of stock borrow. The ASR may also specify additional termination events, for example, if the entity (1) declares an extraordinary cash dividend or a regular quarterly dividend in an amount greater than that specified in the agreement or (2) issues securities or share capital of another entity acquired or owned (directly or indirectly) by the entity as a result of a spin-off or other similar transaction — or any other type of securities (other than shares), rights, or warrants or other assets — for payment (cash or other consideration) at less than the prevailing market price.
4.2 Step 1: Evaluate Any Exercise Contingencies
4.2.1 The Concept of an Exercise Contingency
ASC 815-40 — Glossary
Exercise Contingency
A provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity’s (or the counterparty’s) ability to exercise an instrument and provisions that extend the length of time that an instrument is exercisable are examples of exercise contingencies.
Underlying
A specified interest rate, security price, commodity price, foreign exchange
rate, index of prices or rates, or other variable
(including the occurrence or nonoccurrence of a
specified event such as a scheduled payment under a
contract). An underlying may be a price or rate of an
asset or liability but is not the asset or liability
itself. An underlying is a variable that, along with
either a notional amount or a payment provision,
determines the settlement of a derivative
instrument.
Step 1 of the guidance in ASC 815-40-15-7 on the
determination of whether an equity-linked instrument is considered indexed to an entity’s
own equity is to evaluate the instrument’s exercise contingencies, if any. The following
provisions are examples of exercise contingencies:
Type | Description | Examples |
---|---|---|
Exercise condition | A provision that affects whether the instrument becomes exercisable. | A warrant that becomes exercisable upon an IPO. |
Settlement condition | A provision that affects whether an instrument is settled. | An obligation to issue shares that is contingent on whether revenue has exceeded a specified threshold. |
Acceleration provision | A provision that accelerates the timing of either the entity’s or the
counterparty’s ability to exercise the instrument or that accelerates the
timing of the instrument’s settlement. | The counterparty’s right to exercise the instrument is accelerated upon a merger
event, tender offer, hedging disruption, loss of stock borrow,
nationalization, or delisting. |
Extension provision | A provision that extends the timing of either the entity’s or the counterparty’s
ability to exercise the instrument or extends the timing of the instrument’s
settlement. | A provision that extends the expiration date of an option upon an IPO. |
Deferral provision | A provision that defers the timing of either the entity’s or the counterparty’s
ability to exercise the instrument or defers the timing of the instrument’s
settlement. | A provision that delays the counterparty’s ability to exercise an option if the entity lacks sufficient registered shares or that defers settlement if the counterparty’s ownership of shares exceeds a specified level or the counterparty needs time to unwind related hedges. |
Termination provision | A provision that results in the instrument’s termination (also sometimes called
“cancellation,” “forfeiture,” or “knock-out” provision). | A provision that terminates the instrument upon a change of control, IPO, or
insolvency. |
Some, but not all, equity-linked instruments contain exercise contingencies.
Step 1 does not apply to an equity-linked instrument that does not contain an exercise
contingency (e.g., an option contract that is exercisable at any time before expiration).
The mere passage of time is not considered an exercise contingency; neither is a
contingency that affects the calculation of the settlement amount of an instrument if the
contingency does not alter the availability or timing of settlement (e.g., the occurrence
of a specified event that affects the strike price of an equity-linked option that was
currently exercisable).
4.2.2 Effect of Exercise Contingencies on the Classification of an Equity-Linked Instrument
ASC 815-40
15-7A An exercise contingency
shall not preclude an instrument (or embedded feature)
from being considered indexed to an entity’s own stock
provided that it is not based on either of the
following:
-
An observable market, other than the market for the issuer’s stock (if applicable)
-
An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).
If the evaluation of Step 1 (this paragraph) does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2 (see paragraph 815-40-15-7C).
Exercise contingencies that are based on an observable market or an observable
index preclude an equity-linked instrument from being considered indexed to an entity’s
own equity unless they are based on either of the following:
-
“[T]he market for the issuer’s stock.”
-
“[A]n index calculated or measured solely by reference to the issuer’s own operations.”
Further, an exercise contingency that is based on something other than an observable market or observable index does not preclude equity classification.
Example 4-2
Exercise Contingency Analysis
Entity R issues to certain investors warrants that permit the investors to
purchase R’s common shares at a fixed price if the common shares trade below
$7 per share. (Entity R’s shares currently trade at $10 each.) If the share
price does not drop below $7 before the warrants’ expiration date, the
warrants will expire.
The warrants issued by R contain a contingent exercise provision because they
cannot be exercised unless R’s common shares trade below $7. However, because
the exercise contingency is based directly on the market price of R’s common
shares, the warrants are not precluded from being considered indexed to R’s
own equity.
Had the exercise contingency been based on the price of gold’s dropping below
a certain point, however, the warrants would not have been considered indexed
to R’s own equity because such a contingent exercise provision would have been
based on “[a]n observable market, other than the market for the issuer’s
stock.”
If a freestanding equity-linked instrument contains more than one exercise
contingency, the instrument would not be considered indexed to the entity’s own stock
unless all the contingencies are consistent with equity classification.
4.2.2.1 Exercise Contingencies Based on the Market for the Issuer’s Stock
If an equity-linked instrument can be exercised only if the issuer’s stock
exceeds a specified price, that exercise contingency would not preclude the instrument
from being considered indexed to the entity’s own equity. This is because the issuer’s
stock price is considered to be based on the market for the issuer’s stock. The term
“market for the issuer’s stock” includes not only the price of the entity’s common or
preferred stock but also:
-
The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1).
-
The price of a convertible debt or equity security in the evaluation of whether an equity conversion option embedded in the convertible security qualifies as being indexed to the entity’s own equity.
Examples of exercise contingencies in convertible instruments that would be considered to be based on the market for the issuer’s stock include:
- A provision that permits the instrument to be converted if the entity’s stock price exceeds a certain dollar amount (a market price trigger).
- A provision that permits the instrument to be converted into the entity’s equity shares if the instrument trades for an amount that is less than a specified percentage (e.g., 98 percent) of its if-converted value (a parity provision).
4.2.2.2 Exercise Contingencies Based on the Issuer’s Operations
An exercise contingency based on an index calculated solely by reference to the
issuer’s own operations (e.g., sales of at least $100 million) does not preclude a
conclusion that the equity-linked instrument is indexed to the entity’s own equity.
Similarly, an exercise contingency that is based on an index calculated solely by
reference to the operations of a consolidated subsidiary that is a substantive entity
would not preclude such a conclusion by analogy to ASC 815-40-15-3 (see Section 2.6.1).
Exercise contingencies that are based on other observable markets (e.g., an option that is exercisable only if the market price of gold exceeds a certain level) or observable indexes (e.g., an option that is exercisable only if the CPI or S&P 500 exceeds a certain level) cause the instrument to be considered not indexed to the entity’s own equity.
4.2.2.3 Interaction Between Steps 1 and 2
ASC 815-40
15-7B If an instrument’s
strike price or the number of shares used to
calculate the settlement amount would be adjusted
upon the occurrence of an exercise contingency, the
exercise contingency shall be evaluated under Step 1
(see the preceding paragraph) and the potential
adjustment to the instrument’s settlement amount
shall be evaluated under Step 2 (see the guidance
beginning in [ASC 815-40-15-7C]).
An entity need not consider an instrument’s exercise contingency under step 2 in
ASC 815-40-15-7 if the contingency does not affect the settlement terms. For example,
the entity would not need to consider under step 2 an exercise contingency that affects
only (1) the entity’s ability to exercise or settle the instrument or (2) the timing
thereof. In addition, an exercise contingency that merely results in the instrument’s
cancellation (i.e., it affects only whether the instrument becomes settleable on the
basis of its otherwise applicable settlement terms) does not require evaluation under
step 2. However, some exercise contingencies also affect an instrument’s settlement
terms, in which case the exercise contingencies should be evaluated under both step 1 in
ASC 815-40-15-7 and step 2. In other words, even if an exercise contingency is of a type
that does not preclude equity classification under step 1, any associated adjustment to
the settlement terms may preclude equity classification under step 2 (see Section 4.3.5.7 for an example).
4.2.3 Examples of Exercise Contingencies
4.2.3.1 Classification and Application of Indexation Guidance
The following table contains examples
of exercise contingencies and indicates whether they would preclude an equity-linked
instrument from being considered indexed to the entity’s own stock:
Exercise Contingencies That Do Not Preclude Equity
Classification
|
Exercise Contingencies That Preclude Equity
Classification
|
---|---|
|
|
Examples 2 through 21 in ASC 815-40-55 (listed in Appendix A of this Roadmap) illustrate
the application of the guidance in ASC 815-40-15-7. Five of the examples address how to
apply step 1 of such guidance and involve the following exercise contingencies:
-
IPO (Examples 2 and 5).
-
Sales to third parties (Example 3).
-
Increase in S&P 500 (Example 4).
-
Market price trigger (Example 19).
-
Parity provision (Example 19).
-
Merger announcement (Example 19).
Examples 2, 3, and 4 are reproduced below. Examples 5 and 19 are
addressed in our discussion of step 2 of the guidance (see Sections 4.3.5.6, 4.3.7.9, and 4.3.7.10).
ASC 815-40
Example 2: Variability Involving
Completion of an Initial Public Offering
55-26 Entity A issues warrants that
permit the holder to buy 100 shares of its common stock for $10 per share.
The warrants have 10-year terms; however, they only become exercisable if
Entity A completes an initial public offering. The warrants are considered
indexed to Entity A’s own stock based on the following evaluation:
-
Step 1. The exercise contingency (that is, the initial public offering) is not an observable market or an observable index, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
-
Upon exercise, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share).
Example 3: Variability Involving
Sales Volume
55-27 Entity A issues warrants that
permit the holder to buy 100 shares of its common stock for $10 per share.
The warrants have 10-year terms; however, they only become exercisable after
Entity A accumulates $100 million in sales to third parties. The warrants
are considered indexed to Entity A’s own stock based on the following
evaluation:
-
Step 1. The exercise contingency (that is, the accumulation of $100 million in sales to third parties) is an observable index. However, it can only be calculated or measured by reference to Entity A’s sales, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
-
Step 2. Upon exercise, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share).
Example 4: Variability Involving
Stock Index
55-28 Entity A issues warrants that
permit the holder to buy 100 shares of its common stock for $10 per share.
The warrants have 10-year terms; however, they only become exercisable if
the Standard & Poor’s S&P 500 Index increases 500 points within any
given calendar year during that 10-year period. The warrants are not
considered indexed to Entity A’s own stock based on the following
evaluation:
-
Step 1. The exercise contingency (that is, the increase of 500 points in Standard & Poor’s S&P 500 Index) is based on an observable index that is not measured solely by reference to the issuer’s own operations.
-
Step 2. It is not necessary to evaluate Step 2.
4.2.3.2 Share-Settleable Earn-Out Arrangements
Share-settleable earn-out arrangements are entered into in conjunction
with a merger of a SPAC and an operating entity (or “target”). They may also be entered
into in conjunction with other transactions. For additional discussion of the nature of
these arrangements, see Section
2.5.3.
If share-settleable earn-out arrangements contain only transfer restrictions that lapse
upon the passage of time, they are not subject to an evaluation under ASC 815-40 because
these types of arrangements are accounted for as outstanding shares as opposed to
equity-linked instruments. All other share-settleable earn-out arrangements are considered
equity-linked instruments that are subject to an evaluation under ASC 815-40 regardless of
whether the underlying shares are legally outstanding.
After identifying each unit of account related to a share-settleable earn-out
arrangement, the entity then evaluates the indexation requirements in ASC 815-40-15. If
the entity determines that the equity-linked instrument is not considered indexed to the
combined company’s stock, the arrangement must be classified as a liability (i.e., equity
classification is never permitted). The first step in the analysis of the indexation
guidance is to evaluate exercise contingencies.
All share-settleable earn-out arrangements contain contingent exercise provisions, and
most also contain settlement provisions (i.e., terms or features that affect the
settlement amount). In some cases, a provision may have characteristics of both contingent
exercise and settlement provisions. The determination of whether the terms of a
share-settleable earn-out arrangement are contingent exercise provisions or settlement
provisions can significantly affect whether the equity-linked instrument is indexed to the
combined company’s stock because the guidance on contingent exercise provisions is
markedly different from the guidance on settlement conditions.
For example, assume that a share-settleable earn-out arrangement specifies that the
combined company will issue an aggregate of 5 million shares of its common stock to the
target’s shareholders if either (1) the quoted price of the stock exceeds $20 during a
stated period or (2) there is a change of control. In this example, the combined company’s
stock price and the occurrence of a change of control affects only whether the holders
will receive the 5 million shares. Both variables represent only contingent exercise
provisions because the holders will receive either no shares or 5 million shares. Neither
of these two variables represents an exercise contingency that prevents the instrument
from being indexed to the combined company’s stock under step 1 of ASC 815-40-15-7A. Note
that the facts in this case are different from those in Example
2-3. In that example, the holders may receive no shares, 1 million shares, 2
million shares, 3 million shares, or 4 million shares, depending on the combined company’s
stock price or the price paid in a change of control. In both examples, there are
contingent exercise provisions (i.e., stock price and whether a change of control occurs);
however, only in Example 2-3 are there settlement
provisions because of the variability in the number of shares that will be issued.
For an exercise contingency not to prevent a share-settleable earn-out
arrangement from being indexed to the combined company’s stock, it must meet the
requirements in step 1 of ASC 815-40-15-7A. The terms of share-settleable earn-out
arrangements that reflect contingent exercise provisions (e.g., the combined company’s
stock price or a change of control) generally do not prevent the equity-linked instrument
from meeting the conditions in the first step in the analysis in ASC 815-40-15 of whether
the arrangement is considered indexed to the combined company’s stock. However, terms that
affect the settlement value of the arrangement (i.e., settlement provisions) may prevent
it from being indexed to the combined company’s stock under step 2 of ASC 815-40-15. See
Sections 4.3.7 and
4.3.7.4 for additional
discussion of the evaluation of settlement provisions in share-settleable earn-out
arrangements.
Footnotes
1
An exercise contingency that is based on a
parity provision or the credit rating of the issuer would
generally be included only in the terms of a convertible
instrument, not in those of a freestanding equity-linked
instrument. If an exercise contingency that is based on a parity
provision or the credit rating of the issuer was included in the
terms of a freestanding equity-linked financial instrument, the
exercise contingency would generally preclude the freestanding
financial instrument from being indexed to the entity’s stock.
See, however, Section 4.3.7.14.
2
See footnote 1.
4.3 Step 2: Evaluate the Settlement Provisions
4.3.1 Effect of Settlement Terms on the Classification of an Equity-Linked Instrument
If, after performing step 1 of the guidance in ASC 815-40-15-7
(see Section 4.2), an
entity concludes that an equity-linked instrument’s contingent exercise
provisions (if any) would not preclude a conclusion that the instrument is
indexed to the entity’s own stock, the entity must perform step 2 of such
guidance to evaluate the instrument’s settlement terms. Under step 2, an
equity-linked instrument is considered indexed to the entity’s own stock if
either of the following two conditions is met:
-
The instrument is a “fixed-for-fixed” forward or option on equity shares.
-
The instrument is not fixed for fixed, but the only variables that could affect the instrument’s settlement amount are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares.
An equity-linked instrument that does not meet either of these
conditions does not qualify as equity. Conversely, if the instrument is
considered indexed to the entity’s own stock under both step 1 and step 2, it
could qualify for classification as equity if it also meets the equity
classification criteria in ASC 815-40-25 (see Chapter 5).
4.3.2 The Concept of a Fixed-for-Fixed Forward or Option on Equity Shares
ASC
815-40
15-7C Unless paragraph
815-40-15-7A precludes it, an instrument (or embedded
feature) shall be considered indexed to an entity’s own
stock if its settlement amount will equal the difference
between the following:
-
The fair value of a fixed number of the entity’s equity shares
-
A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.
For example, an issued
share option that gives the counterparty a right to buy
a fixed number of the entity’s shares for a fixed price
or for a fixed stated principal amount of a bond issued
by the entity shall be considered indexed to the
entity’s own stock.
An equity-linked instrument is considered a fixed-for-fixed
forward or option on the entity’s equity shares if the instrument’s settlement
amount will always equal the difference between (1) the “fair value of a fixed
number of the entity’s equity shares” and (2) a fixed monetary amount
denominated in the issuing entity’s functional currency.
Example 4-3
Fixed-for-Fixed Option
Entity X issues freestanding warrants
that allow the holder to purchase a fixed number of
1,000 shares of X’s common stock for a fixed amount of
$10 per share. There are no exercise contingencies and
no potential adjustments to the exercise price or number
of common shares underlying the warrants. As a result,
the warrants are indexed to X’s stock because they are
considered a fixed-for-fixed option on equity shares.
That is, the holder will receive a fixed number of X’s
shares for a fixed price.
The
difference between the fair value of the equity shares
underlying a contract and a contract’s strike price is
sometimes referred to as the contract’s intrinsic value.
If the fair value of each share on the exercise date is
$15, the intrinsic value is $5 per share ($15 – $10) and
the settlement amount is $5,000 (1,000 shares × $5 per
share).
For an equity-linked instrument to qualify as fixed for fixed,
it does not need to involve a gross physical exchange of the full stated amount
of cash for the full stated number of shares. An instrument that involves a net
settlement (e.g., a net number of shares equal in fair value to the settlement
amount) could also qualify as fixed for fixed provided that the settlement
amount equals the difference between the fair value of a fixed number of the
entity’s equity shares and a fixed amount of cash. In addition, an instrument
indexed to the fair value of the equity shares of a consolidated subsidiary can
qualify as a fixed-for-fixed forward or option on equity shares provided that
the subsidiary is a substantive entity (see Section
2.6.1).
Under ASC 815-40-25-27, an equity-linked instrument must
explicitly limit the number of shares to be delivered in a share settlement to
be classified in stockholders’ equity (see Section 5.3.4). The existence of a “share cap”
in the contract’s terms solely to meet this condition would not preclude a
conclusion that a contract is a fixed-for-fixed forward or option on equity
shares.
Some equity-linked instruments have more than one potential
settlement amount that is contingent on the occurrence or nonoccurrence of a
specified event (e.g., whether an operational target is met). Such instruments
are not considered fixed for fixed even if each of those potential settlement
amounts would have been considered fixed for fixed when assessed separately.
Example 4-4
More Than One Potential Settlement
Amount
Entity X issues a freestanding warrant that allows the holder to purchase a
fixed number of shares of X’s common stock (900 shares)
for a fixed amount of $10 per share if the entity’s
revenue is less than $500 million. If the entity’s
revenue equals or exceeds $500 million, the holder has
the right to purchase a different, fixed number of
shares (1,000 shares) for a fixed amount of $10 per
share. There are no exercise contingencies or other
potential adjustments to the exercise price or number of
common shares underlying the warrant. Entity X
determines that the warrant represents only one
freestanding financial instrument. The warrant is
therefore not considered fixed for fixed because the
number of shares that will be delivered under the
contract differs depending on whether the revenue target
is met (i.e., the settlement amount varies on the basis
of revenue).
If the contract instead had specified
that it was exercisable only if the entity’s revenue
equaled or exceeded $10 million for 1,000 shares at $10
per share, it would have been considered fixed for
fixed. That contract would have contained an exercise
contingency based on revenue that would have been
evaluated under step 1, but the settlement amount would
not have varied on the basis of revenue.
As discussed in Section 2.2, an entity applies the indexation and equity
classification guidance in ASC 815-40 in determining whether an embedded
derivative (e.g., an equity conversion option embedded in convertible debt)
qualifies for the scope exception to the derivative accounting guidance in ASC
815-10-15-74(a). An equity conversion option that gives the holder the right to
convert a fixed stated principal amount of a bond issued by the entity and
denominated in the entity’s functional currency into a fixed number of the
entity’s own equity shares is considered a fixed-for-fixed option on equity
shares if there are no potential adjustments to the settlement terms.
Similarly, a conversion option embedded in a preferred stock
instrument that gives the counterparty a right to buy a fixed number of the
entity’s equity shares for a fixed stated amount of the preferred stock
instrument issued by the entity would be considered a fixed-for-fixed option on
equity shares when (1) the preferred stock host is considered a debt host
contract in the evaluation of embedded derivatives and (2) there are no
potential adjustments to the settlement terms. If the host contract in a
convertible preferred stock instrument is considered an equity instrument, the
embedded equity conversion option will be clearly and closely related to its
host contract. Such an option is not separated from its host contract under ASC
815-15 irrespective of whether it would have qualified for the scope exception
to the derivative accounting guidance in ASC 815-10-15-74(a). Therefore, the
option is not assessed under the indexation and equity classification guidance
in ASC 815-40 (see Section
2.2.2).
Under ASC 480-10-S99-3A and other SEC guidance, SEC registrants
are required to classify certain redeemable equity securities in temporary
equity outside of permanent equity (for a comprehensive discussion of the
application of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). In evaluating whether an embedded feature (e.g.,
a written put option embedded in the entity’s preferred stock) meets the scope
exception for certain contracts on own equity in ASC 815-10-15-74(a), an entity
treats temporary equity as equity even though it is presented outside of
permanent equity (ASC 815-10-15-76). See further discussion in Section 2.2.2.
4.3.3 Provisions That Adjust the Settlement Amount
ASC
815-40
15-7D An instrument’s strike
price or the number of shares used to calculate the
settlement amount are not fixed if its terms provide for
any potential adjustment, regardless of the probability
of such adjustment(s) or whether such adjustments are in
the entity’s control. If the instrument’s strike price
or the number of shares used to calculate the settlement
amount are not fixed, the instrument (or embedded
feature) shall still be considered indexed to an
entity’s own stock if the only variables that could
affect the settlement amount would be inputs to the fair
value of a fixed-for-fixed forward or option on equity
shares (provided that paragraph 815-40-15-7A does not
preclude such a conclusion).
15-7E A fixed-for-fixed forward
or option on equity shares has a settlement amount that
is equal to the difference between the price of a fixed
number of equity shares and a fixed strike price. The
fair value inputs of a fixed-for-fixed forward or option
on equity shares may include the entity’s stock price
and additional variables, including all of the
following:
- Strike price of the instrument
- Term of the instrument
- Expected dividends or other dilutive activities
- Stock borrow cost
- Interest rates
- Stock price volatility
- The entity’s credit spread
- The ability to maintain a standard hedge position in the underlying shares.
Determinations and
adjustments related to the settlement amount (including
the determination of the ability to maintain a standard
hedge position) shall be commercially
reasonable.
15-7F An instrument (or
embedded feature) shall not be considered indexed to the
entity’s own stock if its settlement amount is affected
by variables that are extraneous to the pricing of a
fixed-for-fixed option or forward contract on equity
shares. An instrument (or embedded feature) shall not be
considered indexed to the entity’s own stock if
either:
- The instrument’s settlement calculation incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares.
- The instrument contains a feature (such as a leverage factor) that increases exposure to the additional variables listed in the preceding paragraph in a manner that is inconsistent with a fixed-for-fixed forward or option on equity shares.
Equity-linked instruments commonly include provisions that
result in adjustments to the exercise price or to the number of shares for which
the instrument can be settled. Such adjustments may be specified directly in the
contract (e.g., antidilution provisions) or incorporated into the contract by
reference to adjustments defined in standard documentation for equity
derivatives (e.g., ISDA terms related to hedge disruption or loss of stock
borrow).
Examples 2 through 21 in ASC
815-40-55 (listed in Appendix
A of this Roadmap) illustrate the application of the guidance in ASC
815-40-15-7. Seventeen of the examples address how to apply step 2 of such
guidance to instruments that contain settlement adjustments. Those examples
involve adjustments related to the following:
-
The entity’s stock price (Examples 8, 13, 15, 16, and 19; see Sections 4.3.5.1, 4.3.7.9, and 4.3.7.10).
-
Dividends (Examples 12 and 17; see Sections 4.3.5.3 and 4.3.7.1).
-
Dilutive events (Example 17; see Section 4.3.7.1).
-
Down-round protection (Example 9; see Section 4.3.7.2).
-
Table with axes of stock price and time (Example 19; see Sections 4.3.7.9 and 4.3.7.10).
-
Interest rates (Examples 13 and 14; see Section 4.3.5.2).
-
Merger announcement (Example 6; see Section 4.3.7.5).
-
Cost of stock borrow (Example 12; see Section 4.3.5.4).
-
Sales revenue (Example 7; see Section 4.3.5.7).
-
Price of gold (Example 5; see Section 4.3.5.6).
-
Foreign currency (Examples 11, 18, and 20; see Section 4.3.8).
-
Stock option exercise behavior (Example 21; see Section 4.3.5.9).
-
Contingent redemption for a fixed monetary amount (Example 10; see Section 4.3.7.12).
An equity-linked instrument that permits adjustments to the
settlement amount is not considered indexed to the entity’s stock unless the
only variables that could affect the instrument’s settlement amount (i.e., the
exercise price or forward price or the number of shares used to calculate the
settlement amount) are inputs used in the pricing (fair value measurement) of a
fixed-for-fixed forward or option on the entity’s equity shares or adjustments
are made in accordance with a down-round feature (see Section 4.3.7.2). If each potential adjustment
to the settlement terms is consistent with the inputs used in the pricing of a
fixed-for-fixed forward or option on equity shares (e.g., stock price and strike
price), the instrument is considered indexed to the entity’s own stock.
Accordingly, an entity must evaluate whether any adjustments to the settlement
amount that are specified in the contract meet this requirement.
There are two types of inputs:
- An explicit input is an underlying (other than the occurrence or nonoccurrence of a specified event) that could affect the settlement amount of the instrument (i.e., the exercise price or forward price, or the number of equity shares used to calculate the settlement amount). Examples of explicit inputs include a specific interest rate, security price, commodity price, foreign exchange rate, inflation rate, credit rating, prepayment index, or other index or indexes of specified prices or rates.
- An implicit input is an assumption about the occurrence or nonoccurrence of a specified event that could affect the settlement amount of an equity-linked instrument (i.e., the exercise price or forward price or the number of equity shares used to calculate the settlement amount). For example, there may be an implicit assumption in the pricing of an equity-linked instrument that no dilutive event affecting the underlying equity securities will occur (e.g., stock split). Other examples of implicit inputs include the occurrence or nonoccurrence of the following events:
-
An IPO or a subsequent offering of securities by the issuer.
-
A tender offer for the securities of the issuer.
-
A change of control or merger involving the issuer.
-
Bankruptcy or insolvency of the issuer.
-
The incurrence of transaction costs to dispose of equity securities received upon settlement of an equity-linked option.
-
4.3.4 Evaluating Explicit Inputs
In the determination of the price (or fair value) of an
equity-linked financial instrument, standard pricing models (e.g., the
Black-Scholes-Merton option pricing model) require certain explicit inputs. Such
inputs may include the exercise (or forward) price of the instrument, the term
of the instrument, expected dividends, interest rates, and stock price
volatility.
To evaluate whether adjustments to the settlement provisions
that are based on an explicit input preclude a freestanding equity-linked
instrument (or an embedded feature) from being considered indexed to an entity’s
own stock, an entity considers the three questions below, assessing each
explicit input separately. These considerations are relevant regardless of
whether the explicit input (1) affects the exercise price or forward price of
the instrument or the number of equity shares used to calculate the settlement
amount or (2) results in an immediate settlement of the instrument at an
adjusted settlement amount. If an adjustment that is based on an explicit input
indicates that the instrument is not indexed to the entity’s own stock, the
instrument does not qualify as equity.
-
Is the explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For the instrument to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.If the settlement terms are adjusted in response to changes in an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, those do not necessarily preclude the instrument from being considered indexed to the entity’s stock. If, however, the settlement amount varies in response to changes in explicit inputs other than those used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (i.e., extraneous variables), the instrument is not considered indexed to the entity’s stock. In this case, the instrument must be classified as an asset or a liability.The table below includes examples of explicit inputs that may or may not preclude equity classification if an adjustment is made to the settlement amount in response to a change in the explicit input.Permissible (Equity Classification Not Precluded)Not Permissible (Equity Classification Precluded)
-
The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1).
-
The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1).
-
The exercise (or forward) price of the instrument.
-
The term of the instrument.
-
Expected dividends on the instrument (see Section 4.3.5.3).
-
Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4).
-
Risk-free interest rates (e.g., the federal funds rate or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.10, and 4.3.5.11).
-
Stock price volatility. (see Section 4.3.5.5).
-
The entity’s credit spread (generally only for convertible instruments).
-
Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.7).
-
The authorized and unissued common shares of the issuer.
-
The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event).
-
A commodity price (see Section 4.3.5.6).
-
A foreign currency index or rate (see Section 4.3.8).
-
An inflation rate.
-
Stock option exercise behavior (see Section 4.3.5.9).
-
Reimbursement of the holder’s tax obligations (see Section 4.3.5.13).
-
-
Could a change in the explicit input (other than the entity’s stock price) affect the settlement amount in a manner inconsistent with how a change in the input would affect the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.An adjustment in response to a change in an explicit input does not necessarily need to reflect the whole effect that the variable would have had on the fair value of a fixed-for-fixed forward or option on equity shares. If, however, an equity-linked instrument contains a feature (such as a leverage factor) that results in greater exposure to an input (other than the entity’s stock price) than the exposure to the input in the pricing (fair value measurement) of a fixed-for-fixed or option on equity shares, the instrument is considered not indexed to the entity’s stock and must be classified as an asset or a liability. Similarly, if a change in an explicit input (other than a change based solely on the entity’s stock price) affects the settlement amount of the instrument in a manner inconsistent with the effect that the underlying would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (e.g., the underlying affects the settlement amount inversely), the instrument is considered not indexed to the entity’s own equity.Thus, there are two common situations in which a change in an explicit input (other than the entity’s stock price) affects the settlement amount in a manner inconsistent with the effect that a change in the input would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares:
-
The underlying is leveraged (e.g., the interest rate input in a forward equity share contract is based on two times the change in the federal funds rate).
-
The underlying affects the settlement amount inversely (e.g., the interest rate input into the pricing of a written call option is adjusted upward for a decrease in interest rates).
-
-
Could a change in the explicit input (other than the entity’s stock price) result in a settlement at a fixed monetary amount?For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.If a change in the input (other than a change based solely on the entity’s stock price) could result in a settlement amount equal to a fixed monetary amount, the instrument is considered not indexed to the entity’s stock. This is because the effect of the change in the underlying would result in a settlement amount that is inconsistent with such effect on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. For example, an equity-linked instrument that allows the holder to purchase 1,000 shares of an entity’s common stock for $10 per share, but that will be settled for $5 per share upon a specified change in an interest rate, is not indexed to the entity’s stock.
4.3.5 Explicit Inputs: Application Issues and Examples
4.3.5.1 Adjustments Based on the Entity’s Stock Price
The entity’s stock price is an explicit input used in the
pricing (fair value measurement) of a fixed-for-fixed forward or option on
equity shares. Similarly, the stock price of a consolidated subsidiary is a
permissible input as long as the subsidiary is a substantive entity (see
Section 2.6.1).
Examples 8, 13, 15, and 16 in ASC 815-40-55 illustrate that
the following types of adjustments related to the entity’s stock price would
not necessarily preclude a conclusion that the equity-linked instrument is
considered indexed to the entity’s own stock:
-
A cap on the stock price (Examples 8 and 15).
-
A floor on the stock price (Example 15).
-
The use of a weighted-average stock price over a period instead of the current stock price (Example 13).
-
Variability in the number of shares used to determine the settlement amount depending on the entity’s stock price (Example 16). (Note that for such an instrument, an entity should consider whether ASC 480 would apply instead of ASC 815-40 [see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity].)
ASC 815-40
Example 8: Variability
Involving Stock Price Cap
55-32 Entity A purchases
net-settled call options that permit it to buy 100
shares of its common stock for $10 per share.
However, the maximum appreciation on the call
options is capped when Entity A’s stock price
reaches $15 per share (that is, the counterparty’s
maximum obligation is $500 [($15 − $10) × 100
shares]). The call options have 10-year terms and
are exercisable at any time. The call options are
considered indexed to Entity A’s own stock based on
the following evaluation:
-
Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price when Entity A’s stock price is between the $10 stated exercise price and the $15 price cap. However, whenever Entity A’s stock price exceeds $15, the strike price of the call options increases and decreases in amounts equal to the corresponding increases and decreases in Entity A’s stock price, such that the intrinsic value of each call option always equals $5. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed option contract, the call options are considered indexed to the entity’s own stock.
Example 13: Variability
Involving Average Stock Price
55-38 Entity A enters into a
net-settleable forward contract to sell 100 shares
of its common stock in 1 year for an amount equal to
$10 per share plus interest calculated at a variable
interest rate (Federal Funds rate plus a fixed
spread). The share price used to determine the
settlement amount is based on the volume-weighted
average daily market price of Entity A’s common
stock for the 30-day period before the settlement
date. The forward contract is considered indexed to
Entity A’s own stock based on the following
evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. However, the only variables that cause the settlement amount to differ from a fixed-for-fixed settlement amount are the 30-day volume-weighted average daily market price of Entity A’s common stock and an interest rate index. The pricing inputs of a fixed-for-fixed forward contract include the entity’s stock price and interest rates. Additionally, the floating interest rate feature does not introduce a leverage factor or otherwise increase the effects of interest rate changes on the instrument’s fair value.
Example 15: Variability
Involving Stock Price Cap and Floor
55-40 Entity A enters into a
net-settled forward contract to sell 100 shares of
its common stock in 1 year for $1,000. However, the
maximum amount payable to the counterparty at
maturity is capped when Entity A’s stock price is
greater than or equal to $15 per share (that is,
Entity A’s maximum obligation is $500 [($15 − $10) ×
100 shares]). Additionally, the maximum amount
receivable from the counterparty at maturity is
capped when Entity A’s stock price is less than or
equal to $5 per share (that is, the counterparty’s
maximum obligation is $500 [($5 − $10) × 100
shares]). The forward contract is considered indexed
to Entity A’s own stock based on the following
evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($1,000) when Entity A’s stock price is between $5 and $15. However, whenever Entity A’s stock price is greater than or equal to $15 at maturity, the amount payable to the counterparty always equals $500. Additionally, whenever Entity A’s stock price is less than or equal to $5 at maturity, the amount receivable from the counterparty always equals $500. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed forward contract, the instrument is considered indexed to the entity’s own stock.
Example 16: Variability
Involving Cap on Shares Issued
55-41 Entity A enters into a
forward contract to sell a variable number of its
common shares in 1 year for $1,000. If Entity A’s
stock price is equal to or less than $10 at
maturity, Entity A will issue 100 shares of its
common stock to the counterparty. If Entity A’s
stock price is greater than $10 but equal to or less
than $12 at maturity, Entity A will issue a variable
number of its common shares worth $1,000. Finally,
if the share price is greater than $12 at maturity,
Entity A will issue 83.33 shares of its common
stock. The forward contract is considered indexed to
Entity A’s own stock based on the following
evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed strike price ($1,000). Although the strike price to be received at settlement is fixed, the number of shares to be issued to the counterparty varies based on the entity’s stock price on the settlement date. Because the only variable that can affect the settlement amount is the entity’s stock price, which is an input to the fair value of a fixed-for-fixed forward contract on equity shares, the instrument is considered indexed to the entity’s own stock.
Similarly, an equity-linked instrument that is settled at
the maximum (or minimum) stock price over a certain period (instead of the
current stock price) would generally not preclude equity classification
provided that the settlement is not also indexed to another variable such as
the occurrence or nonoccurrence of a specified event. Further, a
volume-weighted average price does not preclude equity classification even
if it excludes trades that do not satisfy the requirements of Rule 10b-18 of
the Securities Exchange Act of 1934.
A change-in-control provision may specify that the
equity-linked instrument will become indexed to the equity shares of the
acquirer in a business combination if all the entity’s stockholders receive
stock of the acquiring entity. ASC 815-40 specifically states that such a
clause does not preclude a conclusion that the instrument is indexed to the
entity’s own stock (ASC 815-40-55-5; see Section 5.2.3.4).
Some warrants permit the holder to choose between share price inputs when the
warrant is settled on a net share (or cashless) basis because the common
shares underlying the warrant are not covered by an effective registration
statement. The share price input elected by the holder is used to calculate
the number of shares to be delivered upon settlement. Such an arrangement
generally would not preclude the warrant from being considered indexed to
the entity’s stock under step 2 in ASC 815-40-15-7 as long as (1) the rights
related to the ability to elect the share price input used upon a net share
settlement do not depend on the warrant’s holder and (2) each such input
represents a reasonable estimate of the issuer’s share price at the time of
settlement.
Example 4-5
Warrant With
Different Share Price Inputs Used in a Net Share
Settlement
An entity issues a warrant that
permits the holder to exercise the warrant on a
cashless basis if at any time there is not an
effective registration statement for the issuance of
the underlying common shares. The calculation of the
number of shares to be delivered if the holder
exercises the warrant on a cashless basis depends on
which share price input the holder elects. Any
holder of the warrant has the right to elect one of
the following share price inputs if it exercises the
warrant during trading hours (the election is made
upon the holder’s notice of exercise to the
issuer):
-
The bid price at the time of execution of the notice of exercise.
-
The VWAP on the trading day immediately preceding the exercise date.
-
The VWAP as of the end of the trading day on the exercise date.
The entity determines that each of
the share price inputs the holder may elect
represents a reasonable share price input at the
time of settlement (i.e., each share price input is
consistent with the settlement of a fixed-for-fixed
option on equity shares). Furthermore, the warrant’s
election provisions do not give the holder the
ability to control settlement on the basis of the
maximum stock price of the issuer. For example,
while the holder may be aware that the VWAP on the
trading day immediately preceding the exercise date
exceeds the bid price at the time of execution of
the notice of exercise, the holder does not control
whether the VWAP on the trading day immediately
preceding the exercise date will exceed the VWAP as
of the end of the trading day on the exercise date.
Accordingly, the warrant agreement is not precluded
from being considered indexed to the entity’s own
stock under step 2 in ASC 815-40-15-7 because the
holder can choose the share price input to use in
calculating the number of shares delivered in a net
share settlement.
If, however, the warrant’s election
provisions indicated that the share price input was
always based on the highest of three prices, the
warrant would be precluded from being indexed to the
issuer’s stock under step 2 in ASC 815-40-15-7
because (1) the settlement amount would exceed the
settlement amount of a fixed-for-fixed option on
equity shares and (2) the settlement of the warrant
would depend on whether there is an effective
registration for the underlying shares. In addition,
if election provisions change or are eliminated upon
a transfer by the holder to a third party, the
variability in the share price input would depend on
the warrant’s holder, which would also preclude the
warrant from being indexed to the issuer’s stock
(see Section
4.3.7.3).
4.3.5.2 Adjustments Based on the Risk-Free Market Interest Rate
The risk-free market interest rate (e.g., the federal funds
rate or the U.S. Treasury rate) is an explicit input used in the pricing
(fair value measurement) of a fixed-for-fixed forward or option on equity
shares. For example, if a conversion option embedded in a debt security
would be settled by the exchange of a fixed number of shares for a fixed
principal amount plus interest accrued at a variable market rate, the
conversion option would not be precluded from classification as equity.
Examples 13 and 14 in ASC 815-40-55 illustrate the
application of step 2 in ASC 815-40-15-7 to variability in an equity-linked
instrument’s settlement terms involving interest rates:
-
Example 13 (reproduced in the previous section) illustrates a forward contract for which variability in the settlement amount based on interest rates does not preclude equity classification. In the example, the forward price adjustment is based on the federal funds rate plus a fixed spread.
-
Example 14 below in ASC 815-40-55-39 illustrates a forward contract for which a change in interest rates affects the settlement amount in a manner inconsistent with the effect that a change in interest rates would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares. In the example, the interest rate used to adjust the forward price is inversely related to LIBOR. Accordingly, that contract does not qualify for equity classification.
ASC 815-40
Example 14: Variability
Involving Interest Rate Index
55-39 Entity A enters into a
forward contract to sell 100 shares of its common
stock in 1 year for an amount equal to $10 per share
plus interest calculated at a variable interest rate
that varies inversely with changes in the London
Interbank Offered Rate (LIBOR) (similar to an
“inverse floater,” as described in paragraphs
815-15-55-170 through 55-172). The forward contract
is not considered indexed to Entity A’s own stock
based on the following evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price varies inversely with changes in an interest rate index. The inverse floating interest rate feature increases the effects of interest rate changes on the instrument’s fair value (that is, the feature increases the instrument’s fair value exposure to interest rate changes) when compared to the exposure to interest rate changes of a fixed-for-fixed forward contract.
4.3.5.3 Adjustments Based on Dividends
The expected dividend on equity shares is an explicit input
used in the pricing (fair value measurement) of a fixed-for-fixed forward or
option on those equity shares. Example 12 in ASC 815-40-55 illustrates that
variability in an equity-linked instrument’s settlement terms based on
dividends would not necessarily preclude equity classification.
ASC 815-40
Example 12: Variability
Involving Dividend Distributions
55-37 Entity A enters into a
forward contract to sell 100 shares of its common
stock for $10 per share in 1 year. Historically,
Entity A has paid a dividend of $0.10 per quarter on
its common shares. Under the terms of the forward
contract, if dividends per common share differ from
$0.10 during any 3-month period, the strike price of
the forward contract will be adjusted to offset the
effect of the dividend differential (actual dividend
versus $0.10) on the fair value of the instrument.
Additionally, the terms of the forward contract
provide for an adjustment to the strike price, using
commercially reasonable means, to offset the effect
of any increased cost of borrowing Entity A’s shares
in the stock loan market on the fair value of the
instrument. The forward contract is considered
indexed to Entity A’s own stock based on the
following evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The only circumstances in which the settlement amount will not equal the difference between the fair value of 100 shares and $1,000 ($10 per share) are if dividends per common share differ from $0.10 during any 3-month period or if there is an increased cost of borrowing Entity A’s shares in the stock loan market. The adjustments to the strike price resulting from those events are intended to offset their effects on the instrument’s fair value. In those circumstances, the only variables that could affect the settlement amount (dividends and stock borrow cost) would be inputs to the fair value of a fixed-for-fixed forward contract on equity shares.
Some ASR transactions have a settlement amount that is
adjusted by the counterparty if the entity declares dividends with an
ex-dividend date that is earlier than the expected ex-dividend date
specified in the agreement. The adjustment is intended to compensate the
counterparty for the lost time value of money as a result of the dividends’
being declared earlier than had been anticipated and thus earlier than had
been priced into the instrument. Such an adjustment is similar to an
adjustment for dividends, stock borrow costs (anticipated dividends factor
into the cost to borrow a stock), and interest rates. Thus, the adjustment
would not preclude the ASR transaction from being considered indexed to the
entity’s common stock, because expected dividends, stock borrow costs, and
interest rates are inputs into the pricing of a fixed-for-fixed forward on
equity shares.
4.3.5.4 Adjustments Based on Cost of Stock Borrow
Like risk-free market interest rates, the cost of borrowing
the entity’s shares in the stock loan market (“cost of stock borrow”) is an
explicit input used in the pricing (fair value measurement) of a
fixed-for-fixed forward or option on equity shares. The following is an
example of an adjustment based on the cost of stock borrow:
If Counterparty determines, using its commercially reasonable
judgment, that its actual cost of borrowing a number of Shares equal
to the Base Shares to hedge its exposure to the Transaction exceeds
a weighted-average rate equal to 50 basis points per annum, over any
consecutive 30-day period, then, at Company’s election, either (A)
Calculation Agent will reduce Forward Price to compensate
Counterparty for the amount by which such cost exceeded a
weighted-average rate equal to 50 basis points per annum during that
period or (B) Borrow Cost Threshold will be reduced to 50 basis
points per annum after that period.
Example 12 in ASC 815-40-55 (reproduced in the previous
section) illustrates that variability in an equity-linked instrument’s
settlement terms based on the cost of stock borrow would not necessarily
preclude equity classification.
4.3.5.5 Adjustments Based on Stock Price Volatility
As noted in ASC 815-40-15-7E, volatility is an explicit
input in a standard pricing model. Upon an early settlement, some option
contracts on an entity’s own equity require the entity to calculate the
settlement amount by applying a standard option pricing model (such as the
Black-Scholes option pricing model) that uses market-based explicit inputs
that are current as of the settlement date, except that the volatility input
is prespecified (e.g., a fixed 20 percent volatility assumption). Such
prespecified volatility assumptions will generally not be consistent with
the volatility assumption in the pricing of a fixed-for-fixed option on
equity shares. For example, the 2002 ISDA Equity Derivatives Definitions refer to the
use of “implied volatility” (as opposed to, e.g., historical volatility) in
the determination of the amount paid upon early settlement of an option
contract. Implied volatility is expected to change over time. A prespecified
volatility will not be consistent with implied volatility or another
volatility assumption that a market participant would use to estimate the
fair value of an option on equity shares. There is a limited exception,
however, for a prespecified volatility assumption that would be used in a
Black-Scholes option pricing model, or other appropriate option pricing
model, to calculate the settlement amount upon an early settlement of an
option contract. Such an assumption may not preclude the contract from being
considered indexed to the entity’s own equity if the volatility input is
prespecified solely to ensure that the settlement amount is determined in a
manner consistent with the volatility assumption that was used in the
initial pricing of the contract. In other words, the settlement amount is
determined on the basis of an assumption that there was no change in this
particular input. This view is consistent with the guidance in ASC
815-40-55-45 and 55-46, which suggests that an equity-linked instrument may
be considered indexed to an entity’s own equity even if the settlement
amount is determined on the basis of an assumption of no change in relevant
pricing inputs other than stock price and time. However, before concluding
that an early settlement amount that is calculated by using an option
pricing model that incorporates a prespecified volatility assumption does
not preclude an option contract from being indexed to an entity’s equity
shares, an entity must consider the nature of the volatility assumption used
in the initial pricing of the contract to determine whether the prespecified
volatility assumption is actually consistent with the volatility assumption
used in the initial pricing (i.e., that volatility changes actually do not
affect the settlement amount of the contract). For example, if the
prespecified volatility assumption used to calculate the option price upon
an early settlement is the same volatility assumption used in the initial
pricing, we would expect that the volatility assumption used reflects a
constant annual volatility input. Further, a volatility input that is based
on the greater of a fixed volatility assumption (e.g., a fixed 100 percent
volatility assumption) and an estimate of current volatility at the time of
settlement would preclude an option contract from being considered indexed
to the entity’s own stock since such an input could result in a settlement
amount that is greater than the settlement amount of a fixed-for-fixed
option on the entity’s equity shares.
4.3.5.5.1 Side Letters That Modify Volatility Assumptions or Other Settlement Provisions
An issuer of convertible debt is often concerned about the dilution that
could result from the conversion of the debt into the issuer’s equity
shares. To reduce the potential for such dilution, issuers can
economically offset the conversion option embedded in the debt by
entering into transactions in which they have a right to receive equity
shares when the debt is converted into equity shares. Such transactions
are usually entered into with financial institutions that participate in
the convertible debt offering. They include:
- Call spread overlays — A call spread overlay consists of a purchased call option and a separate written warrant on the entity’s own equity. Generally, the purchased call option allows the issuer to receive from the option counterparty any shares (or other consideration) that it would issue upon conversion of the convertible debt. The initial strike price of the purchased call option (the “low” strike) equals the initial conversion price in the convertible debt. To offset part of the cost of the purchased call option, the entity writes a separate warrant with an initial strike price that is higher than the initial conversion price in the convertible debt (the “high” strike). On a combined basis, the net economic effect of the convertible debt and the call spread overlay is to increase the effective conversion price to the strike price of the written warrant (i.e., the high strike).
- Capped calls — A capped call is a purchased call option with an embedded cap on the value of the shares (or other consideration) that the counterparty will deliver upon settlement. Economically, a capped call is similar to a call spread overlay. While a call spread overlay consists of two separate transactions (i.e., a purchased call option and a separate written warrant), a capped call is a single integrated transaction (i.e., a purchased call option with an embedded written warrant). The initial strike price of the capped call equals the initial conversion price, and the settlement is capped at an amount equivalent to what the “high” strike would have been in the warrant of a call spread overlay transaction.
In practice, entities that enter into call spread
overlays or capped calls sometimes execute side letters with the
counterparty to the contract, which replace some of the terms described
in the primary contract. For example, it is common for side letters to
modify how the contract’s settlement amount (e.g., “close-out amount” or
“cancellation amount”) is computed upon an early settlement. Whereas the
contract might appear to imply that the settlement amount will be
calculated in accordance with the ISDA’s standard terms and definitions
(e.g., by reference to an ISDA master agreement and ISDA Equity
Derivatives Definitions), the effect of the side letter is to modify the
calculation (e.g., by specifying that a different volatility input
should be used or by including a so-called tax cap that is designed to
ensure that a capped call and the related convertible debt can be
integrated for tax purposes). Side letters may also modify the
allocation of options among multiple counterparties in the event of a
partial early settlement (e.g., in lieu of a pro rata early settlement
of the options among the counterparties, only the options held by
certain counterparties are settled early, or there are specified
calculations that result in a non-pro-rata allocation of the options
settled early among multiple counterparties). Accordingly, entities need
to consider the potential impact of side letters when determining the
accounting for a contract.
As discussed in Section 4.3.3, adjustments to the
calculation of an equity-linked instrument’s settlement amount may
affect whether the contract qualifies as equity or must be accounted for
at fair value with changes in fair value recognized in earnings. For an
equity-linked instrument to be considered indexed to an entity’s own
equity under step 2 in ASC 815-40-15-7, any variable that could affect
the settlement amount must be an input into the pricing of a
fixed-for-fixed forward or option on equity shares and cannot be
extraneous to the pricing of such an option or forward. Accordingly, to
ascertain whether an equity-linked instrument qualifies as equity under
ASC 815-40, an entity should evaluate each adjustment that may affect
the instrument’s settlement amount (including adjustments specified in
side letters, such as adjustments that differ from standard ISDA
terms)3 to determine whether it precludes such a conclusion. Certain
considerations related to the analysis of volatility inputs are
discussed in Sections
4.3.5.5 and 4.3.7.14.
4.3.5.5.2 Example of Capped Call With Side Letter
The example below illustrates a side letter that modifies the volatility
provisions of a capped call option entered into in conjunction with the
issuance of convertible debt.
Example 4-6
Capped Call
With Side Letter
On April 1, 2020, Issuer issued
convertible debt that matures on April 1, 2027
(the “maturity date”). Each $1,000 of note
principal is convertible into 25 shares of
Issuer’s common stock — a conversion price of
approximately $40 per share. The conversion price
represents a 33 percent premium over Issuer’s
common stock price (approximately $30). The debt
can be converted at maturity or upon the
occurrence of an event that constitutes a
“fundamental change.”
Concurrently with the issuance,
Issuer purchased a “capped call option” on its own
common stock from a dealer (“Dealer”). The capped
call option allows Issuer to participate in its
common stock’s appreciation above $40, up to $60.
The single freestanding financial instrument, from
Issuer’s perspective, represents (1) a purchased
call option on its own stock with a strike price
of $40 (the “low strike”) purchased from Dealer
and (2) a written call option on its own stock
with a strike price of $60 (the “cap strike”) sold
to Dealer.
The capped call option expires
on the maturity date and is automatically
exercised if the conversion option in the debt is
exercised, or Issuer can terminate all or a
portion of the option early if it repurchases all
or a portion of its convertible debt (e.g., if
Issuer repurchases debt with a face value of
$1,000, it can terminate the capped call for 25
shares) (“repurchase termination”).
The terms of the ISDA Equity
Derivatives Definitions and an ISDA master
agreement apply to the capped call option. The
terms of the ISDA master agreement, however, were
modified through a side letter to change the
settlement amount if the capped call option is (1)
exercised in connection with a fundamental change
or (2) terminated in connection with a repurchase
termination. In those cases, in calculating the
settlement amount, Dealer will determine the fair
value of both option components of the capped call
option (i.e., the purchased call option with a $40
strike and the written call option with a $60
strike) by using the same volatility input. That
volatility input will be based on the volatility
input applicable to the cap strike.
In the absence of the side
letter, the settlement amount would be calculated
on the basis of the fair value of each option
component and the volatility input for each option
component would be determined separately on the
basis of the strike price of the component (i.e.,
on the basis of the low strike for the purchased
call option and the cap strike for the written
call option).
In the limited circumstances in
which the capped call option will be settled
before the maturity date, the side letter reduces
the number of potentially subjective inputs that
Dealer may need to estimate.
The flat volatility assumption
upon early exercise or repurchase termination has
been included in side letters for both
tax-integrated and non-tax-integrated capped call
options. In a tax-integrated structure, the side
letter caps the settlement amount at the lesser of
the (1) value of the capped call option determined
by using the volatility input for the cap strike
for both option components and (2) synthetic
instrument-adjusted amount (i.e., the cap could
exceed the fair value of the option determined in
accordance with unmodified ISDA terms).
Note that this example discusses
a side letter that requires the volatility inputs
for the low strike and cap strike components of
the capped call option to always be the same in
the event of an early settlement. Other side
letters may specify merely that the volatility
input for the low strike could never be less than
the volatility input for the cap strike. In the
evaluation of these types of side letters, the
counterparty that was intended (or expected) to
benefit from them is not relevant. Rather, the
evaluation focuses on whether a settlement could,
regardless of likelihood, be for an amount that
would deviate from a settlement amount that is
based on the pricing inputs into a fixed-for-fixed
option. If so, the contract would not be
considered indexed to the issuer’s stock under
step 2 of ASC 815-40-15-7 as a result of the side
letter.
4.3.5.6 Adjustments Based on a Commodity Price
A commodity price (e.g., the price of a precious metal,
crude oil, natural gas, or electricity) is not an input used in the pricing
(fair value measurement) of a fixed-for-fixed forward or option on equity
shares. Therefore, an equity-linked instrument that includes such indexation
cannot be classified as equity. Example 5 in ASC 815-40-55 below illustrates
this scenario.
ASC 815-40
Example 5: Variability
Involving a Commodity Price
55-29 Entity A issues
warrants that permit the holder to buy 100 shares of
its common stock in exchange for one ounce of gold.
The warrants have 10-year terms; however, they only
become exercisable if Entity A completes an initial
public offering. The warrants are not considered
indexed to Entity A’s own stock based on the
following evaluation:
-
Step 1. The exercise contingency (that is, the initial public offering) is not an observable market or an observable index, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
-
Step 2. The settlement amount would not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price varies based on the price of one ounce of gold. The price of gold is not an input to the fair value of a fixed-for-fixed option on equity shares.
4.3.5.7 Adjustments Based on the Entity’s Revenue
An entity’s revenue is not an input used in the pricing
(fair value measurement) of a fixed-for-fixed forward or option on the
entity’s shares. Therefore, an equity-linked instrument that includes an
adjustment of the settlement amount based on the entity’s revenue cannot be
classified as equity.
Note that the evaluation of underlyings that are based on
revenue differs under steps 1 and 2 of the guidance in ASC 815-40-15-7:
-
The fact that an equity-linked instrument contains an exercise contingency based on the entity’s revenue does not preclude equity classification under step 1 (see Section 4.2). Thus, an equity-linked instrument that only becomes exercisable or settleable if revenue exceeds a certain target could be classified as equity provided it meets all the other conditions for equity classification. For example, a contingent consideration arrangement that specifies that the entity will deliver 100 shares if the acquired subsidiary’s revenue exceeds a specified level could qualify as equity (provided the subsidiary is a substantive entity).
-
An adjustment of the settlement amount based on the entity’s revenue precludes equity classification under step 2. Thus, an equity-linked instrument in which the strike price or the number of shares specified in the contract is adjusted based on the entity’s revenue cannot be classified as equity. For example, a contingent consideration arrangement that specifies that the entity will deliver 100 shares if revenue exceeds $10 million and 150 shares if revenue exceeds $20 million does not qualify as equity, because the settlement amount is adjusted based on revenue.
Example 7 in ASC 815-40-55 below illustrates the application
of step 2 to an option contract with a strike price that varies depending on
the entity’s revenue.
ASC 815-40
Example 7: Variability
Involving Revenue Target
55-31 Entity A issues
warrants that permit the holder to buy 100 shares of
its common stock for an initial price of $10 per
share. The warrants have 10-year terms and are
exercisable at any time. However, the terms of the
warrants specify that the strike price is reduced by
$0.50 after any year in which Entity A does not
achieve revenues of at least $100 million. The
warrants are not considered indexed to Entity A’s
own stock based on the following evaluation:
-
Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount would not equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price. Although the number of shares that would be issued at settlement is fixed, the strike price would be adjusted after any year in which Entity A does not achieve revenues of at least $100 million. The amount of an entity’s annual revenues is not an input to the fair value of a fixed-for-fixed option on equity shares.
Example 4-7
Adjustment Based on
Revenue
An entity
enters into a contingent consideration arrangement
in conjunction with a business combination. The
arrangement requires the entity to deliver a
variable number of shares to the seller if
investment management and advisory fees earned by
the acquired entity exceed specified levels. The
entity delivers no shares if fees are less than $50
million. The entity delivers 0 to 5,000 shares,
determined by straight-line interpolation, if fees
are from $50 million to $75 million. The entity
delivers 5,000 shares if fees exceed $75
million.
This arrangement includes an exercise contingency (fees earned) that does not
preclude the arrangement from being considered
indexed to the entity’s own stock under step 1 in
ASC 815-40-15-7. In the evaluation of step 2,
however, the variability in the settlement amount
based on fees earned indicates that the instrument
is not indexed to the entity’s stock and that the
instrument must be classified as an asset or a
liability.
4.3.5.8 Adjustments Based on a Percentage of Equity
Some equity-linked instruments are settled on the basis of a
percentage of equity. For example, a warrant may specify that the
counterparty will receive a variable number of shares on the basis of a
fixed percentage (e.g., 5 percent) of the fully diluted equity of the
entity. Because the number of outstanding common shares does not represent
an input in the valuation of a fixed-for-fixed forward or option on equity
shares (except in antidilution adjustments; see Section 4.3.7.1), the equity-linked
instrument is considered not indexed to the entity’s stock and must be
classified as an asset or a liability.
Some convertible instruments include a feature that allows
the holder to convert the instrument into the issuer’s equity shares at a
conversion price that is calculated as a fixed dollar amount (also referred
to as a “valuation cap”) divided by the number of outstanding shares of the
issuer as of the date of conversion. Because the number of outstanding
common shares does not represent an input in the valuation of a
fixed-for-fixed forward or option on equity shares (except in antidilution
adjustments; see Section
4.3.7.1) and the variability does not arise from a down-round
feature, the conversion feature is considered not indexed to the entity’s
stock.
Some equity-linked instruments contain a limit (cap) on the
number of shares that the entity will deliver to the counterparty on the
basis of a fixed percentage of the total number of the entity’s outstanding
shares, voting power, or the entity’s fully diluted equity. Such a cap does
not preclude equity classification if (1) it does not adjust the strike
price or the number of shares underlying the instrument but instead results
in a deferral of the settlement of the instrument in excess of the cap and
(2) the instrument contains no requirement to cash settle the shares owed in
excess of the cap (see Section 5.2.2). Note, however, that equity classification
would be precluded if the cap was indexed to, or contingent on, an input
that was not used in the pricing of a fixed-for-fixed forward or option on
equity shares (e.g., shareholder approval). The equity-linked instrument may
also fail to meet the equity classification conditions in ASC 815-40-25.
Example 4-8
Share Cap Contingent on
Holder’s Beneficial Ownership
Company X has issued a warrant to issue common stock to Company Y. The warrant
specifies that Y is not entitled to take delivery of
any shares owed to it under the contract if, after
such receipt, it would beneficially own more than
4.9 percent of the total number of X’s outstanding
common shares on a fully diluted basis. This
beneficial ownership cap was included in the warrant
to avoid regulatory reporting requirements that
would otherwise apply if Y owned 5 percent or more
of X’s common stock. If any delivery of shares owed
to Y is not made as a result of this provision, X’s
obligation to deliver such excess shares is not
extinguished. However, X has no obligation to settle
the excess shares in cash but must instead deliver
them if or when Y no longer beneficially owns more
than 4.9 percent of the total number of outstanding
common shares. Thus, Y can obtain the excess shares
by selling any shares it holds before exercise and
any shares it receives upon exercise. The warrant is
not precluded from being considered indexed to the
entity’s own equity under ASC 815-40-15 because the
cap (1) represents a permissible exercise
contingency (see Section 4.2.3)
and (2) does not adjust the instrument’s settlement
amount (see Section
4.2.2.3).
A beneficial ownership cap such as the one described above would not typically
prevent an equity-linked instrument from being
indexed to the issuer’s stock, provided that the
holder has the ability to exercise the warrant in
part so that the holder would always have the
ability to realize the full economics of the
instrument. However, if an equity-linked instrument
contained a beneficial ownership cap, only allowed
the holder to exercise or settle the instrument on a
single date, and subjected the holder to variability
on settlement depending on the stated cap (i.e., the
holder would never receive the shares in excess of
the cap), the instrument would not meet the
conditions to be considered indexed to the issuer’s
common stock because the settlement amount depends
on the number of outstanding common shares of the
issuer, which is not an input into the pricing of a
fixed-for-fixed forward or option on equity
shares.
Example 4-9
Share Cap Contingent on
Shareholder Approval
Company X has issued a forward contract to issue common stock. The contract
limits the number of shares that will be delivered
upon settlement to 19.9 percent of the voting power
or 19.9 percent of the total number of shares of
common stock outstanding before the issuance. The
purpose of the cap is to ensure compliance with
certain stock exchange rules, which require
shareholder approval for certain issuances of common
stock equal to 20 percent or more of the shares of
common stock or 20 percent or more of the voting
power outstanding before the issuance. The contract
specifies that X has no obligation to settle excess
shares in cash and that the cap is automatically
removed if X obtains shareholder approval to issue
the excess shares. As long as the contract
represents a single unit of account, it would not
qualify as equity under ASC 815-40-15 because it
contains an adjustment to the settlement amount that
is based on shareholder approval, which is not an
input into the pricing of a fixed-for-fixed forward
or option on equity shares (see Section
4.3.6.2).
Example 4-10
SEPA
Company Y enters into a standby
equity purchase agreement (SEPA) with Investor A
under which Y has the right, but not the obligation,
to issue up to 10 million common shares to A over
the next 18 months at a purchase price equal to 97
percent of the VWAP of Y’s common stock over the
three-trading-day period before Y elects to issue
shares under the SEPA. Company Y can elect to sell
shares to A in increments of 2,000,000; however, in
all cases the contract limits the number of shares
that A is required to purchase so that A would never
own more than 19.99 percent of Y’s common stock
after taking into account A’s current holdings of
such stock. This exchange cap provision is
eliminated if Y obtains approval from its
shareholders for A to own more than 19.99 percent of
Y’s common stock.
Because the number of shares
issuable under the SEPA depends on whether Y’s
shareholders approve the removal of the exchange cap
provision, and such removal is not an input into the
pricing of a fixed-for-fixed forward or option on
equity shares (see Section
4.3.6.2), the SEPA is not indexed to Y’s
stock under step 2 in ASC 815-40-15-7. For
additional information about SEPAs, see Section
6.2.5).
4.3.5.9 Adjustments Based on Stock Option Exercise Behavior
Stock option exercise behavior is not an input used in the
pricing (fair value measurement) of a fixed-for-fixed forward or option on
the entity’s shares. Therefore, an equity-linked instrument that requires
adjustments to the settlement amount on the basis of this variable cannot be
classified as equity. Example 21 in ASC 815-40-55 below illustrates this
scenario.
ASC 815-40
Example 21: Variability Involving Securities Issued to
Establish a Market-Based Measure of Grantee Stock
Option Value
55-48 Entity A issues a
security to investors for purposes of establishing a
market-based measure of the grant-date fair value of
a grant of stock options issued in a share-based
payment transaction. Under the terms of that
market-based stock option valuation instrument,
Entity A is obligated to make variable quarterly
payments to the investors that are a function of the
net intrinsic value received by a pool of Entity A’s
grantees, based on actual stock option exercises by
those grantees each period. The market-based stock
option valuation instrument has a 10-year term,
consistent with the contractual term of the
underlying stock options. The market-based stock
option valuation instrument is not considered
indexed to Entity A’s own stock based on the
following evaluation:
-
Step 1. The analysis of the exercise contingency (or contingencies) depends on the particular terms and features of the instrument. However, as indicated in Step 2 below, a market-based stock option valuation instrument would not be considered indexed to the entity’s own stock.
-
Step 2. The settlement amount will not equal the difference between the fair value of a fixed number of the entity’s equity shares and a fixed strike price. The instrument provides for variable quarterly payments to investors that are based on actual stock option exercises for the period. Because a variable that affects the instrument’s settlement amount is stock option exercise behavior, which is not an input to the fair value of a fixed-for-fixed option or forward contract on equity shares, the instrument is not considered indexed to the entity’s own stock.
Freestanding equity-linked financial instruments issued to
nonemployee investors to establish a market-based measure of the grant-date
fair value of stock options are within the scope of ASC 815-40 since they
are not issued as compensation for goods or services. This is the case even
though the instruments may refer to stock options that qualify for the scope
exception for share-based payment arrangements.
4.3.5.10 Convertible Preferred Stock
When a convertible preferred stock instrument contains a
host debt instrument, the evaluation of whether the embedded conversion
option is considered indexed to the entity’s stock is performed in the same
manner as the evaluation of whether an embedded conversion option in a debt
instrument is considered indexed to the entity’s stock. ASC 815-40-15-7C
indicates that “an issued share option that gives the counterparty a right
to buy a fixed number of the entity’s shares . . . for a fixed stated
principal amount of a bond issued by the entity” is considered a
fixed-for-fixed option on equity shares. An issued share option that gives
the counterparty a right to buy a fixed number of the entity’s shares for a
fixed stated amount of a preferred stock instrument issued by the entity
would also be considered a fixed-for-fixed option on equity shares when the
preferred stock host is considered a debt instrument and there are no
potential adjustments to the settlement terms.
In certain situations, the number of shares issued upon
conversion of a convertible preferred stock instrument varies on the basis
of the amount, if any, of accrued and unpaid dividends (i.e., the conversion
formula specifies that, upon conversion, the investor will receive a number
of equity shares that is equal to the liquidation value of the preferred
stock plus accrued and unpaid dividends divided by a fixed conversion
price). When the number of shares issuable upon conversion of a convertible
preferred stock instrument is affected by accrued and unpaid dividends, the
monetary amount exchanged upon conversion would not be considered fixed
(i.e., the exchange does not involve a fixed amount of a preferred stock
instrument of the issuer in return for a fixed number of equity shares). In
such cases, the entity should evaluate whether the variables that could
affect the settlement amount (i.e., the accrued and unpaid dividends) would
be considered an input used in the pricing (fair value measurement) of a
fixed-for-fixed option on equity shares.
If the convertible preferred stock contains a host debt
instrument, and the dividend is specified as a fixed coupon on the
liquidation value or a variable coupon that varies on the basis of an
interest rate index, this type of conversion formula would generally not
preclude the embedded conversion option from being considered indexed to the
entity’s stock under step 2 in ASC 815-40-15-7. This is because fixed and
variable interest rates would factor into the pricing of a fixed-for-fixed
option on equity shares (see Section 4.3.5.2). However, the entity should consider whether
the conversion formula introduces leverage or results in a fixed monetary
settlement amount of the convertible preferred stock instrument (see Section 4.3.4).
4.3.5.11 Convertible Zero-Coupon Bond
As used in ASC 815-40-15-7C, the term “fixed stated
principal amount” refers to the principal amount of the bond at its
maturity. Therefore, an exchange of the issuer’s zero-coupon bond for a
fixed number of the entity’s shares would qualify as a fixed stated
principal amount of a bond issued by the entity. If the embedded conversion
option does not contain variability in the settlement terms as a result of
other terms, it would be considered a fixed-for-fixed option on equity
shares and would therefore be considered indexed to the entity’s stock.
Otherwise, the issuer would need to evaluate other variability under step 2
in ASC 815-40-15-7 to conclude that the embedded conversion option was
indexed to its stock.
Sometimes, the number of shares issued upon conversion of a
convertible zero-coupon bond varies on the basis of the date of conversion
(e.g., the conversion formula specifies that, upon conversion, the investor
will receive a number of equity shares that is equal to the accreted value
of the bond divided by a fixed conversion price). When the number of equity
shares issuable upon conversion of a convertible zero-coupon bond is
affected by accreted interest on the zero-coupon bond, the monetary amount
exchanged upon conversion would not be considered fixed (i.e., the exchange
does not involve a fixed amount of a debt instrument of the issuer in return
for a fixed number of equity shares). In such cases, the entity should
evaluate whether the variables that could affect the settlement amount
(i.e., the accreted interest) would be considered an input used in the
pricing (fair value measurement) of a fixed-for-fixed option on equity
shares. Since interest rates are a variable in the pricing of a
fixed-for-fixed option on equity shares (see Section 4.3.5.2), this type of conversion
formula generally does not preclude the embedded conversion option from
being considered indexed to the entity’s stock under step 2 in ASC
815-40-15-7. The effective yield on a zero-coupon bond is generally
determined on the basis of risk-free interest rates and the issuer’s credit
spread. The influence of the issuer’s credit spread on the effective yield
does not invalidate this conclusion since the issuer’s credit spread is
considered an input into the pricing (fair value measurement) of a
fixed-for-fixed option embedded in a convertible instrument. However, the
entity should consider whether the conversion formula introduces leverage or
results in a fixed monetary settlement amount of the zero-coupon convertible
bond (see Section
4.3.4).
4.3.5.12 Own-Share Lending Arrangements
For a share-lending arrangement on the entity’s own shares
to be considered indexed to its own equity under ASC 815-40, any variables
affecting the settlement amount of the share-lending arrangement should be
inputs to the fair value (pricing) of a fixed-for-fixed forward or option on
the entity’s equity shares. The variables that typically affect the fair
value of a share-lending arrangement include the contractual processing fee,
the market rate of borrowing the entity’s shares during the arrangement’s
term, and the share borrower’s nonperformance risk. Such variables do not
preclude a conclusion that the instrument is indexed to the issuer’s own
equity under ASC 815-40-15. If a share-lending arrangement contains other
variables that affect the settlement amount, however, an entity should
evaluate those variables to determine whether they preclude a conclusion
that the instrument is indexed to the issuer’s own equity shares. For
example, a share-lending arrangement in contemplation of a settlement amount
that is indexed to the S&P 500 Index or the price of gold does not
qualify for equity classification. ASC 470-20 provides recognition,
measurement, EPS, and disclosure guidance related to an issuer’s accounting
for equity-classified share-lending arrangements on its own shares for those
that are executed in contemplation of a convertible debt issuance (see
Section
2.9).
4.3.5.13 Reimbursement of the Holder’s Taxes
An equity-linked financial instrument may include a provision that requires
the entity to reimburse the holder for any taxes it might incur upon
settlement of the instrument, such as capital gains or withholding taxes
that are attributable to the holder. Because holder-specific taxes are not
an input into the pricing of a fixed-for-fixed forward or option on equity
shares, such a provision precludes the instrument from being indexed to the
entity’s stock under step 2 in ASC 815-40-15-7. The instrument would not be
considered indexed to the entity’s stock even if there were no current tax
requirements under which the entity would have to make an adjustment because
the instrument would still be indexed to changes in tax laws, which is not
an input into the pricing of a fixed-for-fixed forward or option on equity
shares. The likelihood of changes in tax laws is not relevant to the
assessment under step 2.
The above analysis differs from the evaluation of stamp duties, transfer
taxes, or other governmental charges that are imposed on, and payable by,
the issuer for the issuance of its equity shares. Such amounts may not
preclude an equity-linked instrument from being indexed to the entity’s
stock under step 2 because:
-
The taxes are imposed on the issuer as opposed to the holder since they apply to any issuance of shares by the issuer (i.e., the entity, and not the holder of the equity-linked instrument, is legally obligated to pay the taxes).
-
The entity’s obligation is limited to costs (if any) that would be unavoidable upon the entity’s issuance of equity shares.
-
The taxes arise from governmental regulations as opposed to the contractual terms of the equity-linked instrument.
-
The taxes are not based on the tax attributes of the holder of the instrument (i.e., the issuer’s obligation does not encompass any amounts related to capital gains taxes, withholding taxes, or other taxes or expenses that depend on holder-specific factors).
-
The entity expects to incur no or only minimal costs associated with meeting its obligation.
See further discussion in Section
5.2.3.7 of stamp duties, transfer taxes, and other
governmental charges.
4.3.6 Evaluating Implicit Inputs
4.3.6.1 Overview
ASC 815-40
15-7G Standard pricing models
for equity-linked financial instruments contain
certain implicit assumptions. One such assumption is
that the stock price exposure inherent in those
instruments can be hedged by entering into an
offsetting position in the underlying equity shares.
For example, the Black-Scholes-Merton option-pricing
model assumes that the underlying shares can be sold
short without transaction costs and that stock price
changes will be continuous. Accordingly, for
purposes of applying Step 2, fair value inputs
include adjustments to neutralize the effects of
events that can cause stock price discontinuities.
For example, a merger announcement may cause an
immediate jump (up or down) in the price of shares
underlying an equity-linked option contract. A
holder of that instrument would not be able to
continuously adjust its hedge position in the
underlying shares due to the discontinuous stock
price change. As a result, changes in the fair value
of an equity-linked instrument and changes in the
fair value of an offsetting hedge position in the
underlying shares will differ, creating a gain or
loss for the instrument holder as a result of the
merger announcement. Therefore, inclusion of
provisions that adjust the terms of the instrument
to offset the net gain or loss resulting from a
merger announcement or similar event do not preclude
an equity-linked instrument (or embedded feature)
from being considered indexed to an entity’s own
stock.
In the pricing of an equity-linked instrument under standard
valuation models (e.g., the Black-Scholes-Merton option pricing model),
certain assumptions are implicit. Some instruments permit adjustments to the
settlement terms when such implicit assumptions are invalidated. For
example, the pricing of a contract may assume that no dilutive event will
occur. If such an event occurs (e.g., a dilutive event) and is inconsistent
with an implicit assumption in the valuation model (e.g., no dilutive events
will occur), an adjustment to the contract’s settlement terms (e.g., an
antidilution adjustment) does not necessarily preclude the contract from
being considered indexed to the entity’s stock. However, if the settlement
provisions are adjusted because of the occurrence or nonoccurrence of a
specified event that does not invalidate an implicit
assumption in a standard valuation model (e.g., the issuance of additional
equity shares at a price equal to their fair value), the instrument is
considered not indexed to the entity’s stock.
Below are examples of implicit assumptions that may be
contained in a standard valuation model used to determine the fair value of
a fixed-for-fixed forward or option on equity shares. A neutralizing
adjustment to the settlement amount in response to the invalidation of such
an assumption would not preclude a conclusion that the instrument is indexed
to the entity’s own equity:
-
The investor is able to maintain a standard hedge position in the equity shares underlying the instrument (e.g., the shares underlying a forward or option on equity shares can be sold short without transaction costs) — When an investor incurs transaction costs to sell shares short, has a loss of stock borrow, or is unable to maintain a standard hedge position (i.e., a hedging disruption event occurs, as further discussed below), an implicit assumption in standard valuation models is invalidated. Therefore, an adjustment to the settlement amount does not necessarily preclude the instrument from being considered indexed to the entity’s stock.
-
Stock price changes will be continual — Stock price discontinuities invalidate an implicit assumption to the extent that they result in a hedging disruption event. Occurrences that may cause a stock price discontinuity resulting in a hedging disruption event include:
-
A merger event or change of control involving an issuer (see Section 4.3.7.5).
-
A tender offer for an issuer’s shares.
-
A termination of trading of an issuer’s shares (e.g., a delisting).
-
A governmental or political event.
-
A natural disaster.
-
-
Dilutive events will not occur (or, if they occur, the terms of the instruments will be adjusted solely to offset the effects of the dilutive events) — In standard valuation models, it is assumed that dilutive events will not occur (see Section 4.3.7.1). Dilutive events may include:
-
A stock split, subdivision, combination, reclassification, or recapitalization.
-
A stock dividend or distribution by an issuer.
-
A rights offering by an issuer.
-
An offering of additional common stock or equity-linked securities by an issuer at a price that is less than fair value (i.e., the current quoted market price for a public issuer).
-
A repurchase of common stock by an issuer at a price that is more than fair value (i.e., the current quoted market price for a public issuer).
-
A tender offer by an issuer at other than fair value of the issuer’s stock (i.e., the current quoted market price for a public issuer).
-
A distribution by an issuer to all common shareholders of securities other than common stock, evidence of indebtedness, warrants, or other assets or property of the issuer.
-
-
The counterparty in a gain position will be paid the monetary value it is due upon settlement regardless of the form of settlement (i.e., cash, shares, or other assets) — When the counterparty in a gain position is not paid the entire monetary value due upon settlement, an implicit assumption in standard valuation models is invalidated. In this case, an adjustment to the settlement amount does not necessarily preclude the instrument from being considered indexed to the entity’s stock. Implicit assumptions about the settlement amount may include the following:
-
If settlement of an equity-linked instrument is in shares instead of cash, the party receiving the shares will not incur transaction costs to dispose of those shares (see Section 4.3.7.6).
-
If an equity-linked instrument is issued by a public company, the fair value of the shares underlying the instrument is based on the quoted market price of the issuer’s shares (i.e., shares that are registered for resale and listed on a stock exchange; see Sections 4.3.7.7 and 4.3.7.8).
-
-
The holder of an equity-linked instrument will be able to participate in any extraordinary distribution of cash or noncash consideration or other similar event that is provided to all holders of the issuer’s common stock — This is most commonly associated with a tender offer provision in which all holders of common stock are entitled to receive consideration associated with the offer. Certain tender offers for an entity’s shares may be made by a third party. While a tender offer made by a third party is not considered a dilutive event (because the offer does not involve the issuer), if such an offer is available to all holders of the issuer’s common stock (contractually or by law), an adjustment to the settlement terms solely to reflect a pro rata participation in the tender offer would not preclude the instrument from being considered indexed to the entity’s stock.
-
The holder of an equity-linked instrument will be able to realize the remaining time value inherent in the instrument — The occurrence of certain events involving the issuer (e.g., a liquidation or change of control) may invalidate this implicit assumption. In this case, an adjustment to the settlement amount would not necessarily preclude the instrument from being considered indexed to the entity’s stock (see Sections 4.3.7.9 and 4.3.7.10 for an example). That is, a provision that requires an appropriate adjustment to the settlement amount in the event of an early settlement of the instrument does not preclude the instrument from being considered indexed to the entity’s stock. Such adjustments are intended to compensate the counterparty for the “lost” time value upon such early settlements. They would not necessarily preclude the equity-linked instrument from being considered indexed to the entity’s stock, even though the fair value of the instrument under ASC 820 (based on a market participant’s view of a similar instrument without such an adjustment provision) may not include any remaining time value because the specified event truncates any remaining time value in the instrument.
Below are examples of adjustments to the settlement amount
that are not associated with the invalidation of an implicit assumption in a
standard valuation model. Such adjustments indicate that the instrument is
not indexed to the entity’s own equity and thus cannot be classified as
equity:
-
An adjustment to protect the counterparty from the effect of a specified event on the stock price (e.g., a provision that results in settlement by using a stock price input that does not reflect the effect of the specified event on the fair value of the issuer’s shares). An adjustment that protects the counterparty from adverse changes in the issuer’s stock price (which is not permissible) differs from an adjustment that neutralizes the effect that a specified event would have on the remaining time value in an equity-linked instrument (which may be permissible).
-
An adjustment upon the occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4).
-
Certain adjustments upon a change of control of the issuer (see Section 4.3.7.4).
-
An adjustment upon a change in the number of authorized and unissued common shares of an issuer.
-
An adjustment upon a change in the number of outstanding common shares of an issuer that occurs as a result of a specified event other than a dilutive event.
-
An adjustment under a provision that requires shareholder approval.
-
An adjustment upon the bankruptcy or insolvency of the issuer unless the event results in a hedging disruption.
-
An adjustment upon the delisting of the issuer’s stock unless the event results in a hedging disruption.
-
An adjustment based on employee forfeitures of awards subject to ASC 718.
-
An adjustment based on the holder of the instrument.
Connecting the Dots
On April 12, 2021, the SEC staff issued
Staff Statement on Accounting and Reporting Considerations
for Warrants Issued by Special Purpose Acquisition Companies
(“SPACS”) (the “SEC staff statement”),
which discusses certain indexation matters related to SPAC warrants.
The SEC staff statement discusses a fact pattern related to the
terms of warrants that were issued by a SPAC, and states, in part:
[T]he warrants included provisions that
provided for potential changes to the settlement amounts
dependent upon the characteristics of the holder of the warrant.
Because the holder of the instrument is not an input into the
pricing of a fixed-for-fixed option on equity shares, OCA staff
concluded that, in this fact pattern, such a provision would
preclude the warrants from being indexed to the entity’s stock,
and thus the warrants should be classified as a liability
measured at fair value, with changes in fair value each period
reported in earnings.
The SEC staff statement notes that the holder is not
an input into the pricing of an equity-linked instrument. Therefore,
if the holder of an instrument could potentially affect either the
exercise (forward) price or the number of shares issued on
settlement, the instrument is not considered indexed to the issuer’s
stock. For example, certain nonpublicly traded warrants issued by a
SPAC to its sponsor or an anchor investor (“private placement
warrants”) have terms that differ from the terms of publicly traded
warrants also issued by the SPAC (“public warrants”). In the event
that the holder of private placement warrants transfers those
warrants to a nonpermitted transferee (i.e., a nonaffiliate), the
warrants become public warrants. In the fact pattern addressed by
the SEC staff, there were differences between the public warrants
and private placement warrants related to the following terms:
- The issuer could force settlement of the public warrants if the entity’s stock price was $10 or more. The number of shares issuable on such settlement would depend on the date on which they were settled and the stock price (i.e., there was an adjustment to deliver additional shares to compensate the holder for lost time value). The private placement warrants were not subject to this provision but would become subject to it if they were transferred to a nonpermitted transferee.
- Both the public warrants and private placement warrants were subject to an exercise price adjustment in the event of certain changes in control; however, the formula for the exercise price adjustment was different for each type of warrant. Further, a private placement warrant’s exercise price adjustment would change so that it would be adjusted in a manner consistent with the terms of a public warrant if it was transferred to a nonpermitted transferee.
- Different formulas were used in the public warrants and private placement warrants for computing the number of shares deliverable in a cashless, or net share, settlement.
Because the holder is not an input into the pricing
of a fixed-for-fixed forward or option on equity shares, the private
placement warrants were considered not indexed to the issuer’s stock
and their classification as liabilities was required. In addition,
the public warrants issued by some entities included provisions that
affected the warrants’ settlement amount when they were held by the
entities’ directors or officers. Further, public warrants that
contained such terms were considered not indexed to the issuer’s
stock and were required to be classified as liabilities.
The SEC staff’s position that the holder of an
instrument is not an input into the pricing of a fixed-for-fixed
equity-linked instrument is based on the guidance in ASC 815-40-15
and therefore applies to all entities. While the SEC’s position
addresses warrants issued by a SPAC, the guidance could apply in
other circumstances. For more information about the classification
of SPAC warrants, see Deloitte’s October 2, 2020 (last updated April
11, 2022), Financial Reporting Alert.
4.3.6.2 Evaluating Adjustments Based on an Implicit Input
An entity considers the three questions below when
evaluating whether adjustments to the settlement provisions based on an
implicit input preclude a freestanding or embedded equity-linked financial
instrument from being considered indexed to its own stock. The entity
evaluates each implicit input separately. These considerations are relevant
regardless of whether the implicit input (1) affects the exercise price or
forward price of the instrument or the number of equity shares used to
calculate the settlement amount or (2) results in an immediate settlement of
the instrument at an adjusted settlement amount:
-
Does the adjustment to the settlement provisions result from the occurrence or nonoccurrence of a specified event that invalidates an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For the instrument to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.An equity-linked instrument does not qualify as equity if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event unless the occurrence or nonoccurrence of the event is inconsistent with an implicit assumption in a standard valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares.The table below gives examples of events in response to which adjustments to the settlement amount may or may not preclude equity classification.Permissible (Equity Classification Not Precluded)Not Permissible (Equity Classification Precluded)
-
The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow).
-
The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change of control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5).
-
Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1).
-
A down-round protection feature (see Section 4.3.7.2).
-
The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8).
-
The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party).
-
The counterparty is not able to realize the remaining time value inherent in the instrument (i.e., loss of time value upon early settlement; see Section 4.3.7.9).
-
The counterparty does not receive the shares underlying the instrument within a reasonable period (see Section 4.3.7.11).
-
Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4).
-
Occurrence or nonoccurrence of a change of control (unless the adjustment arises from a discontinuity in stock price that causes a hedge disruption event).
-
A change in the entity’s number of authorized and unissued common shares.
-
A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event.
-
A provision that requires shareholder approval.
-
The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption).
-
Delisting of the underlying shares (unless the event results in a hedging disruption).
-
The identity of the holder (see Section 4.3.7.3).
-
-
Is the adjustment to the settlement terms consistent with the effect that the occurrence or nonoccurrence of the specified event had on the fair value of the instrument (i.e., does the adjustment offset — at least partially — the net gain or loss on the instrument that occurs as a result of the specified event)?For the instrument to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.An equity-linked instrument does not qualify as equity if the instrument’s terms include an adjustment in response to the occurrence or nonoccurrence of a specified event that is inconsistent with an implicit assumption in a standard valuation model unless the adjustment is consistent with the effect that the occurrence or nonoccurrence of the specified event has on the fair value of the instrument. Thus, adjustments to neutralize or partially offset the effects of events that invalidate an implicit assumption in a valuation model do not preclude an equity-linked instrument from being considered indexed to the entity’s stock (i.e., such adjustments do not preclude equity classification for the instrument). In this context, “neutralize” means that the calculation of the adjustment to the settlement terms of the equity-linked instrument appropriately offsets the net gain or loss on the instrument that occurred as a result of the specified event.Adjustments from implicit inputs do not necessarily have to result in a complete neutralization of the effect that the occurrence or nonoccurrence of a specified event has on the fair value of an equity-linked instrument (i.e., the net gain or loss on the instrument that occurs as a result of the specified event). However, an adjustment to the terms of an instrument to reflect more than 100 percent of the effect that the variable has on the fair value of a fixed-for-fixed forward or option on equity shares precludes an instrument from being indexed to the entity’s stock because the additional exposure is inconsistent with a fixed-for-fixed forward or option on equity shares.Note that an equity-linked instrument may be considered indexed to the entity’s stock even if no adjustments are made upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption. In a fixed-for-fixed forward or option on equity shares, no adjustments are made upon the occurrence of an event that is inconsistent with any of the implicit assumptions. Instead, the counterparty to the instrument is exposed to the risk of a change in the fair value of the instrument upon the occurrence or nonoccurrence of such events. Further, an instrument may be considered indexed to the entity’s stock even if an adjustment upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption only partially offsets the effect of the specified event.For an equity-linked instrument to qualify as equity, the adjustment cannot compensate the counterparty for adverse changes in the entity’s share price that are not attributable to the effect of the specified event. This is because such an adjustment could “protect” the counterparty from an adverse price change that results from events other than an event that invalidates an implicit assumption. Similarly, an adjustment based on the difference between the pre-event share price and the post-event share price generally would preclude equity classification because the share price could have changed for reasons other than the event itself (ASC 815-40-55-42). The principle is that an adjustment should be designed to capture only the theoretical effect of the event that invalidates an implicit assumption (e.g., a dilutive event).A settlement of an equity-linked instrument at its fair value as of the settlement date (i.e., that reflects the effect of a specified event) is not considered to have been affected by an implicit input because no additional value is exchanged between the counterparties (i.e., no adjustment is made for the net gain or loss resulting from the invalidation of an implicit input). However, when the settlement amount does not reflect fair value (e.g., the settlement amount will be adjusted to reflect the net gain or loss resulting from the occurrence of a specified event), the entity must perform an additional evaluation to determine whether the equity-linked instrument is indexed to its stock.Further, as discussed in the example below, an entity must determine the adjustment by using commercially reasonable means.Example 4-11Use of Commercially Reasonable Means to Determine AdjustmentAssume a contract provision adjusts the settlement terms to offset the net gain or loss that results from a discontinuous stock price change that causes a hedge disruption event. The adjustment is calculated on the basis of the net change in fair value of the equity-linked instrument and an offsetting delta-neutral hedge position that is determined by using commercially reasonable means. The provision, which does not protect the counterparty from a mere adverse change in stock price, does not preclude the equity-linked instrument from being considered indexed to the entity’s own stock because an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares is that a counterparty is able to maintain a delta-neutral hedge. The equity-linked instrument is not considered indexed to the entity’s stock, however, if the adjustment is based on the counterparty’s actual offsetting hedge position and the counterparty is not required to maintain a delta-neutral hedge position. This is because if the entity calculates an adjustment on the basis of the counterparty’s actual hedging position, the adjustment is not considered to have been made in a commercially reasonable manner if there is any possibility that the counterparty’s actual hedging position could differ from a delta-neutral hedging position.Example 4-12Assessment of Adjustment for Lost Time ValueThere is an implicit assumption in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares that the holder of the contract will be able to realize the remaining time value inherent in the instrument. If certain events were to occur that would require early settlement of an equity-linked option contract, the holder would lose any remaining time value in the option. A provision that results in an adjustment to the exercise price of an option contract to reflect a settlement on the basis of the “theoretical value” of the contract (calculated on the basis of the remaining time to expiration as of the date of the specified event and the stock price of the issuer on the date of the occurrence of the specified event) does not preclude the instrument from being considered indexed to the entity’s stock. The adjustment provision is considered to appropriately compensate the counterparty for the lost time value that results from the occurrence of a specified event that invalidates an implicit assumption in the pricing of the option contract. It does not adjust the settlement terms to protect the counterparty against a potential adverse change in the issuer’s stock price.
-
Could a change in an implicit input result in a settlement at a fixed monetary amount?For the instrument to be considered indexed to the entity’s stock, the answer must be no. If the answer is yes, the instrument does not qualify as equity irrespective of whether it meets the other conditions for equity classification.If a change in an implicit input can result in a settlement based on a fixed monetary amount, the equity-linked instrument is not indexed to the entity’s stock (see Section 4.3.7.12 for an example). This is because the occurrence of the specified event would result in a settlement amount that would be inconsistent with the effect that the event would have had on the fair value of a fixed-for-fixed forward or option on equity shares.Example 4-13Fixed Monetary SettlementA warrant allows the holder to purchase 1,000 shares of an entity’s common stock for $10 per share. However, if there is a change of control of the issuer, the holder can require the entity to redeem the warrant for $20,000. The instrument is not indexed to the entity’s stock because of the potential for a fixed monetary settlement.
4.3.7 Implicit Inputs: Application Issues and Examples
4.3.7.1 Antidilution Adjustments
As discussed in Section 4.3.6, there is an implicit
assumption in the pricing (fair value measurement) of a fixed-for-fixed
forward or option on equity shares that dilutive events will not occur (or,
if they occur, that the terms of the instrument will be adjusted solely to
offset the effect of the dilutive events). When an equity-linked instrument
contains adjustments upon the occurrence of a dilutive event and the
adjustments always result in the same intrinsic value for the equity-linked
instrument both before and after the dilutive events, the adjustments do not
preclude the instrument from being considered indexed to the entity’s stock.
That is, if an adjustment is designed to offset or neutralize the effect of
the dilutive event on the holder of the instrument, it does not preclude
equity classification.
Examples of such adjustments include those designed to
offset or neutralize the effect of the following:
-
The entity effects a share split or share combination.
-
The entity issues shares of common stock as a dividend or distribution on all shares of common stock.
-
The entity issues to all holders of common stock any rights, options, or warrants entitling them to subscribe for or purchase shares of common stock at a price per share that is less than the currently quoted sales price or fair value of such shares.
-
The entity distributes to all holders of its common stock (1) shares of its capital stock, evidence of indebtedness, other assets, or its property or (2) rights, options, or warrants to acquire its capital stock or other securities.
-
The entity pays any cash dividend or distribution to all holders of its common stock.
-
The entity, or any of its subsidiaries, makes a payment on a tender offer or exchange offer for the entity’s common stock to the extent that the cash and value of any other consideration included in the payment per share of common stock exceeds the currently quoted sales price or fair value of such shares.
-
The entity repurchases shares of common stock at a price that exceeds the currently quoted sales price or fair value of such shares.
Example 4-14
Antidilution
Adjustments
Entity Y issues freestanding warrants that allow the holder to purchase 1,000
shares of Y’s common stock for $10 per share any
time before the warrants’ expiration date. The
exercise price and number of shares underlying the
warrants are adjusted (1) upon a change in the
risk-free interest rate (on a nonleveraged basis)
and (2) if Y undertakes a stock split (the
adjustment solely offsets the dilution caused by the
stock split). In this case, the warrants are not
fixed for fixed because the settlement amount will
not always equal the difference between the fair
value of a fixed number of equity shares and a fixed
exercise price. However, the warrants are still
considered indexed to Y’s stock because (1) the
risk-free interest rate is an explicit input used in
the pricing (fair value measurement) of a
fixed-for-fixed option on equity shares and there is
no feature (such as a leverage factor) that
increases exposure to that input in a manner that is
inconsistent with a fixed-for-fixed option on equity
shares and (2) an implicit assumption used in the
pricing (fair value measurement) of a
fixed-for-fixed option on equity shares is that a
stock split will not occur (or that the exercise
price and number of shares underlying the warrants
will be adjusted to offset the dilution caused by
the stock split).
Example 17 in ASC 815-40-55 below illustrates adjustments to
offset the effect of dilutive events.
ASC 815-40
Example 17: Variability
Involving Various Underlyings
55-42 Entity A enters into a
forward contract to sell 100 shares of its common
stock for $10 per share in 1 year. Under the terms
of the forward contract, the strike price of the
forward contract would be adjusted to offset the
resulting dilution (except for issuances and
repurchases that occur upon settlement of
outstanding option or forward contracts on equity
shares) if Entity A does any of the following:
-
Distributes a stock dividend or ordinary cash dividend
-
Executes a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend
-
Issues shares for an amount below the then-current market price
-
Repurchases shares for an amount above the then-current market price.
The contractual terms
that adjust the forward contract’s strike price are
eliminating the dilution to the forward contract
counterparty that would otherwise result from the
occurrence of those specified dilutive events. The
adjustment to the strike price of the forward
contract is based on a mathematical calculation that
determines the direct effect that the occurrence of
such dilutive events should have on the price of the
underlying shares; it does not adjust for the actual
change in the market price of the underlying shares
upon the occurrence of those events, which may
increase or decrease for other reasons.
55-43 The forward contract is
considered indexed to Entity A’s own stock based on
the following evaluation:
- Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
- Step 2. The only circumstances in which the settlement amount will not equal the difference between the fair value of 100 shares and $1,000 ($10 per share) are upon the occurrence of any of the following:
-
The distribution of a stock dividend or ordinary cash dividend
-
The execution of a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend
-
The issuance of shares for an amount below the then-current market price
-
The repurchase of shares for an amount above the then-current market price.
-
An implicit assumption
in standard pricing models for equity-linked
financial instruments is that such events will not
occur (or that the strike price of the instrument
will be adjusted to offset the dilution caused by
such events). Therefore, the only variables that
could affect the settlement amount in this example
would be inputs to the fair value of a
fixed-for-fixed option on equity shares.
Questions are often raised regarding how transaction costs
should be treated in the determination of whether an adjustment arising from
a dilutive event precludes an instrument from being considered indexed to
the entity’s stock. For example, a provision may result in an adjustment to
the settlement terms of an equity-linked instrument if an issuer sells
additional common shares at less than fair value. The adjustment may be
calculated on the basis of the difference between the actual number of
common shares issued and the number of common shares that could have been
purchased at the current quoted market price with the net proceeds
(including transaction costs) received in the issuance. Alternatively, the
adjustment may be calculated on the basis of the difference between the
actual number of common shares issued and the number of common shares that
could have been purchased at the current quoted market price with the gross
proceeds (excluding transaction costs) received in the issuance.
Whether transaction costs are included in, or excluded from,
the calculation of adjustments from dilutive events should generally not
affect the assessment of whether the equity-linked instrument is considered
indexed to the entity’s stock. Transaction costs incurred by an issuer may
affect the post-event fair value of the issuer’s shares and thus could be
included in a dilutive-type adjustment. Such costs could also be excluded
because the exclusion results in an adjustment that does not fully
neutralize the effect of the dilutive event and does not otherwise create
leverage.
4.3.7.2 Down-Round Protection
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.
A down-round feature is a term in an equity-linked financial
instrument (e.g., a freestanding warrant or an equity conversion feature
embedded within a host debt or equity contract) that triggers a downward
adjustment to the instrument’s strike price (or conversion price) if equity
shares are issued at a lower price (or equity-linked financial instruments
are issued at a lower strike price) than the instrument’s then-current
strike price. The purpose of the feature is to protect the instrument’s
counterparty from future issuances of equity shares at a more favorable
price. For example, a warrant may specify that the strike price is the lower
of $5 per share or the common stock offering price in any future offering of
the shares. Similarly, a debt instrument may include an embedded conversion
feature whose conversion price is the lower of $5 per share or the future
offering price. Such provisions are frequently included in warrants,
convertible shares, and convertible debt issued by private entities and
development-stage companies.
Note that a conversion feature that economically represents
a share-settled redemption feature is not a down-round feature.
Example 4-15
Adjustment That
Is Not a Down-Round Feature
An entity has issued a debt
instrument with a principal amount of $10 million
that is automatically converted into the issuer’s
equity shares upon an IPO. The conversion price is
the lower of 80 percent of the stock price in the
IPO or $50. Although the conversion price in this
scenario is reduced to the IPO price if the IPO
price is below $50, the potential adjustment is not
a down-round feature because the associated
settlement has a monetary value equal to a fixed
monetary amount ($10,000,000 ÷ 0.80 = $12,500,000).
The entity should evaluate this share-settled
redemption feature in a manner similar to how it
evaluates a put or call option embedded in a debt
host contract to determine whether the feature must
be separated as a derivative under ASC 815-15 (see
Section 8.4.7.2.5 of Deloitte’s
Roadmap Issuer’s Accounting for
Debt). Note that an entity must
also evaluate the facts and circumstances of each
adjustment provision to determine whether it is a
down-round feature. In some circumstances, a
pre-specified adjustment feature based on an IPO
price could represent a down-round feature.
Example 4-16
Adjustment That
Is a Down-Round Feature
An entity has issued a 10-year
convertible debt instrument with a principal amount
of $10 million. The conversion price is $50. If an
IPO were to occur with an IPO price of less than
$50, the conversion price would be reduced to the
IPO price. The holder is not required to convert the
debt upon an IPO; it can continue to hold the debt
and elect to convert it later. In such a scenario,
the potential adjustment to the conversion price
upon an IPO is a down-round feature because the
conversion feature has a monetary value that varies
on the basis of changes in the issuer’s stock price
both before and after the IPO. If, however, the
entity was required to convert the debt upon the
IPO, the adjustment would not meet the definition of
a down-round feature because the associated
settlement has a monetary value that is equal to a
fixed monetary amount.
Economically, a down-round provision is different from an
antidilution feature. An antidilution feature may be designed to adjust the
terms of an equity-linked instrument in such a way that the holder is not
worse off because of a dilutive event (e.g., stock split). As a result of
the adjustment, the holder is protected against the effect of the dilutive
event but is not in an economically better position than it was before the
event. The holder of a down-round feature, however, can obtain equity shares
at a more favorable price than before the event, giving it an advantage
relative to existing holders of the underlying shares. The issuance of new
equity shares is not dilutive to existing investors if the new investors pay
fair value for the shares.
The ASC master glossary definition of a down-round feature
does not explicitly refer to a down-round adjustment effected through an
increase in the number of shares issuable under the instrument instead of,
or in addition to, a reduction of the strike price for an issuer that sells
shares at a lower price or issues an equity-linked financial instrument with
a lower strike price. On the basis of informal discussions with the SEC
staff, however, it is acceptable to evaluate such an adjustment as a
down-round feature if it economically achieves the same outcome as a
down-round feature. For instance, if an equity-linked instrument specified
an economically proportional increase to the number of shares issuable, the
same economic outcome might be achieved. Alternatively, the same economic
outcome might be achieved through a combination of a strike price reduction
and an increase in the number of shares issuable. However, an adjustment
effected through an increase in the number of shares issuable under the
instrument should not be evaluated as a down-round feature if it potentially
could result in the transfer of more value than would be possible through a
reduction in the strike price. In particular, the value of shares
transferred could not exceed the value that would be transferred if the
strike price were zero, because the strike price cannot be reduced to a
negative amount. Further, an adjustment indexed to the number of outstanding
shares (e.g., an adjustment based on a percentage of equity; see Section 4.3.5.8)
would not meet the definition of a down-round feature.
To meet the definition of a down-round feature, the feature
should not protect the holder against changes in inputs other than those
directly related to the issuer’s subsequent (1) issuance of any equity
shares at a lower stock price or (2) issuance or repricing of any
equity-linked financial instruments at a lower strike price. For example, a
feature would not meet the definition of a down-round feature if it
specifies that a substantively identical adjustment must be made to the
instrument’s terms if the terms of any new convertible instrument issued by
the entity are more favorable to the holder (e.g., a more favorable
conversion rate, interest rate, or other term), because it could protect the
holder against adverse changes in interest rates or other inputs unrelated
to the types of adjustments that are contemplated by the definition of a
down-round feature.
A financial instrument may contain a feature that requires a
reduction to its strike price if the issuer subsequently modifies the terms
of any other outstanding financial instrument so that its strike price is
below that of the instrument with the feature. Although such a feature might
be triggered even if the issuer has not issued any new financial
instruments, it is acceptable to evaluate the feature as a down-round
feature under ASC 815-40 since an instrument has come into existence whose
strike price is below the currently stated strike price of the instrument
with the feature. Conversely, a feature that requires a reduction in an
instrument’s strike price if a subsequent estimate of a share’s value is
below the instrument’s current strike price would not meet the definition of
a down-round feature because that definition does not contemplate
adjustments to the strike price that are not triggered by the creation of an
instrument with more favorable terms.
ASC 815-40
15-5D When
classifying a financial instrument with a down round
feature, the feature is excluded from the
consideration of whether the instrument is indexed
to the entity’s own stock for the purposes of
applying paragraphs 815-40-15-7C through 15-7I (Step
2).
Example 9:
Variability Involving Future Equity Offerings and
Issuance of Equity-Linked Financial
Instruments
55-33 This
Example illustrates the application of the guidance
beginning in paragraph 815-40-15-5 for a financial
instrument that includes a down round feature.
Entity A issues warrants that permit the holder to
buy 100 shares of its common stock for $10 per
share. The warrants have 10-year terms and are
exercisable at any time. However, the terms of the
warrants specify both of the following:
- If the entity sells shares of its common stock for an amount less than $10 per share, the strike price of the warrants is reduced to equal the issuance price of those shares.
- If the entity issues an equity-linked financial instrument with a strike price below $10 per share, the strike price of the warrants is reduced to equal the strike price of the newly issued equity-linked financial instrument.
55-34 The
warrants are considered indexed to Entity A’s own
stock based on the following evaluation:
- Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
- Step 2. In accordance with paragraph 815-40-15-5D, when classifying a financial instrument with a down round feature, an entity shall exclude that feature when considering whether the instrument is indexed to the entity’s own stock for the purposes of applying paragraphs 815-40-15-7C through 15-7I (Step 2). The instrument does not contain any other features to be assessed under Step 2.
55-34A See
paragraph 260-10-45-12B for earnings-per-share
considerations, paragraph 260-10-25-1 for
recognition considerations, and paragraphs
505-10-50-3 through 50-3A for disclosure
considerations.
A contractual provision that meets the definition of a
down-round feature does not affect the entity’s analysis of whether the
related instrument is indexed to the entity’s own stock under step 2 in ASC
815-40-15-7 (i.e., the guidance in ASC 815-40-15-7C through 15-8). That is,
the down-round feature does not preclude the entity from concluding that the
instrument that includes the down-round feature is indexed to the entity’s
own stock.
For example, an entity’s evaluation of whether it is
required to classify a freestanding warrant that gives the counterparty the
right to acquire the entity’s common stock as a liability or equity under
ASC 815-40 would not be affected by the existence of the down-round feature.
Accordingly, if the warrant otherwise is considered indexed to the entity’s
own equity under ASC 815-40-15 and meets the other condition for equity
classification in ASC 815-40-25, it would be classified as equity.
Similarly, in the analysis of whether an embedded conversion feature in a
debt host contract must be bifurcated as an embedded derivative under ASC
815-15, the existence of a down-round provision would not prevent the
instrument from qualifying for the scope exception in ASC 815-10-15-74 that
applies to contracts indexed to an entity’s own stock and classified in
stockholders’ equity (see Section 2.2.2).
While instruments or features that contain down-round
features are not precluded from being considered indexed to the entity’s
stock, they may still not qualify for equity classification for other
reasons (e.g., if the issuer could be forced to net cash settle the
instrument or feature; see Chapter 5).
4.3.7.3 Identity of the Holder
The identity or nature of the holder is not an input into the pricing of a
fixed-for-fixed forward or option on equity shares. Therefore, to be
considered indexed to the entity’s stock under step 2 in ASC 815-40-15-7,
the settlement amount must not vary on the basis of the party that holds the
equity-linked instrument.
As discussed in Section 4.3.6.1, if the
identity or nature of the holder of an instrument could potentially affect
the exercise (forward) price or the number of shares issued on settlement,
the instrument is not considered indexed to the entity’s stock. The
following are examples of situations in which equity-linked instruments are
not indexed to the entity’s stock under step 2 in ASC 815-40-15-7 because
the settlement amount varies on the basis of the holder of the instrument:
-
Private placement warrants issued by SPACs (see Section 4.3.6.1).
-
Warrants with provisions that require the issuer to reimburse the holder for taxes that are holder-specific (see Section 4.3.5.13).
-
Warrants for which the share price input used in a net share settlement changes if the holder transfers the warrants (see Section 4.3.5.1). (Note that if any settlement provision of an equity-linked instrument changes as a result of the transfer of the instrument by the holder, the instrument is not indexed to the entity’s stock under step 2 in ASC 815-40-15-7.)
4.3.7.4 Adjustment Contingent on the Occurrence or Nonoccurrence of an IPO or a Change of Control, Including Share-Settleable Earnouts
The occurrence or nonoccurrence of an IPO is not an input
used in the pricing (fair value measurement) of a fixed-for-fixed forward or
option on the entity’s shares. Therefore, a provision that adjusts the
settlement amount upon the occurrence of an IPO (e.g., adjusts to a
different fixed price) indicates that the equity-linked instrument is not
indexed to the entity’s own equity and would disqualify the instrument from
equity classification unless the adjustment provision meets the definition
of a down-round feature (see Section 4.3.7.2). Keep in mind that to
meet the definition of a down-round feature, the adjustment must be a
reduction in the exercise price and can only be required if the IPO price is
lower than the exercise price.
Example 4-17
Adjustment Contingent on
Occurrence of an IPO
Entity X issues freestanding warrants that allow the holder to purchase 1,000
shares of X’s common stock for $10 per share. The
warrants are exercisable at any time for 10 years.
The exercise price of the warrants is adjusted if
there is an IPO of X, which is an implicit input.
However, whether X has an IPO is not used in the
pricing (fair value measurement) of a
fixed-for-fixed option on equity shares. Therefore,
the warrants are not considered indexed to X’s stock
and do not qualify as equity unless the adjustment
provision meets the definition of a down-round
feature (see Section
4.3.7.2).
As discussed in Sections 4.3.7.5 and 4.3.7.9, adjustments
that occur upon a merger of the issuing entity that reasonably compensate
the holder for the loss of time value or a hedging disruption do not prevent
an equity-linked instrument from being indexed to the entity’s stock under
step 2 in ASC 815-40-15-7. However, some equity-linked instruments contain
provisions that change the settlement amount solely on the basis of whether
a change of control occurs (i.e., the contract is indexed to the occurrence
or nonoccurrence of a change of control irrespective of whether such event
results in the investor’s loss of time value or a hedging disruption).
Variability in the settlement amount as a result of the occurrence or
nonoccurrence of a change of control that does not neutralize the effect of
an implicit assumption in the pricing of a fixed-for-fixed forward or option
on equity shares precludes an equity-linked instrument from being considered
indexed to the entity’s stock under step 2 in ASC 815-40-15-7.
A common type of equity-linked instrument that may be
indexed to a change of control is a share-settleable earnout arrangement
issued in conjunction with a merger or other business combination. A number
of these types of arrangements have been issued in business combinations
involving a SPAC and an operating entity (or a “target”).
As discussed in Section 2.5.3, a SPAC and target may
agree to enter into a share-settleable earn-out arrangement as a form of
additional consideration for a SPAC merger transaction. Such an arrangement
represents an equity-linked instrument that must be evaluated under ASC
815-40 unless the arrangement (1) contains only transfer restrictions that
lapse upon the passage of time (and therefore the arrangement is treated as
an outstanding share) or (2) is within the scope of ASC 718.
All share-settleable earn-out arrangements contain
contingent exercise provisions (e.g., the combined company’s stock price or
a change of control), which generally do not prevent the contract from
meeting the criterion in step 1 under ASC 815-40-15-7 (see Section 4.2.3.2).
Most share-settleable earn-out arrangements also contain settlement
provisions, which may prevent them from being indexed to the combined
company’s stock under step 2 of such guidance.
The following are some common terms in these arrangements that affect the
settlement amount but generally do not prevent the contract from meeting the
step 2 criterion:
-
The combined company’s stock price (i.e., the quoted price or a reasonable average of quoted prices [see Section 4.3.5.1]).
-
Standard antidilutive adjustments (see Section 4.3.7.1).
-
Adjustments for dividends on the combined company’s stock (see Section 4.3.5.3).
-
Adjustments for lost time value upon an early settlement (provided that those adjustments reflect only reasonable compensation for lost time value [see Example 4-12]).
The following are some common terms in these arrangements that affect the
settlement amount but generally prevent the contract from meeting the step 2 criterion:
-
All remaining shares would be issuable (or the forfeiture provisions would lapse) upon any change of control involving the combined company.
-
All remaining shares would be issuable (or the forfeiture provisions would lapse) upon a bankruptcy or insolvency of the combined company.
-
The number of shares that would be issuable varies on the basis of employee forfeitures of awards subject to ASC 718-10.
In practice, share-settleable earn-out arrangements can be
generally categorized into four different types, which are discussed in the
table below.
Type
|
Evaluation of Indexation Guidance
|
---|---|
A fixed number of shares will be issued if (1) the
combined company’s stock price meets or exceeds a
stated price or (2) there is a change of control of
the combined company.
Example:
As additional consideration for a SPAC transaction, 5
million common shares of the combined company will
be issued to the target’s shareholders if either (1)
the quoted price of the stock exceeds $20 during a
stated period or (2) there is a change of control.
|
If either of these two conditions is met, the
issuance of the earn-out shares is only considered
an exercise contingency because there is no
variability in the number of shares issuable. This
exercise contingency does not preclude the earn-out
share arrangement from being considered indexed to
the combined company’s stock.
|
A variable number of shares will be issued on the
basis of the combined company’s stated stock prices.
If there is a change of control, all the earn-out
shares will be issued.
Example:
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will
be issued to the target’s shareholders for each of
the following share price levels achieved over the
next five years:
If Level 4 is achieved, an aggregate of 4 million
common shares of the combined company (i.e., 1
million shares for each level) will be issued pro
rata to the target’s shareholders on the basis of
their pretransaction ownership interests. If,
however, the combined company is acquired in a
change of control, all previously unissued shares
will be issued.
|
This arrangement contains a
provision that affects the settlement amount. The
number of earn-out shares issuable varies on the
basis of whether there is a change of control of the
combined company. That is, in the absence of a
change of control, a variable number of shares will
be issued on the basis of stock price. However, if a
change of control occurs, all of the earn-out shares
will be issued (i.e., 4 million shares will be
issued regardless of the combined company’s stock
price). Because the arrangement contains a
settlement provision that precludes it from being
indexed to the combined company’s stock under step 2
in ASC 815-40-15-7, liability classification is
required.
|
A variable number of shares will be issued on the
basis of the combined company’s stated stock prices.
If there is a change of control at a price per share
that equals or exceeds a stated amount that is less
than the price needed for all the earn-out shares to
be issued, all of the earn-out shares will
nevertheless be issued.
Example:
As additional consideration for a SPAC transaction, 1
million common shares of the combined company will
be issued to the target’s shareholders for each of
the following share price levels achieved over the
next five years:
If Level 4 is achieved, an aggregate of 4 million
common shares of the combined company (i.e., 1
million shares for each level) will be issued pro
rata to the target’s shareholders on the basis of
their pretransaction ownership interests. If,
however, the combined company is acquired in a
change of control at a price of $15 or more, all
previously unissued shares will be issued.
|
This arrangement contains a provision that affects
the settlement amount. The number of earn-out shares
issuable varies depending on whether there is a
change of control of the combined company at a
stated price. That is, in the absence of a change of
control at a stated price, a variable number of
shares will be issued on the basis of stock price.
However, if a change of control occurs at a price
per share of $15 or more, all the earn-out shares
will be issued (i.e., 4 million shares will be
issued regardless of the combined company’s stock
price). Because the arrangement contains a
settlement provision that precludes it from being
indexed to the combined company’s stock under step 2
in ASC 815-40-15-7, liability classification is
required.
|
A variable number of shares will be issued on the
basis of either (1) the combined company’s stated
stock prices or (2) the price per share in a change
of control of the combined company.
See Example 2-3.
|
This arrangement contains a provision that affects
the settlement amount. The determination of whether
the arrangement is indexed to the combined company’s
stock under step 2 in ASC 815-40-15-7 depends on (1)
how the price per share is calculated in a change of
control of the combined company and (2) an entity’s
interpretation of the application of ASC 815-40-15
to the potential settlement that would occur upon a
change of control.
Some entities have determined that
the settlement amount is affected by the occurrence
or nonoccurrence of a change of control, which is
not an input into the pricing of a fixed-for-fixed
forward or option on equity shares. These entities
have therefore concluded that the share-settleable
earn-out arrangement is not indexed to the combined
company’s stock under step 2 in ASC 815-40-15-7. As
a result, the earn-out arrangement is classified as
a liability. Note that these entities reach this
conclusion without evaluating the calculation of the
price per share in a change of control of the
combined company.
Other entities focus on the calculation of price per
share in the event of a change of control. On the
basis of a preclearance with the staff of the SEC’s
Office of the Chief Accountant (OCA), there are two
possible outcomes:
A price-per-share calculation that
includes the number of shares issuable under the
share-settleable earn-out arrangement and other
potentially issuable shares of the issuer can be
described as a “circular,” “net,” or “as-diluted”
calculation. Although computable, it is not a simple
calculation. In addition, the terms of the provision
that apply in the event of a change of control are
often subject to interpretation (i.e., ambiguous).
In these situations, entities may wish to consult
with attorneys to obtain a legal interpretation that
supports equity classification of the instrument.
However, if the terms of the provision in the
earn-out agreement do not specifically indicate that
a calculation method consistent with the circular,
net, or as-diluted approach applies, the entity
would not have sufficient evidence to support a
conclusion that the share-settleable earn-out
arrangement is indexed to the entity’s stock under
step 2 in ASC 815-40-15-7; therefore, liability
classification is required. That is, an entity
cannot rely on an attorney’s interpretation of an
ambiguous provision and conclude that the circular,
net, or as-diluted calculation applies, because it
would not be able to support such a conclusion with
sufficient evidence.
|
Connecting the Dots
In the table above, it is assumed that none of the
earn-out shares are within the scope of ASC 718. In practice,
share-settleable earn-out share arrangements may be issuable to
employees of the target that hold vested or unvested shares or
options on the date on which the SPAC merges with a target. In
addition to considering the guidance in ASC 718, entities should
assess whether the potential shares issuable to common stockholders
under ASC 815-40 could be affected by the number of shares issuable
to recipients whose earn-out shares are within the scope of ASC 718
(i.e., recipients that receive those shares as a form of stock-based
compensation). For example, assume that earn-out shares will be
issued to holders of unvested stock options on the merger date
provided that those holders are still employees on the date on which
the earn-out share target or targets are met. If an option holder is
no longer an employee as of that date, the earn-out shares otherwise
receivable by the holder will be reallocated to the pool of shares
receivable by common stockholders that did not receive such shares
in return for services (i.e., that were not within the scope of ASC
718). In this situation, as a result of the guidance on the unit of
account in ASC 815-40, the portion of the share-settleable earn-out
arrangement that is within the scope of ASC 815-40 would not be
considered indexed to the combined company’s stock because the
number of shares varies on the basis of employee behavior. In a
manner consistent with Example 20 in ASC 815-40-55, the
share-settleable earn-out arrangement within the scope of ASC 815-40
must be classified as a liability in its entirety.
4.3.7.5 Merger Adjustments
There is an implicit assumption in the pricing (fair value
measurement) of a fixed-for-fixed forward or option on equity shares that a
discontinuous stock price event will not affect the counterparty’s ability
to hedge the price risk inherent in the instrument by using a delta-neutral
strategy. If a discontinuous stock price event occurs as a result of a
merger announcement, the terms of an equity-linked instrument related to the
exercise price or the number of the entity’s shares used to calculate the
settlement amount may need to be adjusted to neutralize the effect that the
discontinuous stock price event has on the counterparty’s ability to
maintain a delta-neutral hedging strategy. The calculation of the adjustment
may be based on the difference between (1) the aggregate fair value of the
instrument and a standard delta-neutral hedging position immediately before
the occurrence of the specified event and (2) the aggregate fair value of
the instrument and a standard delta-neutral hedging position immediately
after the occurrence of the specified event. This results in an adjustment
to the settlement terms for the effects of the hedging disruption as if the
specified event had not occurred. The adjustment does not protect the
counterparty from a change in stock price of the issuer as a result of a
specified event. Accordingly, the adjustment does not preclude the
instrument from being considered indexed to the entity’s stock.
Example 6 in ASC 815-40-55 below illustrates these
concepts.
ASC 815-40
Example 6: Variability
Involving Merger Announcement
55-30 Entity A issues
warrants that permit the holder to buy 100 shares of
its common stock for $10 per share. The warrants
have 10-year terms and are exercisable at any time.
However, the terms of the warrants specify that if
there is an announcement of a merger involving
Entity A, the strike price of the warrants will be
adjusted to offset the effect of the merger
announcement on the net change in the fair value of
the warrants and of an offsetting hedge position in
the underlying shares. The strike price adjustment
must be determined using commercially reasonable
means based on an assumption that the counterparty
has entered into a hedge position in the underlying
shares to offset the share price exposure from the
warrants. That strike price adjustment is not
affected by the counterparty’s actual hedging
position (for example, the strike price adjustment
does not differ in circumstances when the
counterparty is over-hedged or under-hedged). The
warrants are considered indexed to Entity A’s own
stock based on the following evaluation:
-
Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share), unless there is a merger announcement. If there is a merger announcement, the settlement amount would be adjusted to offset the effect of the merger announcement on the fair value of the warrants. In that circumstance, the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed option on equity shares. For further discussion, see paragraphs 815-40-15-7E and 815-40-15-7G.
A change-of-control provision may specify that the
equity-linked instrument will become indexed to the equity shares of the
acquirer in a business combination if all the entity’s stockholders receive
stock of the acquiring entity. ASC 815-40 specifically states that such a
clause does not preclude a conclusion that the instrument is indexed to the
entity’s own stock (ASC 815-40-55-5; see Section 5.2.3.4). However, a
change-of-control provision that affects the exercise price or number of
shares issued upon the settlement of an equity-linked instrument could cause
the instrument to be considered not indexed to the entity’s stock.
The occurrence or nonoccurrence of a change of control is
not an implicit input into the pricing of a fixed-for-fixed forward or
option on equity shares. Thus, an instrument would be considered not indexed
to the entity’s stock if it contains adjustments to the exercise (forward)
price or number of shares that are based solely on the occurrence or
nonoccurrence of a change of control (i.e., an adjustment subject to step 2
under ASC 815-40-15-7). However, if the adjustments are designed only to
neutralize the effect of a discontinuous stock price event that affects the
counterparty’s ability to hedge the instrument, they would not necessarily
preclude the instrument from being considered indexed to the entity’s stock.
Rather, the implicit input that is invalidated is related to an assumption
that stock price movements will be continuous and the counterparty can
reasonably use a delta-neutral strategy as opposed to the occurrence or
nonoccurrence of a change of control. That implicit assumption could be
invalidated for a number of reasons other than just the occurrence of a
change of control.
For some equity-linked instruments, the number of shares
issuable depends on the entity’s stock price (e.g., contingent consideration
and other similar earn-out arrangements). If the number of shares also
depends on the occurrence or nonoccurrence of a change of control, the
instrument is considered not indexed to the entity’s stock. If, however, the
price paid in a change of control is used as a measure of stock price, the
evaluation depends on the facts and circumstances. For additional discussion
of share-settleable earn-out arrangements issued by SPACs, see Section 4.3.7.4.
4.3.7.6 Adjustments Based on the Counterparty’s Transaction Costs
There is an implicit assumption in the pricing of a
fixed-for-fixed forward or option on equity shares that the counterparty
will receive the full monetary value it is due upon settlement irrespective
of the form of settlement (e.g., cash or shares). This assumption is
invalidated if an entity elects to settle an equity-linked instrument in
shares instead of cash, and the counterparty incurs transaction costs to
dispose of those shares. Therefore, a commercially reasonable adjustment for
transaction costs would not necessarily preclude equity classification. For
example, some equity-linked instruments include symmetrical make-whole
provisions that guarantee that the proceeds will equal what a cash
settlement would have been (see Sections 5.2.5 and 5.3.6).
Example 4-18
Adjustment Based on
Counterparty’s Transaction Costs
An entity issues a stock purchase
warrant that allows the counterparty to purchase
100,000 common shares. The issuer is allowed to
settle the warrant in either cash or its common
shares, at its option. The terms of the warrant also
state that if the issuer elects share settlement,
additional shares will be issued in an amount equal
to the actual transaction costs incurred by the
investor to dispose of the shares received within a
reasonable period, up to a maximum of 1,000
additional common shares.
There is an implicit assumption in the pricing of a fixed-for-fixed forward or
option on equity shares that the party receiving the
shares will not incur transaction costs to dispose
of those shares. If the issuer elects to settle the
stock purchase warrant in shares, this implicit
assumption is invalidated because the investor will
incur costs to dispose of such shares. The
additional share delivery is intended to offset the
investor’s actual transaction costs, not to exceed
1,000 additional shares.
In this example, the adjustment to
the settlement terms may not fully offset the costs
incurred by the investor, because it is possible
that the fair value of an additional 1,000 shares is
less than the actual transaction costs incurred by
the investor. Nevertheless, because the adjustment
is for an amount equal to or less than 100 percent
of the actual transaction costs of the investor, the
warrants may still be considered indexed to the
issuer’s stock.
4.3.7.7 Adjustments Based on the Entity’s Inability to Deliver Registered Shares
An equity-linked instrument may specify that if the entity
settles the instrument by delivering unregistered shares (e.g., if
securities laws preclude the entity from delivering registered shares), the
number of unregistered shares it will deliver is greater than the number of
registered shares it would otherwise have delivered. Such an adjustment does
not preclude equity classification if the difference is intended to account
for any marketability discount applicable to the unregistered shares and the
adjustment is determined by using commercially reasonable methods. In this
case, the value of the unregistered shares delivered is intended to
approximate the value of the registered shares that would have otherwise
been deliverable. For example, some equity-linked instruments include
symmetrical make-whole provisions that guarantee that the proceeds will
equal what the value of a settlement in registered shares or cash would have
been.
4.3.7.8 Adjustments to the Conversion Price of a Convertible Instrument Under a Registration Payment Arrangement
A convertible instrument may specify that the conversion
price is adjusted if the issuer fails to file a registration statement for
the resale of the shares underlying the instrument or fails to have the
registration statement declared effective by the end of a specified grace
period. Such an adjustment is excluded from the scope of the guidance on
registration payment arrangements in ASC 825-20 because it is related to the
conversion ratio (see Section
3.2.4). Therefore, the adjustment provision is taken into account
in the evaluation of the conversion feature under ASC 815-40-15.
If the adjustment compensates the holder merely for the
difference between the fair value of registered and unregistered shares, the
adjustment does not necessarily preclude equity classification for the
conversion feature. If the feature compensates the holder for an amount in
excess of the difference, however, the conversion feature does not qualify
as equity because the adjustment is not consistent with the effect the
failed registration statement has on the fair value of a fixed-for-fixed
forward or option on the entity’s equity shares.
4.3.7.9 Adjustments Based on a Formula or a Table
An equity-linked instrument may contain a formula or table
that is used to calculate an adjustment to the settlement amount as a result
of the occurrence or nonoccurrence of a specified event that invalidates an
implicit assumption used in the pricing of a fixed-for-fixed forward or
option on equity shares. The inputs into these provisions are often stock
price and time. For instance, Example 19 in ASC 815-40-55 (see Section 4.3.7.10)
illustrates a contractual adjustment to the settlement terms that (1)
applies if the entity is acquired for cash before a specified date and (2)
is defined “by reference to a table with axes of stock price and time.” The
formula or tables discussed in this section are those that are designed to
compensate the counterparty for a loss of time value related to a specified
event.
Example 4-19
Make-Whole Table
Entity A has issued convertible notes. Each note is convertible into A’s common
stock at the holder’s election at a conversion rate
of 15 shares of common stock per $1,000 principal
amount of notes. The terms of the notes specify that
if a change of control, the sale of substantially
all of A’s assets, or another fundamental change (as
defined in the terms of the notes) occurs and the
holder elects to convert, A will adjust the
conversion rate by increasing the number of shares
that will be delivered upon conversion. The number
of additional shares, if any, that will be delivered
is determined by reference to the make-whole table
below on the basis of (1) the effective date on
which the fundamental change occurs and (2) the
stock price as of that date. The adjustment to the
conversion rate is designed to compensate the holder
for the expected option value that the holder would
lose as a result of the fundamental change. That is,
the adjustment is intended to make the holder whole
for the expected loss of the time value of money
that would result from an early exercise of the
conversion option. Accordingly, the aggregate fair
value of the shares deliverable (including the
make-whole shares) upon conversion is expected to
approximate the fair value of the conversion option
on the settlement date as long as there has been no
change in relevant pricing inputs (other than stock
price and time) since the instrument’s inception. In
no event will the conversion rate be increased to
exceed 20.36 shares of common stock per $1,000
principal amount of notes.
In the make-whole table above, the conversion option is not precluded from being
considered indexed to A’s own stock because the
adjustment (1) results from the occurrence of an
event that invalidates an implicit assumption used
in the pricing of a fixed-for-fixed option on equity
shares (i.e., that the holder will realize the
remaining time value inherent in the notes), (2) is
consistent with compensating the holders for lost
time value (i.e., the number of additional shares
that will be delivered is reduced as the stock price
increases and as time to maturity decreases), (3)
does not protect the holder from an adverse price
change that is unrelated to the event, (4) is not
leveraged (i.e., does not contain compensation in
excess of expected lost time value), and (5) does
not result in the delivery of shares worth a fixed
monetary amount.
Although the inputs (stock price and time) for these types
of provisions are explicit and are used in the pricing (fair value
measurement) of a fixed-for-fixed forward or option on equity shares, an
entity is still required to evaluate whether the provisions are designed to
neutralize (in whole or in part) the effect that the specified event would
have on the time value of the instrument. If, at the instrument’s inception,
the provisions are designed to (if all other factors are held constant)
neutralize no more than 100 percent of the effect that the specified event
would have on the time value of the instrument, the provisions do not
preclude the instrument from being considered indexed to the entity’s
stock.
The provisions would, however, preclude the instrument from
being considered indexed to the entity’s stock if they are designed so that
they could result in (1) protection against an adverse change in the fair
value of the issuer’s stock, (2) an adjustment to the terms of the
instrument that exceeds the effect that the specified event would have on
the time value of the instrument (i.e., contains leverage), (3) a settlement
based on a fixed monetary amount, or (4) an adjustment to compensate the
counterparty for lost time value in a separate freestanding financial
instrument. See Section
4.3.6 for more information.
Connecting the Dots
To conclude that a make-whole provision does not preclude equity
classification under step 2 in ASC 815-40-15-7, an entity must
determine that (1) the provision is appropriately designed to
neutralize no more than 100 percent of the effect that the specified
event would have on the time value of the instrument and (2) the
adjustment only compensates the holder for that lost time value.
Because of the complexity of the calculations entities must perform
to evaluate the amounts in a make-whole table or other similar
formula, they and their auditors generally will need to engage
valuation specialists for assistance. It is not sufficient to simply
observe that the values prescribed by a make-whole table are
directionally consistent with expected amounts on the basis of axes
of time and stock price.
4.3.7.10 Example of a Make-Whole Provision in Contingent Convertible Debt
Example 19 in ASC 815-40-55 below illustrates multiple types
of exercise contingencies and adjustments that do not necessarily preclude
equity classification for an equity feature embedded in a debt security
under ASC 815-40-15:
- Exercise contingencies that depend on the following variables:
- A market price trigger that is based on the entity’s stock price.
- A parity provision that is based on the trading price of the convertible debt in which the equity feature being evaluated is embedded.
- A merger announcement involving the entity.
- An adjustment to the settlement amount in the form of make-whole shares if the entity is acquired for cash before a specified date. The adjustment is defined by reference to a table with axes of stock price and time.
ASC 815-40
Example 19: Variability
Involving Contingently Convertible Debt With a
Market Price Trigger, Parity Provision, and Merger
Provision
55-45 Entity A issues a
contingently convertible debt instrument with a par
value of $1,000 that is convertible into 100 shares
of its common stock. The convertible debt instrument
has a 10-year term and is convertible at any time
after any of the following events occurs:
-
Entity A’s stock price exceeds $13 per share (market price trigger).
-
The convertible debt instrument trades for an amount that is less than 98 percent of its if-converted value (parity provision).
-
There is an announcement of a merger involving Entity A.
55-46 The terms of the
convertible debt instrument also include a
make-whole provision. Under that provision, if
Entity A is acquired for cash before a specified
date, the holder of the convertible debt instrument
can convert into a number of shares equal to the sum
of the fixed conversion ratio (100 shares per bond)
and the make-whole shares. The number of make-whole
shares is determined by reference to a table with
axes of stock price and time. That table was
designed such that the aggregate fair value of the
shares deliverable (that is, the fair value of 100
shares per bond plus the make-whole shares) would be
expected to approximate the fair value of the
convertible debt instrument at the settlement date,
assuming no change in relevant pricing inputs (other
than stock price and time) since the instrument’s
inception. The embedded conversion option is
considered indexed to Entity A’s own stock based on
the following evaluation:
-
Step 1. The market price trigger and parity provision exercise contingencies are based on observable markets; however, those contingencies relate solely to the market prices of the entity’s own stock and its own convertible debt. Also, the merger announcement exercise contingency is not an observable market or an index. Therefore, Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
-
Step 2. An acquisition for cash before the specified date is the only circumstance in which the settlement amount will not equal the difference between the fair value of 100 shares and a fixed strike price ($1,000 fixed par value of the debt). The settlement amount if Entity A is acquired for cash before the specified date is equal to the sum of the fixed conversion ratio (100 shares per bond) and the make-whole shares. The number of make-whole shares is determined based on a table with axes of stock price and time, which would both be inputs in a fair value measurement of a fixed-for-fixed option on equity shares.
Although the conclusion in step 2 in ASC 815-40-55-46
focuses on the axes in the table (i.e., stock price and time), the
discussion refers to the table’s objective. Therefore, an entity is required
to evaluate the design and purpose of an adjustment to the settlement terms
of an equity-linked instrument that is based on a table in determining
whether the adjustment meets the indexation requirements of ASC 815-40.
The adjustment to the terms of the embedded conversion
option (i.e., the make-whole provision) results in the aggregate fair value
of the shares deliverable upon settlement approximating the fair value of
the convertible debt instrument on the settlement date, assuming no change
in relevant pricing inputs (other than stock price and time) since the
debt’s inception. On the basis of informal discussions with the FASB staff,
we understand that the adjustment actually reflects a settlement at the
“theoretical value” of the embedded conversion option. Such value is
calculated on the basis of (1) the fair value of the underlying common
shares, including the effect of the specified event that resulted in early
settlement, and (2) an amount for time value, determined by using (a) the
issuer’s stock price, including the effect of the specified event that
resulted in early settlement, and (b) the remaining time to contractual
expiration as of the date of the specified event. That is, the adjustment
provision compensates the counterparty for lost time value upon early
settlement and does not result in a settlement that is based on the fair
value of the convertible instrument. Because the lost time value is
calculated on the basis of the time to expiration as of the adjustment date
and the relevant share price on the adjustment date (which takes into
account the effect that the event resulting in early settlement had on the
issuer’s share price), the provision does not preclude the instrument from
being considered indexed to the entity’s stock.
4.3.7.11 Buy-In and Share Delivery Failure Payments
Some equity-linked financial instruments contain “buy-in”
provisions that require the issuing entity to make a stated cash payment for
each day shares are not delivered to the holder in a timely manner (e.g.,
deliveries that occur after a two- to three-day settlement period). A “share
delivery failure” provision further requires the issuer to make the
counterparty whole if, because of the entity’s failure to transfer the
shares on a timely basis, the holder incurs a loss by purchasing (in the
open market or otherwise) shares of the entity’s common stock to deliver in
satisfaction of a sale order that the holder anticipated fulfilling with the
shares receivable from the issuer upon settlement of the instrument.
Both buy-in and share delivery payments arise from the invalidation of an
implicit input into the pricing of a fixed-for-fixed forward or option on
equity shares that the holder will receive the shares underlying an
equity-linked instrument within a reasonable period after the exercise or
settlement date. As long as the amount of such payments represents
reasonable compensation to the holder for the damages incurred as a result
of the issuer’s failure to perform, these provisions will not preclude an
equity-linked instrument from being indexed to the entity’s stock under step
2 in ASC 815-40-15-7. See Section
5.2.3.7.1 for discussion of the application of the equity
classification criteria to buy-in and share delivery failure payment
provisions.
4.3.7.12 Contingent Obligation to Settle an Equity-Linked Instrument at a Fixed Monetary Amount
If a change in a variable (other than the entity’s stock
price) could result in the instrument’s settlement based on a fixed monetary
amount, the instrument cannot be classified as equity. Example 10 of ASC
815-40-55 below illustrates such a scenario.
ASC 815-40
Example 10: Variability
Involving Regulatory Approval
55-35 Entity A issues
warrants that permit the holder to buy 100 shares of
its common stock for $10 per share. The warrants
have 10-year terms and are exercisable at any time.
However, the terms of the warrants specify that if
Entity A does not obtain regulatory approval of a
particular drug compound within 5 years, the holder
can surrender the warrants to Entity A for $2 per
warrant (settleable in shares). The contingently
puttable warrants are not considered indexed to
Entity A’s own stock based on the following
evaluation:
-
Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share), unless regulatory approval of a particular drug compound is not obtained within 5 years. If that approval is not obtained within the allotted time period, the holder could elect to surrender the warrants to Entity A in exchange for $2 per warrant. The contingent obligation to settle the warrants by transferring consideration with a fixed monetary value if regulatory approval of a particular drug compound is not obtained within a specified time period does not represent an input to the fair value of a fixed-for-fixed option on equity shares. A freestanding equity-linked instrument that provides for a fixed payoff upon the occurrence of a contingent event which is not based on the issuer’s share price is not indexed to an entity’s own stock.
4.3.7.13 Bail-In Provisions
The European Union (EU)’s Bank Recovery and Resolution Directive
(Directive 2014/59/EU; BRRD) specifies that resolution authorities in EU
member states must be able to apply bail-in powers to banks and other
financial institutions within the BRRD’s scope. Such powers include the
right to write down liabilities of a failing institution or convert such
liabilities into the institution’s equity (or both). Under BRRD Article 55,
EU member states must, in certain circumstances, require institutions to
include a bail-in provision in the contractual terms of some liabilities.
Under such a provision, “the creditor or party to the agreement creating the
liability [recognizes] that liability may be subject to the write-down and
conversion powers and agrees to be bound by any reduction of the principal
or outstanding amount due, conversion or cancellation that is effected by
the exercise of those powers by a resolution authority” even if the contract
otherwise is governed by laws outside of the EU.
On April 23, 2018, Deloitte participated in a discussion
with the staff of the SEC’s Office of the Chief Accountant (OCA) about the
impact of the EU bail-in provisions on an entity’s evaluation of an
equity-linked instrument under ASC 815-40. The specific fact pattern
discussed with the SEC staff involved an equity-linked instrument between an
EU-domiciled bank with a U.S. branch and a U.S.-domiciled commercial entity
(the issuer) that, other than having incorporated BRRD Article 55, was
governed by New York state law. The SEC staff indicated that it would not
object to a conclusion that the addition of a bail-in provision under BRRD
Article 55 to a contract would not in itself prevent the contract from being
classified in equity under ASC 815-40 if the contract otherwise qualifies
for equity classification. The SEC staff also indicated that it would not
object to an entity’s decision to classify such types of contracts as
liabilities on the basis of this provision. The SEC staff’s view applies
only to the fact pattern discussed herein.
4.3.7.14 Tax Integration of Capped Calls and Convertible Debt
Sometimes issuers purchase freestanding capped call options
on their own equity shares in connection with the issuance of convertible
debt to increase the effective conversion price of the combination of the
debt and the capped call. Further, the contractual terms of the capped call
may include a “tax cap” on the amount payable to the issuer if the capped
call is settled early because of early conversion of the related convertible
debt. The purpose of the tax cap is to help ensure that the capped call and
the related convertible debt can be integrated (i.e., treated as a single,
combined synthetic instrument) for tax purposes. Upon early settlement of
the capped call because of the early conversion of the related convertible
debt, the tax cap places a ceiling on the capped call’s settlement amount
(e.g., the lower of the capped call’s fair value and the tax cap amount).
That tax cap might be defined as the excess, if any, of the amount paid (in
cash or shares) to the holder of the convertible debt upon early conversion
over the original issue price of the convertible debt (e.g., $1,000).
Alternatively, it might be defined as the excess, if any, of the amount paid
(in cash or shares) to the holder of the convertible debt upon early
conversion over an amount that varies solely as a function of time (e.g., as
indicated in a table showing the projected “synthetic instrument adjusted
price” of the combination of the convertible debt and the capped call for
tax purposes at different settlement dates).
Depending on its terms, a tax cap on the settlement amount
of a capped call that is integrated with a related convertible debt
instrument for tax purposes does not necessarily preclude the capped call
from being considered indexed to the entity’s own equity if it varies solely
as a function of the conversion consideration paid upon early conversion, as
function of time (e.g., as indicated in a table), or both. It is assumed in
U.S. GAAP that many issuers of convertible debt purchase capped calls and
integrate them with the convertible debt for tax purposes. Accordingly, it
is reasonable to evaluate capped calls that are integrated with convertible
debt for tax purposes against a fixed-for-fixed capped call linked to
convertible debt; that is, it is not necessary to evaluate it against a
traditional fixed-for-fixed option on the entity’s own equity shares. In
addition, holders of convertible debt typically act rationally on the basis
of marketplace assumptions about the entity’s stock price and the market
price of the convertible debt, and uneconomical exercises can be ignored for
these instruments (e.g., the possibility of early conversion if it would
involve a loss of time value). Moreover, ASC 815-40-55-46 implies that
equity classification under step 1 in ASC 815-40-15-7 is not precluded for
an exercise contingency in convertible debt that is related solely to the
market prices of the entity’s own stock and its own convertible debt.
Therefore, the exercise contingency that is related to the capped calls may
be appropriately analyzed as the event that permits early conversion of the
convertible debt as opposed to conversion option exercise behavior. For
these reasons, it is not necessary to analyze the capped call’s settlement
amount as being indexed to conversion option exercise behavior, which would
have represented an impermissible input (see Section 4.3.5.9). However, the
acceptability of a tax cap on the settlement amount of a capped call depends
on a conclusion that in no circumstance can the settlement amount of the
capped call exceed its fair value on the settlement date. The only
acceptable tax caps are those that have the effect of preventing the issuer
from potentially receiving the full fair value of the capped call on the
early settlement date.
4.3.8 Foreign Currency Provisions
ASC
815-40
15-7I The issuer of an
equity-linked financial instrument incurs an exposure to
changes in currency exchange rates if the instrument’s
strike price is denominated in a currency other than the
functional currency of the issuer. An equity-linked
financial instrument (or embedded feature) shall not be
considered indexed to the entity’s own stock if the
strike price is denominated in a currency other than the
issuer’s functional currency (including a conversion
option embedded in a convertible debt instrument that is
denominated in a currency other than the issuer’s
functional currency). The determination of whether an
equity-linked financial instrument is indexed to an
entity’s own stock is not affected by the currency (or
currencies) in which the underlying shares
trade.
Example 11: Variability
Involving a Currency Other Than the Entity’s
Functional Currency
55-36 Entity A, whose
functional currency is U.S. dollars (USD), issues
warrants with a strike price denominated in Canadian
dollars (CAD). The warrants permit the holder to buy 100
shares of its common stock for CAD 10 per share. Entity
A’s shares trade on an exchange on which trades are
denominated in CAD. The warrants have 10-year terms and
are exercisable at any time. The warrants are not
considered indexed to Entity A’s own stock based on the
following evaluation:
-
Step 1. The instruments do not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The strike price of the warrants is denominated in a currency other than the entity’s functional currency, so the warrants are not considered indexed to the entity’s own stock.
Example 18: Variability
Involving Forward Contract Settled in a Currency
Other Than the Entity’s Functional
Currency
55-44 Entity A, whose
functional currency is US$, enters into a forward
contract that requires Entity A to sell 100 shares of
its common stock for 120 euros per share in 1 year. The
forward contract is not considered indexed to Entity A’s
own stock based on the following evaluation:
-
Step 1. The instrument does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. The strike price of the forward contract is denominated in a currency other than the entity’s functional currency, so the forward contract is not considered indexed to the entity’s own stock.
Example 20: Variability
Involving Functional Currency Debt Convertible to
a Stock That Trades in a Currency Other Than the
Entity’s Functional Currency
55-47 Entity A, whose
functional currency is the Chinese yuan (CNY), issues a
debt instrument denominated in CNY with a par value of
CNY 1,000 that is convertible into 100 shares of its
common stock. Entity A’s shares only trade on an
exchange in which trades are denominated in US$. Those
shares do not trade on an exchange (or other established
marketplace) in which trades are denominated in CNY. The
convertible debt instrument has a 10-year term and is
convertible at any time. The embedded conversion option
is considered indexed to Entity A’s own stock based on
the following evaluation:
-
Step 1. The embedded conversion option does not contain an exercise contingency. Proceed to Step 2.
-
Step 2. Upon exercise of the embedded conversion option, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price denominated in its functional currency (CNY 1,000 fixed par value of the debt). The determination of whether the embedded conversion option is indexed to the entity’s own stock is not affected by the currency (or currencies) in which the underlying shares trade.
If an equity-linked instrument’s exercise price, forward price,
or conversion price is denominated in a currency other than the issuer’s
functional currency (as determined under ASC 830), the instrument is not
considered to be indexed to the entity’s own equity even if the amount is fixed
in that currency. This is the case even if the shares that would be delivered
under the instrument are traded or quoted in the foreign currency. (This is
different from the guidance on share-based payment arrangements in ASC
718-10-25-14A.)
Some equity-linked instruments include a strike price expressed
in the functional currency, but the amount of functional currency varies in such
a way that it equals a fixed amount of foreign currency translated into the
functional currency at the spot rate on the date of exercise or settlement.
Including a settlement term like this is economically the same as having a
strike price denominated in the foreign currency. Although the strike price will
be converted at the spot rate on the date of exercise such that payment will be
made in the functional currency, the instrument should be analyzed as if it were
denominated in a foreign currency.
Example 4-20
Strike Price Denominated in
Functional Currency
An entity’s functional currency is the U.S. dollar. The entity issues an option
that gives the holder the right to purchase a fixed
number of 1,000 equity shares. The contractual terms of
the option describe the strike price as a U.S. dollar
amount and require the holder to use U.S. dollars to pay
the strike price upon the option’s exercise. The amount
of U.S. dollars that will be paid upon exercise is
defined as a fixed strike price of €10 converted to U.S.
dollars at the spot foreign exchange rate on the date of
settlement. The option is precluded from equity
classification because the strike price effectively is
denominated in a foreign currency from the perspective
of the issuing entity.
ASC 815-10
Example 15:
Contracts Involving an Entity’s Own Equity —
Derivative Instrument Indexed to Both the Issuer’s
Equity Price and a Foreign Currency Exchange
Rate
55-144 This
Example illustrates the application of paragraph
815-10-15-74(a). Assume that Entity A, whose functional
currency is the U.S. dollar (USD), and the Counterparty
enter into a one-year forward contract that is indexed
to Entity A’s common share price translated into euros
(EUR) at spot rates and that will be settled in net
shares of Entity A. If the value of Entity A’s common
stock in EUR appreciates, then Entity A will receive
from the Counterparty a number of shares of Entity A
stock equal to the appreciation. If the value of Entity
A’s stock in EUR depreciates, then Entity A will pay
Counterparty a number of shares of Entity A stock equal
to the depreciation. Thus, the forward contract is
indexed both to Entity A’s common stock and the USD/EUR
currency exchange rates.
55-145 Assume
further that Entity A’s common stock price at inception
is USD 100 per share, and the forward exchange rate of
USD to EUR is 1:1.2. The strike price of the forward
contract is then set at EUR 120. One year later, the
share price of Entity A rises to USD 150, and the spot
exchange rate of USD to EUR is 1:1. Then, the share
price of Entity A translated is EUR 150. At settlement,
Entity A will receive from the Counterparty 20 shares of
its own common stock according to the following
calculation:
(EUR 150 – EUR 120)
× 100 shares = EUR 3,000
EUR 3,000 ÷ EUR 150
per share = 20 shares
55-146 A
forward contract that is indexed to both an entity’s own
stock and currency exchange rates should be accounted
for as a derivative instrument in its entirety by both
parties to the contract if the contract in its entirety
meets the definition of a derivative instrument in
paragraphs 815-10-15-83 through 15-139.
55-147
Paragraph 815-20-25-71(a)(2) prohibits separating a
derivative instrument into components based on different
risks. Consequently, it would be inappropriate to
bifurcate the forward contract described in this Example
according to its differing exposures to changes in
Entity A’s stock price and changes in the USD/EUR
exchange rate and then attempt to apply paragraph
815-10-15-74(a) only to the exposure to changes in
Entity A’s stock price. That paragraph must be applied
to an entire contract.
ASC 815 prohibits an entity from separating derivative
instruments into components on the basis of risk in determining the appropriate
accounting for the instrument. Thus, an entity could not bifurcate an
equity-linked instrument that has a strike price denominated in a foreign
currency into an instrument with a strike price denominated in the functional
currency and an instrument exchanging functional currency and foreign currency
(ASC 815-10-55-147).
4.3.9 Uneconomic Settlement Terms
4.3.9.1 Subjective Modification Provisions
ASC 815-40
15-7H Some equity-linked
financial instruments contain provisions that
provide an entity with the ability to unilaterally
modify the terms of the instrument at any time,
provided that such modification benefits the
counterparty. For example, the terms of a
convertible debt instrument may explicitly permit
the issuer to reduce the conversion price at any
time to induce conversion of the instrument. For
purposes of applying Step 2, such provisions do not
affect the determination of whether an instrument
(or embedded feature) is considered indexed to an
entity’s own stock.
In some circumstances, the settlement terms contain
subjective modification provisions that allow the issuer to unilaterally
modify the terms of the instrument at any time. Such provisions do not
affect the determination of whether an equity-linked instrument is
considered indexed to the entity’s stock as long as the modifications
benefit the counterparty. For example, if the terms permit the issuer to
decrease the exercise price or increase the conversion rate, those terms
would not preclude a conclusion that the instrument is indexed to the
entity’s own stock.
If a modification occurs, an entity should reconsider
whether the equity-linked freestanding financial instrument (or embedded
feature) is still considered indexed to the entity’s stock. The entity
should also evaluate whether the modification has any accounting consequence
in the period in which it occurs (e.g., as an induced conversion under ASC
470-20-40-13 or an effect on EPS under ASC 260). For further discussion of
the accounting for induced conversions, see Section 12.3.4 of Deloitte’s Roadmap
Issuer’s Accounting
for Debt. For additional guidance on the calculation
of EPS, see Deloitte’s Roadmap Earnings per Share.
Example 4-21
Subjective Modification
Provision in a Convertible Debt
Instrument
The following
is an example of a subjective modification provision
in a convertible debt instrument:
The indenture permits us to increase the
conversion rate, to the extent permitted by law
and subject to the stockholder-approval
requirements (if any) of any relevant national
securities exchange or automated dealer quotation
system, for any period of at least 30 days. We
will give notice of at least 10 days of any such
increase. In addition to the above increases, we
may, as our board of directors deems advisable,
increase the conversion rate to avoid or diminish
any income tax to holders of our common stock
resulting from any dividend or distribution of
stock (or rights to acquire stock) or from any
event treated as such for income tax
purposes.
An example of a subjective modification provision is one
that permits the entity to increase the conversion rate at its discretion,
to the extent permitted by law if such an increase is to avoid or diminish
any U.S. federal income tax to holders of the entity’s common stock
resulting from any dividend or distribution of stock (or rights to acquire
stock) or from any event treated as such for U.S. federal income tax
purposes.
4.3.9.2 Right to Settle at Less Than Fair Value
Some equity-linked instruments include terms that give one
or both of the parties the right to settle early at an amount that would
always be unfavorable relative to settling the instrument at its fair value
(e.g., because of lost time value). A provision under which one of the
parties has the right, but not the obligation, to settle early at an
unfavorable price relative to the instrument’s fair value would not prevent
a contract from being considered indexed to the issuer’s stock as long as
the settlement amount does not incorporate any extraneous factors into such
early settlement.
4.3.10 Warrants on Convertible Stock With Conversion Price Adjustments
Sometimes entities issue warrants that permit the holder to
purchase a fixed number of the entity’s nonredeemable convertible preferred
shares for a fixed price. The preferred shares that the entity would deliver
upon exercise of the warrants are convertible into the entity’s common shares at
a fixed price except for an adjustment to the conversion price that precludes
the conversion feature from being considered indexed to the entity’s own equity
(e.g., variability involving a revenue target, see Section 4.3.5.7).
To determine whether this warrant potentially qualifies as
equity, the entity needs to ascertain whether the conversion price adjustment in
the preferred stock precludes a conclusion that the warrant is indexed to the
entity’s own equity. (A similar issue arises for an embedded conversion option
in a debt host; e.g., an option to convert debt into convertible preferred stock
that has conversion price adjustments.)
In circumstances in which the following apply, two views are
acceptable depending on the entity’s policy regarding whether to assess
indexation to its own shares by (1) evaluating only the warrant’s direct
exercise provision (the warrant-level view) or (2) “looking through” to all
indirect exercise provisions (i.e., exercise provisions in instruments
underlying the warrant — the look-through view):
-
There are no other features in the warrant (excluding the conversion price adjustment) that would preclude the entity from concluding that the warrant is indexed to its own stock.
-
The preferred stock underlying the warrant would, upon issuance, qualify for classification in permanent equity under ASC 480-10-S99-3A. If the preferred stock does not meet the conditions for classification in permanent equity under ASC 480-10-S99-3A, the warrant would be accounted for as a liability under ASC 480-10-25-8 because it embodies an obligation to issue an instrument (the convertible preferred stock) that may require a transfer of assets (see Section 5.2.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity). In determining whether the preferred stock qualifies for permanent equity classification, the entity should evaluate the liquidation preferences of the preferred stock (including “deemed liquidation” provisions) to identify features that may result in a conclusion that the stock is redeemable.
-
The preferred stock is substantive (i.e., it is reasonably possible that an investor would exercise the warrant and not immediately convert the preferred stock into common stock).
-
The conversion option in the preferred stock would not be required to be bifurcated from the preferred stock and accounted for separately as a derivative under ASC 815 once the holder exercises the warrant.
Once an entity adopts one of the two views as its accounting
policy, it should consistently apply that policy. An entity’s ability to select
an alternative accounting policy is limited to the analysis of whether a warrant
is indexed to the entity’s own stock under ASC 815-40-15 and should not be
applied by analogy to the analysis of the entity’s ability to control settlement
in shares upon exercise (see Chapter 5) or the classification of instruments under ASC 480 (see
Deloitte’s Roadmap Distinguishing Liabilities From Equity).
4.3.10.1 Warrant-Level View
Under this view, the warrant is not precluded from being
considered indexed to an entity’s own stock because of the conversion price
adjustment. The number of preferred shares issuable upon the warrant’s
exercise and the warrant’s exercise price are both fixed. Therefore, in
accordance with ASC 815-40-15-7C, the warrant is not precluded from being
considered indexed to the entity’s own stock. In this case, the entity does
not look through the convertible preferred stock to assess whether the
ultimate number of common shares to which the holder is entitled is
fixed.
4.3.10.2 Look-Through View
Under this view, the warrant is not considered indexed to an
entity’s own stock. The ultimate number of common shares to which the holder
of the warrant is entitled (by first exercising the warrants into shares of
convertible preferred stock and then converting those shares into shares of
common stock) is variable because of the conversion price adjustment.
Further, the adjustment provision in the convertible preferred stock is not
an input in the pricing model of a fixed-for-fixed forward or option on
equity shares.
This approach is analogous to the look-through view that an
entity would apply to settlement provisions in determining the
classification of warrants on puttable shares (i.e., an entity would
consider the holder’s indirect right to settle in cash under the put right
that is embedded in the puttable shares in assessing whether a warrant on
puttable shares should be accounted for as a liability under ASC 480).
Footnotes
3
When the indexation that was incorporated into
ASC 815-40-15 was being developed, the standard setters were
mindful of standard ISDA terms and definitions. Nevertheless,
without analyzing the contractual terms, an entity cannot assume
that a contract prepared in accordance with standard ISDA
documentation meets the indexation guidance in ASC
815-40-15.
Chapter 5 — Classification Guidance
Chapter 5 — Classification Guidance
5.1 Overview
To qualify for equity classification, an equity-linked instrument within the
scope of ASC 815-40 (see Chapter
2) must be indexed to the entity’s stock, and the issuing entity must be
required or permitted to share settle it. Any provision that could require the
issuer to net cash settle the instrument precludes equity classification, with
limited exceptions. The likelihood of an event that would trigger a net cash
settlement does not matter. Some equity-linked instruments provide either the issuer
or the counterparty with a choice of settlement method (i.e., physical, net shares,
or net cash). In other instruments, the settlement method depends on the occurrence
or nonoccurrence of a specified event. In these circumstances, the existence of
settlement alternatives may affect the classification of the instrument (see Section 5.2).
Even if an equity-linked instrument ostensibly requires or permits an entity to
settle in shares (e.g., a warrant that requires physical settlement), the entity
cannot assume that it has the ability to do so unless there are no circumstances in
which it could be forced to net cash settle the instrument. The accounting
literature contains a series of conditions that must be met (see Section 5.3) and assessed
continually (see Section 5.4)
for an issuer to conclude that it is able to share settle an instrument. Some of the
conditions do not apply to certain convertible debt instruments (see Section 5.5).
Freestanding equity-linked instruments are often executed and documented by
using ISDA standard documentation (see Section 3.1.3). For such instruments, the entity needs to consider not
only the trade confirmation but also the provisions of any related master agreement
and the applicable ISDA equity derivatives definitions in determining whether there
are circumstances under which the entity could be forced to net cash settle the
instrument. For example, the ISDA documentation may include early settlement
provisions that give the counterparty a right to net cash settle the instrument in
certain circumstances (see Section
5.2.2).
5.2 Settlement Methods
5.2.1 Overview
ASC 815-40
25-1 The guidance in this
Section applies for the purpose of determining whether
an instrument or embedded feature qualifies for the
second part of the scope exception in paragraph
815-10-15-74(a). The first part of the scope exception
in paragraph 815-10-15-74(a) is addressed in Section
815-40-15. The initial balance sheet classification of
contracts within the scope of this Subtopic generally is
based on the concept that:
- Contracts that require net cash settlement are assets or liabilities.
- Contracts that require settlement in shares are equity instruments.
ASC 815-40 — Glossary
Net Cash
Settlement
The party with a loss delivers to the
party with a gain a cash payment equal to the gain, and
no shares are exchanged.
Net Share Settlement
The party with a loss delivers to the party with a gain shares with a current
fair value equal to the gain.
Physical Settlement
The party designated in the contract as the buyer delivers the full stated amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer.
ASC 815-10
Example 5: Net
Settlement Under Contract Terms — Net Share
Settlement
55-90 This
Example illustrates the concept of net share settlement.
Entity A has a warrant to buy 100 shares of the common
stock of Entity X at $10 a share. Entity X is a
privately held entity. The warrant provides Entity X
with the choice of settling the contract physically
(gross 100 shares) or on a net share basis. The stock
price increases to $20 a share. Instead of Entity A
paying $1,000 cash and taking full physical delivery of
the 100 shares, the contract is net share settled and
Entity A receives 50 shares of stock without having to
pay any cash for them. (Net share settlement is
sometimes described as a cashless exercise.) The 50
shares are computed as the warrant’s $1,000 fair value
upon exercise divided by the $20 stock price per share
at that date.
For an equity-linked instrument to qualify for equity classification, an entity
must be required or permitted to share settle it. A share settlement can be
either physical or net in shares.
Example 5-1
Settlement Methods
Entity A writes a call option on its own stock that permits the holder to purchase 100 shares of A’s common stock at an exercise price of $10 per share. Entity A’s stock price rises to $15 per share. Entity B, the holder of the option, exercises the option. If the contract specifies physical settlement, then:
Entity B pays A $1,000 (100 shares at $10 per share).
Entity A issues to B 100 shares with a fair value of $1,500.
If the contract specifies net share settlement (cashless exercise), then:
Entity A issues 33.33 of its shares1 to B as follows: 100 shares – ($1,000 ÷ $15
per share) = ($1,500 – $1,000) ÷ $15 per share.
If the contract is net cash settled, then:
Entity A makes a cash payment of $500 to B ($1,500 – $1,000).
An equity-linked instrument that will be physically settled may qualify as
equity even if it involves the issuer’s delivery of cash and receipt of shares.
For example, a physically settled purchased call option on an entity’s own stock
is not disqualified from equity classification even though the entity would
deliver cash and receive shares upon exercise. Similarly, a physically settled
embedded written put option (e.g., in a puttable share) could qualify as equity
even though the entity could be forced to deliver cash and receives shares if
the counterparty were to exercise the put option.
Under ASC 480-10-S99-3A and other SEC guidance, SEC registrants are required to
classify certain redeemable equity securities outside of permanent equity (for a
comprehensive discussion of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). In the evaluation of whether an embedded feature
(e.g., a written put option embedded in the entity’s preferred stock) meets the
scope exception for own equity in ASC 815-10-15-74(a), temporary equity is
considered equity even though it is presented outside of permanent equity (ASC
815-10-15-76). For example, if an SEC registrant issues equity shares that
contain an embedded written put option that permits the holder to put the shares
back to the registrant in exchange for a cash payment, the registrant may be
required to classify the shares in temporary equity under ASC 480-10-S99-3A. In
evaluating whether the embedded put option permits the issuer to settle in
shares, the entity would consider the equity shares to be equity even though
they are presented outside of permanent equity. See further discussion of the
scope of ASC 815-10-15-76 in ASC 815-40 in Section
2.2.2.
5.2.2 Effect of Net Cash Settlement Provisions
ASC 815-40
25-7 Contracts that include any
provision that could require net cash settlement cannot
be accounted for as equity of the entity (that is, asset
or liability classification is required for those
contracts), except in those limited circumstances in
which holders of the underlying shares also would
receive cash (as discussed in the following two
paragraphs and paragraphs 815-40-55-2 through 55-6).
25-8 Generally, if an event
that is not within the entity’s control could require
net cash settlement, then the contract shall be
classified as an asset or a liability. However, if the
net cash settlement requirement can only be triggered in
circumstances in which the holders of the shares
underlying the contract also would receive cash, equity
classification is not precluded.
25-9 This Subtopic does not
allow for an evaluation of the likelihood that an event
would trigger cash settlement (whether net cash or
physical), except that if the payment of cash is only
required upon the final liquidation of the entity, then
that potential outcome need not be considered when
applying the guidance in this Subtopic.
Except in certain limited instances, if there are any
circumstances under which an entity could be required to net cash settle an
equity-linked instrument (e.g., upon an early termination event), equity
classification is prohibited. Such an instrument cannot be classified as equity
even if it is considered indexed to the entity’s stock under ASC 815-40-15. An
entity is precluded from considering probability when assessing whether it could
be required to net cash settle an equity-linked instrument. Equity
classification would be prohibited even if net cash settlement could be required
only upon the occurrence of a remote event. Conversely, an instrument might
qualify as equity even if the entity expects or intends to net cash settle the
instrument as long as it could not be forced to net cash settle.
5.2.2.1 Cash Settlement Outside the Entity’s Control
If cash settlement of an equity-linked instrument is
controlled by the holder, the instrument cannot be classified in equity (see
Section 5.2.4). In addition, if an
entity can be required to cash settle an equity-linked instrument upon the
occurrence or nonoccurrence of an event that is not solely within the
entity’s control, the instrument cannot (with limited exceptions; see
Section 5.2.3) be classified in
equity. The SEC’s Current Accounting and Disclosure Issues in the
Division of Corporation Finance (as updated
November 30, 2006) notes the following as one of the most common reasons
warrants must be classified as liabilities under ASC 815-40-25:
[T]he warrants could be required to be settled in cash
if certain events occurred, such as delisting from the registrant’s
primary stock exchange or in the event of a change of control. . . .
Even if delisting is not considered probable of ever occurring, the
warrants would still be classified as a liability under the [ASC
815-40-25] analysis. Similarly, the likelihood that a change in control
could occur is not a factor.
Equity-linked instruments (e.g., those executed under ISDA
standard documentation) often include early termination provisions that give
the counterparty a right to early settle the instrument in specified
circumstances. If those circumstances are outside the entity’s control and
could require the entity to net cash settle the instrument (e.g., because
the counterparty obtains the right to terminate the contract net in cash
under a “cancellation and payment” provision), the instrument cannot be
classified as equity. Examples of events that may be referred to in standard
documentation and would be considered outside the entity’s control
include:
-
The counterparty’s ability to establish or maintain a hedge position against the contract by using commercially reasonable means (hedge disruption event).
-
A material increase in the counterparty’s cost of hedging (increased cost of hedging).
-
The counterparty’s inability to borrow the shares underlying the contract (loss of stock borrow).
-
The counterparty’s cost to borrow the shares underlying the contract exceeds a specified rate.
In remarks at the 2007 AICPA Conference on
Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow
Ashley Carpenter said:
[ASC 815-40-25] is clear that
equity classification is precluded if an entity does not control the
ability to share settle the contract. The [SEC] staff understands that
the ISDA Agreements incorporated into many equity derivative contracts
contain provisions that may allow the counterparty to net-cash settle
the contract upon the occurrence of events outside the control of the
entity. To address this issue, the transaction Confirmation often
includes an overriding provision to allow the entity to share settle the
contract upon the occurrence of events outside its control. Absent this
provision, the contract may not meet the equity classification
requirements in [ASC 815-40-25].
If the early termination provision is outside the entity’s
control but does not require the entity to net cash settle the instrument
(e.g., because of an override provision), the feature must still be
evaluated under the indexation guidance and other equity classification
conditions in ASC 815-40.
Some equity-linked instruments contain provisions that could
require the issuer, upon the occurrence of events outside its control, to
make cash payments that do not represent a net cash settlement of the entire
instrument (e.g., a requirement to make a cash payment if the issuer fails
to file financial statements on time or if the counterparty sells the
underlying shares for less than their fair value on the settlement date).
These types of payments could preclude the classification of an
equity-linked instrument as equity even though the payments do not result in
the net cash settlement of the entire contract (see Sections 5.2.3.7 and 5.3.6).
5.2.2.2 Cash Settlement Provisions in the Shares Underlying the Contract
In evaluating the appropriate classification of an
equity-linked instrument, entities should consider any cash settlement
provisions in the shares underlying it. If such shares embody an obligation
to transfer cash or other assets and the entity could be forced to issue
those shares, ASC 480-10-25-8 precludes equity classification (see Chapter 5 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity). For
example, equity classification is inappropriate if the shares that would be
delivered upon settlement of a written call option or a forward sale on the
entity’s own equity embody an obligation to transfer cash or other assets
(e.g., certain redeemable preferred stock).
Some equity-linked instruments are not within the scope of
ASC 480 because they do not embody any obligation of the issuer (see
Section
2.2.1.3 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Nevertheless, ASC 815-40-25 may preclude equity
classification if the shares that would be delivered upon the contract’s
settlement embody an obligation to deliver cash or other assets. For
example, a purchased put option that permits an entity to require the
counterparty to purchase the entity’s shares would be outside the scope of
ASC 480. However, such a contract could not be classified in equity under
ASC 815-40-25 if the entity could be forced to immediately redeem the shares
that it would deliver upon exercise of the contract at the then-current fair
value of such shares. Although the entity has the ability to avoid a cash
settlement by electing not to exercise the put option, it cannot disregard
the cash settlement provision in the shares underlying the contract in its
accounting analysis under ASC 815-40-25. This is because that guidance
involves an assessment of whether an entity, assuming that a contract is
settled, could be forced to cash settle the contract. That is, ASC 815-40-25
does not permit an entity to assume that it will elect not to exercise a
contract. For the same reason, if an entity has purchased a net-cash-settled
option on its own stock, ASC 815-40-25 precludes equity classification even
though the entity could avoid a cash settlement by electing not to exercise
the option. Further, although an entity may adopt either a “warrant-level”
or a “look-through” view when applying the indexation requirements in ASC
815-40-15 (see Section
4.3.10), it cannot elect a “warrant-level” view when applying
the equity classification requirements in ASC 815-40-25.
5.2.3 Permissible Net Cash Settlement Provisions
As an exception to the requirement to classify equity-linked instruments that
the entity could be forced to net cash settle as assets or liabilities, a
contractual term that could require an instrument to be net cash settled is
permitted in the following circumstances:
-
The event that would cause net cash settlement is within the entity’s control (see Section 5.2.3.1).
-
The contract must be net cash settled only upon the final liquidation of the entity (see Section 5.2.3.2).
-
The contract must be net cash settled only if (1) all holders of the shares underlying the contract would also receive (or be entitled to receive) cash in exchange for their shares (see Section 5.2.3.3) or (2) the cash settlement is the result of a change of control (see Section 5.2.3.4) or nationalization or expropriation (see Section 5.2.3.5).
-
The contract is an own-share lending arrangement executed in conjunction with a convertible debt issuance, and the cash settlement provision has certain characteristics (see Section 5.2.3.6).
See Section 5.2.3.7
for further discussion of cash payment provisions that do not represent a cash
settlement of the entire instrument. Application of the equity conditions to
certain convertible instruments is discussed in Section 5.5.
5.2.3.1 Net Cash Settlement Within the Entity’s Control
If a net cash settlement can be triggered only by the occurrence or
nonoccurrence of an event that is solely within the entity’s control, that
net cash settlement provision does not preclude the instrument from being
classified as equity. If the event or circumstance that can trigger a net
cash settlement is not solely within the entity’s control, the instrument is
classified as an asset or a liability unless an exception applies (see
Sections 5.2.3.2
through 5.2.3.6).
The assessment of whether an event or circumstance is within the entity’s
control depends on the entity’s governance structure. Normally, decisions
made by management or the board of directors are considered to be within the
entity’s control. On the other hand, decisions made by shareholders are
considered to be outside the entity’s control (see, for example, ASC
815-40-25-19). At the 2009 AICPA Conference on Current SEC and PCAOB
Developments, then Professional Accounting Fellow Brian Fields made the
following remarks:
I’d like to turn now to the evaluation of contracts
on own stock and redeemable shares. A key question in accounting for
both types of instruments is whether the company can avoid settling
the instrument in cash or other assets even in contingent scenarios
that may be improbable. With a few defined exceptions, a share-based
derivative, such as a warrant or option on common stock, is
accounted for by its issuer as an asset or liability (rather than as
equity) if there is any circumstance in which the issuer could be
required to settle it in cash. . . .
In some cases determining whether a company can
avoid paying out cash in all possible circumstances can be a
difficult question, requiring a detailed analysis of both the
instrument’s terms and various debt versus equity accounting
requirements. One question that has come up several times recently
is-specifically who needs to have the power to decide how an
instrument is settled to conclude that the company is in control of
a settlement alternative? . . .
So who does need to have the power? In a typical corporate structure, the power to
control the form of settlement might be expected to reside with
the Board of Directors or executive management. However,
there are a variety of governance structures in practice. For a limited partnership, the governance
structure of the entity would often consist of the general
partner, and one would usually expect cash versus share
settlement decisions to reside with that partner in order for a
decision to be within the company’s control. In any case, in order
for a settlement option to be under company control, one would generally expect that control would
rest with the party or parties tasked with management or
governance by the owners of the entity. [Emphasis added]
The table below lists events and circumstances that may be considered within and outside the entity’s
control. Note, however, that the assessment of whether an event is within the entity’s control could differ
depending on the specific facts and circumstances (e.g., whether the counterparty controls the entity’s
decision to net cash settle through board representation or other rights or the issuer is firmly committed to undertaking an action that will cause the event to occur).
Solely Within the Issuer’s Control | Not Solely Within the Issuer’s Control |
---|---|
|
|
Note that if the event that could cause a net cash settlement is within the
entity’s control, and the event occurs, the entity would need to reclassify
the equity-linked instrument as an asset or a liability until it is settled
(see Section 5.4).
If the instrument is subject to a netting provision (e.g.,
under standard ISDA terms), the entity should consider whether such a
provision could require the company to net settle the instrument against
contracts not classified as equity. If the netting provision could result in
the netting of the instrument against contracts not classified as equity
(e.g., receivables or payables) in circumstances outside the entity’s
control (e.g., the counterparty’s default), equity classification is
precluded. To avoid this outcome, the entity may seek to include terms in
the instrument that specify that the instrument cannot be netted or can only
be netted against other equity-classified instruments.
Connecting the Dots
Many standby equity purchase agreements (SEPAs) contain provisions
that may require the issuer to net cash settle a forward issuance of
shares upon the occurrence of events outside the issuer’s control
(e.g., bankruptcy or a change of control). As a result, SEPAs
generally do not meet the equity classification conditions in ASC
815-40-25. For more information about SEPAs, see Section
6.2.5.
5.2.3.2 Net Cash Settlement Upon Final Liquidation of the Entity
If net cash settlement of an equity-linked instrument is required only upon the
entity’s final liquidation, equity classification is not precluded (ASC
815-40-25-9). A deemed liquidation provision that requires net cash
settlement of the instrument upon the redemption of one or more classes of
equity securities but not all classes of equally or more subordinated equity
instruments (e.g., upon a change in control) does not qualify for this
exception.
5.2.3.3 Net Cash Settlement When Holders of Underlying Shares Receive Same Form of Consideration
Equity classification is not precluded when an entity can only be forced to net
cash settle an equity-linked instrument if all
holders of the shares underlying the instrument receive, or have a right to
receive, cash for their shares. Similarly, an equity-linked instrument that
permits the counterparty to settle the instrument into the kind and amount
of consideration to which it would have been entitled had the instrument
been converted into stock does not preclude the instrument from being
classified as equity. If all holders of the underlying shares are given a
choice of the form of consideration, for example, equity classification is
not precluded if the counterparty to the instrument is given the same
choice.
An equity-linked instrument could not be classified as equity if the form of
consideration in settling the instrument (e.g., cash, shares, property, or
other assets) would be different from the form of consideration paid to
holders of the underlying shares.
Example 5-2
All Holders of Underlying Shares Receive Same Form of
Consideration
Entity A has issued warrants on shares of its common stock. If A effects a
reorganization, the holders of the warrants have the
right to exercise the warrants immediately before
the reorganization and receive, in lieu of shares of
common stock, the capital stock, securities, or
other property to which all common stockholders are
entitled as owners of common shares. The terms of
the warrants define a reorganization as any
reclassification, capital reorganization,
conversion, or change to A’s common stock (other
than cash dividends or distributions or a
subdivision or combination), any consolidation or
merger involving A, or any sale of all or
substantially all of A’s assets. The only
circumstance that would result in settlement of the
warrants through the issuance of consideration other
than shares of A’s common stock is a reorganization.
Entity A controls the actions or events that could
result in delivery of consideration other than
common stock for each event that constitutes a
reorganization, with the exception of a
consolidation, which could include a change of
control that is outside A’s control. Upon the
occurrence of a consolidation, the holders of the
warrants are not entitled to receive cash or any
other form of consideration (including a choice
among forms of consideration) that differs from the
form of consideration that each holder of common
stock is entitled to receive because, as stated
above, the holders of the warrants merely have
exercised those warrants before the consolidation
and are able to “stand in line” with all other
holders of common shares. Therefore, this settlement
provision would not preclude equity classification
for the warrant.
Consider a warrant that specifies that the counterparty will receive the same
form of consideration (in cash or shares) as the holders of the underlying
shares if the value of the consideration exceeds the warrant exercise price.
If the value of the consideration is less than the warrant exercise price,
the counterparty will receive a cash payment equal to the fair value (i.e.,
time value) of the warrant. Such a provision does not qualify for the
exception in ASC 815-40-25-8 because the warrant holder may receive
consideration that is different from that received by shareholders.
5.2.3.4 Change of Control Clauses
ASC 815-40
55-2 An event that causes a change in control of an entity is not within the entity’s control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.
55-3 However, if a
change-in-control provision requires that the
counterparty receive, or permits the counterparty to
deliver upon settlement, the same form of
consideration (for example, cash, debt, or other
assets) as holders of the shares underlying the
contract, permanent equity classification would not
be precluded as a result of the change-in-control
provision. In that circumstance, if the holders of
the shares underlying the contract were to receive
cash in the transaction causing the change in
control, the counterparty to the contract could also
receive cash based on the value of its position
under the contract.
55-4 If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt).
55-5 Similarly, a change-in-control provision could specify that if all stockholders receive stock of an acquiring entity upon a change in control, the contract will be indexed to the shares of the purchaser (or issuer in a business combination accounted for as a pooling of interests) specified in the business combination agreement, without affecting classification of the contract.
An entity must further analyze an equity-linked instrument
that requires net cash settlement upon a change in control to determine
whether that net cash settlement requirement precludes equity
classification. If the change-in-control provision specifies that the
counterparty will receive the same form of consideration as holders of the
underlying shares, equity classification is not precluded. On the basis of
informal discussions with the SEC staff, this exception applies only if the
event that gives rise to cash settlement is a change of control. In this
scenario, a change of control is considered a transaction in which the
acquirer of the entity’s shares would obtain control of the entity.
Before the SEC staff’s issuance on April 12, 2021, of
Staff Statement on Accounting and Reporting
Considerations for Warrants Issued by Special Purpose Acquisition
Companies (“SPACS”) (the “SEC staff statement”),
it was our understanding that holders of equity-linked instruments could be
entitled to receive cash (i.e., to be net cash settled) only if all holders of the shares underlying the instrument
would also receive or be entitled to receive cash for their shares (see
Section 5.2.3.3). Under this
interpretation, ASC 815-40-55-2 through 55-5 did not provide an exception to
the general principle in ASC 815-40 that if net cash settlement could be
required for an event that is not within the entity’s control, an
equity-linked financial instrument should be classified as an asset or
liability unless all holders of the shares
underlying the instrument would also receive cash. However, in the SEC staff
statement, the OCA staff clarified that it believes that ASC 815-40-55-2
through 55-5 contain an exception to this principle that would apply only in
change-of-control situations. That is, if there is a change of control, it
is unnecessary for all holders of the shares underlying the instrument to
receive cash. This exception would not apply in situations such as the
following:
- An entity has a dual-class common stock structure, and the acquisition by a third party of any number of shares of one class would not result in a change of control because the holder of the other class of common shares would continue to control the entity.
- An entity has a dual-class common stock structure and, as a result of the acquisition by a third party of shares of one class, the holders of equity-linked instruments of the other class would be entitled to receive cash even though holders of the outstanding shares of that class are not entitled to receive cash.
- An equity-linked instrument on a class of preferred stock is redeemable if a third party acquires more than 50 percent of the entity’s preferred stock but the common stock controls the entity.
Note that the exception would never apply to a class of shares that is not
the most residual class of the entity’s equity.
Connecting the Dots
The term “change of control” is not defined in ASC 815-40 or the ASC
master glossary. On the basis of informal discussions with the SEC
staff, we understand that it is reasonable to interpret the term to
represent a transaction in which more than 50 percent of the voting
power of an entity is obtained by an acquirer (or acquirer group).
In practice, some contracts use the phrase “50 percent or more” as
opposed to “more than 50 percent” to define what constitutes a
change of control of the entity. When the contractual terms of an
equity-linked instrument include the phrase “50 percent or more” to
define a change of control, it is generally acceptable to apply the
change of control exception discussed above on the basis that (1)
the previous shareholder group has lost control of the entity and
(2) the distinction between the two phrases is minimal (e.g., a 0.1
percent difference in ownership is not substantive enough to affect
the classification of the contract). However, an entity should
consider consulting with its accounting and legal advisers in
determining whether the change of control exception discussed above
may be applied to an equity-linked instrument.
5.2.3.5 Nationalization (Expropriation) Clauses
ASC 815-40
55-6 In the event of nationalization, cash compensation would be the consideration for the expropriated assets and, as a result, a counterparty to the contract could receive only cash, as is the case for a holder of the stock underlying the contract. Because the contract counterparty would receive the same form of consideration as a stockholder, a contract provision requiring net cash settlement in the event of nationalization does not preclude equity classification of the contract.
An equity-linked instrument that requires net cash settlement if the entity is
nationalized does not preclude equity classification. This is because the
counterparty would be legally entitled to receive cash compensation for the
expropriated contract in a manner similar to a holder of the underlying
stock.
5.2.3.6 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
The terms of some share-lending arrangements executed in conjunction with a
convertible debt issuance (see Section 2.9) may allow the borrower
(e.g., the bank) to cash settle all or a portion of an arrangement if, after
making its reasonable best effort, the borrower is unable to obtain a
sufficient number of the entity’s common shares to settle the entire
arrangement through physical delivery or is otherwise prohibited from
settling via physical delivery in accordance with a law, rule, or regulation
of a government authority. ASC 470-20-50-2A requires entities to disclose
circumstances in which cash settlement would be required. Except for certain
limited instances, equity classification is precluded under ASC 815-40-25 if
there are any circumstances in which the issuer could be required to net
cash settle an equity-linked instrument. Because ASC 470-20-50-2A specifies
disclosure requirements for cash settlement provisions related to
equity-classified share-lending arrangements (see Section 6.1.6), a situation in which a
share-lending arrangement could have a cash settlement requirement and still
be classified in equity appears to be specifically contemplated in ASC
470-20, regardless of the requirements of ASC 815-40-25. However, to be
classified in equity by the issuing entity, the share-lending arrangement
should meet all of the other conditions for equity classification in ASC
815-40.
Therefore, a share-lending arrangement executed in conjunction with a
convertible debt issuance is not precluded from classification in equity if
it allows the counterparty to cash settle the arrangement upon the
occurrence of certain events, but it must make its reasonable best effort to
effect a physical settlement, and the situations in which cash settlement
may be permitted must be limited, outside the control of the counterparty
(e.g., delisting of the entity’s shares), and highly unlikely to occur. In
addition, the best-effort requirement must be substantive, and there should
be an expectation at the inception of the arrangement that the counterparty
would physically settle the arrangement. A share-lending arrangement would
not be classified in equity if it unilaterally allowed the counterparty to
cash settle the arrangement at its option or without having made a
reasonable effort to obtain shares to physically settle the arrangement.
5.2.3.7 Cash Payments Other Than Net Cash Settlements
As noted in Section
5.2.2, some equity-linked instruments contain provisions that
could require the issuer, upon the occurrence of events outside its control,
to make cash payments that do not represent a net cash settlement of the
entire instrument. Except for the following types of provisions, equity
classification is precluded if an equity-linked instrument could require the
entity to make any cash payments:
-
Penalty payments if the entity fails to file on a timely basis — Under ASC 815-40-25-10(d), an equity-linked instrument can qualify as equity even if it requires the entity to make penalty payments for failing to file financial statements with the SEC on time. Paragraph BC79 of ASU 2020-06 notes that such a provision is permissible “because [it does] not result in settlement of a contract.” However, an equity-linked instrument could not be classified as equity if it must be net cash settled because the entity fails to file on a timely basis (see Section 5.3.5) or requires the entity to make other types of cash payments. As noted in paragraph BC84 of ASU 2020-06, an instrument that requires a cash payment to be made upon settlement (e.g., cash-settled top-off, make-whole provisions, or compensation for the difference in value between registered and unregistered shares) does not qualify as equity irrespective of whether such a payment represents a net cash settlement of the instrument. Therefore, to apply this exception, an entity must conclude that the cash payment is (1) akin to a penalty payment as opposed to a partial settlement of the contract and (2) not made in conjunction with the settlement of the contract (i.e., the equity-linked instrument must continue to exist after the payment is made). See discussion in Section 5.2.3.7.1 of buy-in and share delivery payments.
-
Normal contractual remedies for the entity’s contract breach — An equity-linked instrument may qualify as equity even if it (1) includes an indemnification clause that holds each party harmless against damages, losses, or claims resulting from the breach of contract or gross negligence and (2) requires any such obligations to be paid in cash. This is because such payments are considered to be the result of an action that was within the entity’s control.
-
Cash payment provisions within the scope of the guidance on registration payment arrangements — Sometimes an equity-linked instrument requires the entity to pay cash penalties if it is unable to register the shares underlying the instrument or is unable to maintain an effective registration statement. In such a case, the entity should consider whether that penalty provision meets the definition in ASC 825-20 of a registration payment arrangement. Under ASC 825-20-25-1, a registration payment arrangement that has the characteristics described in ASC 825-20-15-3 is recognized as a unit of account that is separate from the instrument subject to the agreement. In accordance with ASC 825-20-25-2, an equity-linked instrument that is subject to a registration payment arrangement within the scope of ASC 825-20 is evaluated under ASC 815-40 without regard to the contingent obligation to transfer consideration under the registration payment agreement. See Section 3.2.4.
-
Minimal or nonsubstantive payment provisions associated with the issuance or delivery of the entity’s equity shares — Equity classification of an equity-linked instrument that otherwise qualifies for classification within equity is not precluded if the entity is obligated to pay stamp duties, transfer taxes, or other governmental charges that might be imposed with respect to the issuance of the entity’s equity shares upon the instrument’s settlement if (1) the entity’s obligation is limited to costs (if any) that would be unavoidable upon the entity’s issuance of equity shares; (2) the entity would be legally liable to pay such costs if the counterparty does not pay them; (3) the obligation does not encompass expenses related to any applicable capital gains taxes, withholding taxes, or any other expenses, taxes, or charges that depend on holder-specific factors; and (4) the entity expects to incur no or only minimal costs associated with meeting its obligation. However, a requirement to reimburse the holder for any applicable capital gains, withholding taxes, or other holder-specific taxes associated with an equity-linked instrument precludes equity classification irrespective of the likelihood and expected amount of such payments (see also Section 4.3.5.13).
-
Fractional shares — An equity-linked instrument that requires fractional shares (i.e., a quantity of shares that is less than one full share) to be settled in cash is not precluded from equity classification if it does not otherwise require or permit cash settlement.
Example 5-3
Contract With Fractional Shares Settled in Cash
Company A has written a call option to Company B. The option permits Company B
to purchase 100,000 shares of A’s common stock at an
exercise price of $120 per share. The contract
specifies net share settlement except that any
fractional share will be settled in cash. Company B
exercises the option when A’s stock price is $140.
Accordingly, the fair value of the settlement amount
is $2 million, or 100,000 shares × ($140 – $120),
which is equivalent to 14,285.714 shares ($2 million
÷ $140). Because the contract specifies net share
settlement with cash settlement of any fractional
share, A delivers 14,285 whole shares as well as
$100 of cash (0.714 share × $140). This contract
could qualify as equity under ASC 815-40 even though
it includes a requirement to cash settle any
fractional share.
5.2.3.7.1 Buy-In and Share Delivery Failure Payments
As discussed in Section 4.3.7.11, some
equity-linked financial instruments contain “buy-in” provisions that
require the issuing entity to make a stated cash payment for each day on
which shares are not delivered to the holder in a timely manner (e.g.,
deliveries that occur after a two- to three-day settlement period). A
“share delivery failure” provision further requires the issuer to make
the counterparty whole if, because of the entity’s failure to transfer
the shares on a timely basis, the holder incurs a loss by purchasing (in
the open market or otherwise) shares of the entity’s common stock to
deliver in satisfaction of a sale order that the holder anticipated
fulfilling with the shares receivable from the issuer upon settlement of
the instrument.
If triggered, buy-in and share delivery payments are
made in conjunction with settlement of the related equity-linked
instrument.2 As a result, they do not meet the exception for penalty payments
(see Section
5.3.5). However, the issuer of the equity-linked
instrument often controls the ability to avoid the actions for which
such payments would be required (i.e., the issuer generally controls the
ability to deliver shares in a timely manner upon the settlement of an
equity-linked instrument).
Connecting the Dots
Many issuers of equity-linked instruments use
the services of a transfer agent to deliver shares to the
counterparty. In some cases, the buy-in and share delivery
payments are required only if the issuer fails to instruct the
transfer agent to transfer the shares on a timely basis. In
these situations, the issuer controls the ability to avoid
making such payments (i.e., to avoid defaulting) as long as it
has sufficient authorized and unissued shares to settle the
contract, which is an existing condition for equity
classification. In other contracts, the issuer is obligated to
make the payments if the transfer agent fails to deliver the
shares in a timely manner upon instruction of the issuer.
However, there are controls in place to ensure that the transfer
agent performs as instructed. Furthermore, the transfer agent is
acting as an extension of the issuer in the delivery of shares
in accordance with a contract that establishes an agency
relationship between the issuer and the transfer agent. In fact,
the use of transfer agents by publicly traded entities is often
necessary. Therefore, provided that the established timely
delivery period is reasonable, it is acceptable to conclude that
even though the transfer agent is a third party, it is
performing at the direction, and as an extension of, the issuer.
The issuer would thus still be considered to control the ability
to avoid making these payments. As a result, such payment
provisions would not affect the classification of the
equity-linked instrument. This conclusion is specific to
transfer agents and should not be applied to other scenarios by
analogy.
5.2.4 Settlement Alternatives: General Requirements
ASC 815-40
25-2 Further, an entity shall observe both of the following:
- If the contract provides the counterparty with a choice of net cash settlement or settlement in shares, this Subtopic assumes net cash settlement.
- If the contract provides the entity with a choice of net cash settlement or settlement in shares, this Subtopic assumes settlement in shares.
25-4 Accordingly, unless the
economic substance indicates otherwise:
- Contracts shall be initially
classified as either assets or liabilities in both
of the following situations:
- Contracts that require net cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the control of the entity)
- Contracts that give the counterparty a choice of net cash settlement or settlement in shares (physical settlement or net share settlement).
- Contracts shall be initially
classified as equity in both of the following
situations:
- Contracts that require physical settlement or net share settlement
- Contracts that give the entity a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement), assuming that all the criteria set forth in paragraphs 815-40-25-7 through 25-30 and 815-40-55-2 through 55-6 have been met.
35-2 Contracts that are initially classified as equity under Section 815-40-25 shall be accounted for in permanent equity as long as those contracts continue to be classified as equity. . . . Both of the following shall be reported in permanent equity:
- Contracts that require that the entity deliver shares as part of a physical settlement or a net share settlement
- Contracts that give the entity a choice of either of the following:
- Net cash settlement or settlement in shares (including net share settlement and physical settlement that requires that the entity deliver shares)
- Either net share settlement or physical settlement that requires that the entity deliver cash.
35-5 Net share settlement should be assumed for contracts that are classified under Section 815-40-25 as equity instruments that provide the entity with a choice of either of the following:
- Net share settlement
- Physical settlement that may require that the entity deliver cash.
35-6 Physical settlement should be assumed for contracts that are classified under Section 815-40-25 as equity instruments that provide the counterparty with a choice of either of the following:
- Net share settlement
- Physical settlement that may require that the entity deliver cash.
The table below describes various settlement alternatives that may be specified
in an equity-linked instrument and the instrument’s resulting classification
provided that (1) any settlement alternatives have the same economic value (see
Section 5.2.5), (2) the
gain and loss positions for the settlement alternatives do not differ (see Section 5.2.6), and (3) the
instrument is not otherwise precluded from equity classification (e.g., under
the indexation guidance in ASC 815-40-15 or the additional equity classification
conditions in ASC 815-40-25; see Chapter 4 and Section
5.3).
Classification | |
---|---|
Equity Provided All Other Conditions for
Equity Classification Are Met
|
Asset or Liability
|
|
|
If an entity intends or expects to net cash settle an equity-linked instrument
but cannot be forced to do so, the instrument is not precluded from being
classified in equity. What matters is not whether the entity expects or intends
to settle in shares but whether it has the legal right to settle in shares (and
controls the ability to settle in shares). If the entity elects to settle net in
cash, however, the entity should consider whether the instrument needs to be
reclassified as an asset or a liability until it is settled (e.g., if the
election is binding and cannot be revoked).
5.2.4.1 Application to Convertible Securities With “Greater-of” Redemption Features
Some convertible securities give the investor a share-settled equity conversion option and a cash-settled redemption option in which the redemption amount is the greater of the fair value of the underlying shares or the face amount of the securities. In such a scenario, the “greater-of” redemption option effectively gives the security’s holder the ability to net cash settle the embedded conversion option. Accordingly, the conversion option does not qualify as equity under ASC 815-40. ASC 815-15 addresses whether an entity is required to bifurcate the option as an embedded derivative (see Section 2.2).
5.2.4.2 Application to Certain Freestanding Equity-Linked Instruments
ASC 815-40-55-13 contains a table that illustrates the effect of different
settlement methods and alternatives on the classification of a freestanding
equity-linked instrument under which the entity sells its shares (including
forward sale contracts, written call options or warrants, and purchased put
options on the entity’s own equity). The table also applies to purchased
call options on the entity’s own equity.
ASC 815-40
Forward Sale Contracts, Written Call Options or Warrants, and Purchased Put Options
55-13 The issuing entity (the seller) agrees to sell shares of its stock to the buyer of the contract at a specified price at some future date. The contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing entity or counterparty may have a choice of settlement methods. The guidance in this Subtopic would be applied as follows.
Note: In all cases above, the contracts must be reassessed at each reporting period to determine whether the contract
must be reclassified.
Purchased Call Options
55-14 The entity (the buyer) purchases call options that provide it with the right, but not the obligation, to buy from the seller, shares of the entity’s stock at a specified price. If the options are exercised, the contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing entity or the counterparty may have a choice of settlement methods. The entity should follow the preceding table in accounting for purchased call options.
5.2.4.3 Application to Certain Embedded Features
In the evaluation of whether the scope exception for own equity is met,
temporary equity is considered equity (ASC 815-10-15-76). For example, if an
SEC registrant issues equity shares that contain an embedded written put
option that permits the holder to put the shares back to the registrant in
exchange for a cash payment, the registrant may be required to classify the
shares in temporary equity under ASC 480-10-S99-3A (for a comprehensive
discussion of the application of this guidance, see Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity). In
evaluating whether the embedded put option qualifies for the scope exception
in ASC 815-10-15-74(a) under the equity classification guidance in ASC
815-40 (e.g., in assessing whether the instrument permits the issuer to
settle in shares), the entity would consider the equity shares to be equity
even though they are presented outside of permanent equity. The guidance on
treating temporary equity as equity under ASC 815-40 does not apply to
freestanding equity-linked instruments.
5.2.5 Settlement Alternatives With Different Economic Value
ASC 815-40
25-3 Except as noted in the
last sentence of this paragraph, the approach discussed
in paragraphs 815-40-25-1 through 25-2 does not apply if
settlement alternatives do not have the same economic
value attached to them or if one of the settlement
alternatives is fixed or contains caps or floors. In
those situations, the accounting for the instrument (or
combination of instruments) shall be based on the
economic substance of the transaction. For example, if a
freestanding contract, issued together with another
instrument, requires that the entity provide to the
holder a fixed or guaranteed return such that the
instruments are, in substance, debt, the entity shall
account for both instruments as liabilities, regardless
of the settlement terms of the freestanding contract.
However, the approach discussed in paragraphs
815-40-25-1 through 25-2 does apply to contracts that
have settlement alternatives with different economic
values if the reason for the difference is a limit on
the number of shares that must be delivered by the
entity pursuant to a net share settlement
alternative.
25-18 If a settlement
alternative includes a penalty that would be avoided by
an entity under other settlement alternatives, the
uneconomic settlement alternative shall be disregarded
in classifying the contract.
Some equity-linked instruments contain settlement alternatives (e.g., net share
or net cash) that could have different economic values (i.e., the net monetary
amount of consideration receivable or payable differs depending on which
settlement alternative applies). For example, one settlement alternative might
have an economic value that is different from other settlement alternatives
because:
-
It is for a fixed dollar amount.
-
It specifies a cap or a floor (e.g., the entity has a right to either net cash or net share settle an instrument, but the number of shares that would be delivered in a net share settlement is subject to a cap).
-
It contains a penalty that would not be incurred under other settlement alternatives (e.g., the entity has a right to either net cash or net share settle an instrument, but the fair value of the net cash settlement alternative is at a discount to the net share settlement alternative).
In such cases, the entity should consider the instrument’s substance in
determining its classification. The entity should ignore any share settlement
alternative that would always be uneconomic. If one of the settlement
alternatives is associated with a penalty that the entity could avoid by
electing a different settlement alternative, the entity would disregard the
alternative with the penalty in determining the appropriate classification.
However, if one of the settlement alternatives involves delivery of unregistered
shares, a reasonable discount from the value of registered shares is permitted
if it is determined by using commercially reasonable means and reflects the
difference in fair value between registered and unregistered shares.
Under some equity-linked instruments, the number of shares to be delivered to
the counterparty if the contract is settled in unregistered shares must be in
excess of the amount of cash or the number of registered shares that would
otherwise be delivered; however, a make-whole provision is included in the
instrument to ensure that the counterparty receives proceeds upon the ultimate
disposition of the shares equal to the amount that would be delivered under a
net cash or registered share settlement. This settlement alternative should not
be viewed as including a penalty as long as the make-whole provision is
symmetrical. In other words, any excess value received by the counterparty must
be returned to the entity. The additional shares delivered at settlement are
meant to provide a cushion to reduce the likelihood that the entity will have to
deliver additional shares after the counterparty sells the shares it received
upon settlement.
5.2.5.1 Certain Put Warrants
ASC 815-40
55-15 An entity issues senior
subordinated notes with a detachable warrant that
gives the holder both the right to purchase 6,250
shares of the entity’s stock for $75 per share and
the right (that is, a put) to require that the
entity repurchase all or any portion of the warrant
for at least $2,010 per share at a date several
months after the maturity of the notes in about 7
years. The proceeds should be allocated between the
debt liability and the warrant based on their
relative fair values, and the resulting discount
should be amortized in accordance with Subtopic
835-30. The warrants should be considered, in
substance, debt and accounted for as a liability
because the settlement alternatives for the warrants
do not have the same economic value attached to them
and they provide the holder with a guaranteed return
in cash that is significantly in excess of the value
of the share-settlement alternative on the issuance
date.
If a warrant was issued to give the counterparty a fixed or guaranteed return so
that the instrument is in-substance debt, the instrument would be classified
as a liability. ASC 815-40-55-15 describes a warrant that contains a right
for the counterparty to either exercise the warrant at a price of $75 per
share or put the warrant to the entity for cash of at least $2,010 per
share. The guidance suggests that this warrant would be classified as a
liability because the settlement alternatives have different economic values
and give the holder a guaranteed return that is significantly in excess of
the fair value of the share settlement alternative as of the issuance date.
Note, however, that the detachable stock purchase warrant in this example
represents a put warrant. Even if the detachable stock purchase warrant in
ASC 815-40-55-15 gave the counterparty a right to put the warrant at an
amount of cash that was not significantly in excess of the share settlement
alternative, this type of warrant would be classified as a liability as
illustrated in ASC 480-10-55-31 (see Section 5.2.4 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity). The wording of ASC
815-40-55-15 was developed before the issuance of the requirements that were
later incorporated into ASC 480, under which all redeemable warrants on the
entity’s own equity are liabilities.
5.2.6 Settlement Alternatives That Differ in Gain and Loss Positions
ASC 815-40
25-36 This guidance addresses two circumstances in which settlement alternatives differ in gain and loss positions:
- Net cash payment required in loss position
- Net-stock alternative in loss position.
Net Cash Payment Required in Loss Position
25-37 A contract indexed to, and potentially settled in, an entity’s own stock, with multiple settlement alternatives that require the entity to pay net cash when the contract is in a loss position but receive (a) net stock or (b) either net cash or net stock at the entity’s option when the contract is in a gain position shall be accounted for as an asset or a liability.
Net-Stock Alternative in Loss Position
25-38 A contract indexed to, and potentially settled in, an entity’s own stock, within the scope of this Subtopic and with multiple settlement alternatives that require the entity to receive net cash when the contract is in a gain position but pay (a) net stock or (b) either net cash or net stock at the entity’s option when the contract is in a loss position shall be accounted for as an equity instrument. This guidance does not apply to a contract that is predominantly a purchased option in which the amount of cash that could be received when the contract is in a gain position is significantly larger than the amount that could be paid when the contract is in a loss position because, for example, there is a small contractual limit on the amount of the loss. Those contracts shall be accounted for as assets or liabilities.
Some equity-linked instruments allow different settlement methods depending on
whether the instrument is in a gain or a loss position from the entity’s
perspective. For example, a forward sale contract may require or permit net
share settlement if the contract is in a loss position (i.e., the entity would
deliver a net number of shares equal in value to the settlement amount if the
contract is unfavorable) but require net cash settlement if the contract is in a
gain position (i.e., the entity would receive cash from the counterparty equal
to the settlement amount if the contract is favorable). If the instrument
permits the entity to net share settle when the instrument is in a loss
position, a net cash settlement requirement that applies when the instrument is
in a gain position would not preclude the instrument from being classified as
equity.
This guidance cannot be used to justify equity classification for purchased
option contracts that require or permit the counterparty to settle the contract
net in cash even though the contract would never require the entity to deliver
cash. The guidance also does not apply to an equity-linked instrument that is
predominantly a purchased option (e.g., because there is a small contractual
limit on the amount of loss). Such an instrument would be classified as an asset
or a liability even if the entity has the right to net share settle the
instrument in a loss position.
5.2.7 Settlement in Shares Issued by Another Entity Within a Consolidated Group
Some equity-linked instruments require or permit settlement in a variable number
of equity shares issued by another entity within a consolidated group (e.g., a
contract issued by a parent that the holder is permitted to settle either in a
fixed number of equity shares issued by the parent or a variable number of
equity shares issued by its subsidiary that have an aggregate fair value at
settlement equal to that of a fixed number of parent shares). If (1) the equity
indexation and classification conditions in ASC 815-40 are met and (2) the
instrument is not required to be classified as an asset or a liability under ASC
480 (see Deloitte’s Roadmap Distinguishing Liabilities From Equity), such an
instrument is not precluded from being classified in equity in consolidated
financial statements that include both entities since the shares that will be
delivered qualify as equity in the consolidated financial statements. However,
such an instrument would not qualify as equity in financial statements that do
not include consolidated information of both entities since the instrument would
be indexed to, or involve delivery of shares that do not qualify as, equity in
the reporting entity’s financial statements. See Section 2.6 for further discussion about
the analysis under ASC 815-40 of instruments indexed to, or settled in, the
shares of an affiliated entity.
Footnotes
1
Even if Entity A were to be
required to pay an equivalent amount of cash
instead of delivering 0.33 fractional shares, the
contract would still be considered net share
settled. The payment (receipt) of cash for
fractional shares does not affect the
classification of an equity-linked contract under
ASC 815-40-25.
2
It is uncommon that (1) the issuer has the unconditional right to
reinstate the equity-linked instrument or (2) the instrument is
automatically reinstated when such payments are made.
5.3 Additional Equity Classification Conditions
5.3.1 Overview
ASC 815-40
Because any contract provision that
could require net cash settlement precludes accounting
for a contract as equity of the entity (except for those
circumstances in which the holders of the underlying
shares would receive cash, as discussed in paragraphs
815-40-25-8 through 25-9 and paragraphs 815-40-55-2
through 55-6), all of the following conditions must be
met for a contract to be classified as equity:
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
- Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
- Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
- No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
- No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
- Subparagraph superseded by Accounting Standards Update No. 2020-06.
Paragraphs 815-40-25-39 through 25-42
explain the application of these criteria to convertible
debt and other hybrid instruments.
25-10A The following
conditions are not required to be considered in an
entity’s evaluation of net cash settlement (that is, if
any one of these provisions is in a contract [or the
contract is silent on these points], they should not
preclude equity classification, except as described
below):
- Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
- Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
- Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.
The fact that an equity-linked instrument specifies that it will be settled in
shares or permits the entity to settle in shares does not necessarily justify a
conclusion that the entity could not be forced to net cash settle the
instrument. With certain exceptions, if there are any circumstances under which
the entity could be required to net cash settle the instrument, the instrument
cannot be accounted for as equity (see Section 5.2). For an entity to conclude that
it cannot be required to net cash settle an equity-linked instrument, the entity
must ensure that the conditions in ASC 815-40-25-10 are met.3 These conditions address whether there are circumstances under which the
issuer could be forced to net cash settle the instrument.
Connecting the Dots
EITF Issue 00-19 (released before the FASB’s codification of U.S. GAAP)
identified an additional condition for equity classification by stating
that a “contract requires net-cash settlement only in specific
circumstances in which holders of shares underlying the contract also
would receive cash in exchange for their shares.” Under ASC 815-40, this
condition still applies, but it is not one of the conditions described
in ASC 815-40-25-10 (see Sections
5.2.2 and 5.2.3).
The conditions apply even if the contract stipulates either physical settlement
or net share settlement. That is, an entity cannot
assume that it can physically settle or net share
settle an equity-linked instrument unless all the
conditions are met irrespective of whether the
instrument specifies that it will be share
settled.
An entity assesses whether the conditions are met without regard to the
likelihood that an event could force the entity to net cash settle the
instrument. Accordingly, if there are circumstances under which the entity could
be forced to net cash settle the instrument during its term, the instrument is
classified as an asset or a liability even if the likelihood is remote that the
circumstances will occur.
The entity must continually evaluate whether the conditions are
met (see Section 5.4). An equity-linked
instrument that initially meets the conditions and qualifies as equity would
need to be reclassified out of equity if one or more of the equity
classification conditions is no longer met. Conversely, an instrument that does
not initially qualify for equity classification is reclassified as equity if it
later meets all the conditions for such classification.
An entity is not required to
consider the following conditions in determining whether an equity-linked
instrument qualifies for equity classification:
- The entity is permitted to settle the instrument in unregistered shares.4
- No counterparty rights rank higher than shareholder rights.
- There is no requirement in the contract for the issuing entity to post collateral at any point for any reason.
While an entity can classify
an equity-linked instrument within equity even if the above three conditions are
not met, SEC registrants must consider the guidance in ASC 480-10-S99-3A that
applies to redeemable equity securities. An equity-linked instrument that does
not meet any of the above three conditions would generally need to be classified
as temporary equity. For example, assume that an entity must settle an option in
shares of common stock that are registered for resale. The fact that this
requirement does not affect the evaluation of whether the equity classification
conditions in ASC 815-40-25 have been met does not mean that the entity controls
the ability to issue registered shares. In the absence of preclearance with the
SEC, an entity should classify an equity-linked instrument (including a hybrid
financial instrument with an embedded equity-linked feature) as temporary equity
if it does not meet one of the three conditions in ASC 815-40-25-10A.
If the issuer cannot be required to deliver any shares to settle the instrument,
the conditions that address the entity’s ability to settle in shares do not
apply (e.g., that the entity has sufficient authorized and unissued shares).
Depending on the instrument’s terms, therefore, scenarios in which those
conditions may not apply include the following:
-
A net-share-settled put or call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
-
A physically settled call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
-
A physically settled written put option embedded in own stock. (If the counterparty elects to exercise the embedded put option, the entity will receive, not deliver, shares.)
-
A contingent physically settled forward contract to repurchase own stock that is embedded in an outstanding share. (If the contingency is met, the entity will receive, not deliver, shares.)
Those conditions do apply, however, to a physically settled put option held by
the entity, since the entity would deliver shares
upon exercise. This is the case even though the
decision to exercise the option is within the
entity’s control (ASC 815-40-25-11).
5.3.2 Settlement Required in Registered Shares
An equity-linked instrument that requires the issuing entity to
deliver shares to the counterparty can meet the conditions for equity
classification whether the shares to be delivered are unregistered or registered
provided that the contract does not explicitly state that an entity must settle
in cash if registered shares are unavailable (see ASC 815-40-25-10A(a)).5 However, if the entity must deliver registered shares and the contract
meets the indexation and equity classification conditions in ASC 815-40, the
equity-linked instrument must be classified in temporary equity unless the
entity controls the ability to deliver registered shares. In determining whether
it controls the ability to deliver shares, an entity focuses on whether it has
the legal ability to deliver the registered shares when settling the instrument.
Under the Securities Act of 1933, offers and sales of securities must be
registered with the SEC unless a specific exemption from the registration
requirements applies. Accordingly, depending on the facts and circumstances, an
entity may not be able to settle an instrument by delivering shares unless those
shares have been registered with the SEC. As an issuer of shares, however, an
entity cannot control whether the SEC will approve the registration of its
shares, and even if the entity has an effective registration statement, the SEC
may suspend the registration before the equity-linked instrument is settled.
Further, the entity cannot control whether its auditor will provide it with an
audit opinion or any consents required for share registration. Consequently, if
it is unable to deliver registered shares because of such circumstances, the
entity must classify the contract in temporary equity even though the contract
meets the indexation and equity classification conditions in ASC 815-40.
An entity can classify an equity-linked instrument that requires
settlement in registered shares as permanent, as opposed to temporary, equity if
one or more of the following apply:
- The instrument involves the delivery of shares at settlement that were registered at contract inception and there are no further requirements related to timely filing or registration.
- The instrument clearly states that the issuer has no obligation to net cash settle the instrument if it is unable to deliver registered shares (i.e., the contract contains specific language that the entity’s nonperformance or failure to settle the contract is an available option).
- The entity will never be required to deliver any shares under the instrument (i.e., upon any settlement, the issuing entity would receive, as opposed to issue, shares).
Connecting the Dots
In practice, it is sometimes difficult for an entity to
conclude at contract inception that the shares to be delivered were
registered and that there are no further requirements related to timely
filing or registering the shares. If securities laws (e.g., the
Securities Exchange Act of 1934) require the entity to periodically file
(e.g., Form 10-K or 10-Q) and deliver a current, updated prospectus to
maintain the shares’ registration, this exception is not available. An
entity may need to consult legal counsel to determine whether the
exception is available.
In a speech at the 2006 AICPA Conference on Current SEC
and PCAOB Developments, Stephanie Hunsaker, then associate chief
accountant in the SEC’s Division of Corporation Finance, indicated that
the legal analysis of whether there are further requirements related to
timely filing or registration may depend on whether the counterparty
will make an investment decision upon the instrument’s exercise or
settlement. For a warrant, for example, the counterparty may need to
make an investment decision regarding whether to exercise the warrant
(whereas for a forward contract, the investment decision would be made
at contract inception). She said:
During the term of the warrants, the issuer will
have to deliver a ‘current prospectus’ to the warrant holders in
connection with any exercises by them. These
further registration requirements stem from the fact that
the holder of the warrant has to make a separate investment
decision at the time of the exercise of the warrant and
therefore a current prospectus must be delivered to the holder.
Initially the issuer will be able to use the prospectus that was
declared effective with respect to the unit offering when it
sells shares to exercising warrant holders. However, as time
passes, the prospectus will be required to be updated to
disclose additional information or provide updated financial
information. . . .
[A] forward contract requires the holder to
purchase shares of common stock on a preset date in the future.
. . .
The conclusion that there
are not further timely filing or registration requirements
stems from the fact that the investment decision (to
purchase common stock in the future under the stock purchase
contract) has been made at inception and there is no further
investment decision to be made. In effect, there really
is just a delayed delivery of the shares underlying the stock
purchase contract. [Emphasis added]
In evaluating whether there are further requirements
related to timely filing or registration, an entity should consider
whether any specific exemption from the SEC’s registration requirements
applies. Ms. Hunsaker emphasized that an exemption may be available
under Section 3(a)(9) of the Securities Act of 1933 if one class of
securities of an issuer is exchanged for a different class of securities
of the same issuer as long as no consideration or commissions are being
paid.
Further, Ms. Hunsaker stressed that registrants may need
to consult with legal counsel:
However, registrants
should ensure they have discussed with their legal counsel the
availability of the Section 3(a)(9) exemption to their fact pattern,
particularly in unusual circumstances such as when it is uncertain
if the securities are convertible into those of the same issuer,
arrangements which may involve the payment of remuneration for
soliciting the exchange, or arrangements where the convertible
securities are not potentially immediately convertible into shares
of common stock of the registrant and the issuer has not registered
all of the shares which could be issued upon conversion at inception
along with the convertible debt.
5.3.2.1 Interaction With the Guidance on Registration Payment Arrangements
Sometimes an equity-linked instrument requires the entity to pay cash penalties
if it is unable to register the shares underlying
the instrument or is unable to maintain an
effective registration statement. In this case,
the entity should consider whether that penalty
provision meets the definition of a registration
payment arrangement under ASC 825-20 (see Section
3.2.4). Under ASC 825-20-25-1, a
registration payment arrangement that has the
characteristics described in ASC 825-20-15-3 is
recognized as a unit of account that is separate
from the contract subject to the agreement. Thus,
an equity-linked instrument that is subject to a
registration payment arrangement within the scope
of ASC 825-20 is evaluated under ASC 815-40
without regard to the contingent obligation to
transfer consideration under the registration
payment agreement (ASC 825-20-25-2). In other
words, an equity-linked instrument is not
necessarily precluded from equity classification
because it specifies cash penalties if the entity
is unable to register the shares underlying the
instrument, as long as the entity is not required
to net cash settle the instrument.
If an equity-linked instrument permits the entity to settle by delivering
unregistered shares, the instrument can qualify as permanent equity even if
it requires the entity to use commercially reasonable best efforts to
register any unregistered shares delivered. This is analogous to ASC
815-40-25-28, which states, in part:
Use of the entity’s
best efforts to obtain sufficient authorized shares to settle the
contract is within the entity’s control.
5.3.3 Entity Has Sufficient Authorized and Unissued Shares
ASC 815-40
25-19 If an entity could be required to obtain shareholder approval to increase the entity’s authorized shares to net share or physically settle a contract, share settlement is not controlled by the entity.
25-20 Accordingly, an entity shall evaluate whether a sufficient number of authorized and unissued shares exists at the classification assessment date to control settlement by delivering shares. In that evaluation, an entity shall compare both of the following amounts:
- The number of currently authorized but unissued shares, less the maximum number of shares that could be required to be delivered during the contract period under existing commitments, including any of the following:
- Outstanding convertible debt that is convertible during the contract period
- Outstanding stock options that are or will become exercisable during the contract period
- Other derivative financial instruments indexed to, and potentially settled in, an entity’s own stock.
- The maximum number of shares that could be required to be delivered under share settlement (either net share or physical) of the contract.
25-21 When evaluating whether
there are sufficient authorized and unissued
shares available to settle a contract, an entity
shall consider the maximum number of shares that
could be required to be delivered under a
registration payment arrangement to be an existing
share commitment, regardless of whether the
instrument being evaluated is subject to that
registration payment arrangement.
25-22 If the amount in paragraph 815-40-25-20(a) exceeds the amount in paragraph 815-40-25-20(b) and the other conditions in this Subtopic are met, share settlement is within the control of the entity and the contract shall be classified as a permanent equity instrument. Otherwise, share settlement is not within the control of the entity and asset or liability classification is required.
25-23 For purposes of this calculation, if a contract permits both (a) net share and (b) physical settlement by delivery of shares at the entity’s option (both alternatives permit equity classification if the other conditions in this Section are met), the alternative that results in the lesser number of maximum shares shall be included in this calculation.
25-24 If a contract is classified as either an asset or a liability because the counterparty has the option to require settlement of the contract in cash, then the maximum number of shares that the counterparty could require to be delivered upon settlement of the contract (whether physical or net share) shall be assumed for purposes of this calculation.
An equity-linked instrument cannot be classified as equity unless either of the
following criteria is met:
-
The entity currently has a sufficient number of authorized and unissued shares available to share settle the instrument.
-
The entity is able, without shareholder approval, to increase the number of authorized shares to make a sufficient amount of authorized and unissued shares available to share settle the instrument.
Whether shareholder approval would be required for an increase in the number of
authorized shares is a legal determination (e.g., it may differ across
jurisdictions). If shareholder approval is required for such an increase (e.g.,
under corporate law), the instrument cannot be classified as equity unless the
entity currently has a sufficient number of authorized and unissued shares
available to share settle the instrument. This is because the entity cannot
assume that the shareholders will vote for an increase in the number of
authorized shares.
If shareholder approval is obtained for an increase in the number of authorized
shares, the entity should consider whether
equity-linked instruments that previously were
classified as assets or liabilities (because the
number of authorized shares was insufficient) will
need to be reclassified as equity (see Section
5.4).
In assessing whether it has a sufficient number of authorized and unissued
shares, an entity does not take into account only
the number of its currently authorized and
unissued shares. It must also consider how many
shares it might be required to deliver under any
other commitment to deliver shares during the
maximum period in which the equity-linked
instrument being evaluated might remain
outstanding, including any top-off or make-whole
commitments (see Section 5.3.6). Such
commitments include not only instruments within
the scope of ASC 815-40 but also instruments
within the scope of other accounting guidance such
as ASC 480 or ASC 718. Examples include warrants,
options, forwards, employee stock options,
convertible debt, convertible preferred stock,
share-settled contingent consideration in a
business combination, and share-settled
registration payment arrangements.
The entity deducts the maximum number of shares it could be required to deliver
during the contract period under such commitments from the number of currently
authorized but unissued shares. Equity classification for the instrument being
assessed is precluded unless the number of authorized and unissued shares that
remains after deduction of all the shares the entity might have to deliver under
other commitments exceeds the maximum number of shares that the entity could be
required to deliver under the instrument.
If an entity anticipates issuing shares but is not committed to doing so, it
would not consider those shares in the calculation, but it would consider them
in its periodic reassessment of the classification of equity-linked instruments
when the issuances actually occur.
Example 5-4
Sufficient Authorized and Unissued Shares
An entity has issued a warrant that expires in one year. If the holder exercises the warrant, the contractual terms of the warrant require the entity to deliver 20,000 shares of the entity’s stock in exchange for a cash payment of $5 million. Further, the entity determines that (1) it currently has 100,000 authorized shares, of which 40,000 are in issuance, and (2) the maximum number of shares that it could be required to deliver during the warrant’s one-year term because of other commitments (e.g., outstanding convertible debt, employee stock options) is 35,000.
The entity would calculate the number of shares available to share settle the warrant being evaluated as follows:
Calculation and Comparison | Number of Shares |
---|---|
Currently authorized shares | 100,000 |
Less: Issued shares | (40,000) |
Less: Maximum number of shares the entity could be forced to deliver during the contract term under other commitments | (35,000) |
Equals: Shares available to share settle the contract | 25,000 |
Compare: Maximum number of shares that the entity could be forced to deliver under the contract being evaluated | 20,000 |
The warrant being evaluated is not precluded from equity classification because the entity has a sufficient number of authorized and unissued shares available to share settle the contract. That is, the contract being evaluated would never require delivery of more than 20,000 shares, and the entity has 25,000 shares available to share settle the contract.
In calculating the maximum number of shares that might have to be delivered
under an equity-linked instrument that (1) could
require the entity to deliver shares and (2)
includes a choice of settlement method (e.g.,
physical settlement, net shares, or net cash), the
entity considers which party controls the manner
of settlement. If the entity has the option to
elect either net share or physical settlement, the
entity reflects the alternative with the lesser
number of shares in the calculation (i.e., net
share settlement), since the entity cannot be
forced to deliver the greater number of shares
that would be delivered in a physical settlement.
If the counterparty can elect the settlement
method, the entity reflects the alternative that
will require delivery of the greater number of
shares in the calculation. If this is the case,
the entity incorporates the greater number of
shares in the calculation even if the instrument
is classified as an asset or a liability (e.g.,
because the counterparty has the right to elect
net cash settlement).
The classification requirements in ASC 815-40 apply to each equity-linked
instrument as a whole unless the instrument permits partial net share
settlement. If an equity-linked instrument does not permit partial net share
settlement, the whole instrument is classified as an asset or a liability if the
entity does not have sufficient shares to share settle the entire instrument.
ASC 815-40-35-11 addresses contracts that permit partial net share settlement.
If the issuer cannot be required to deliver any shares to settle
an equity-linked instrument, the entity does not need to satisfy the condition
that it have sufficient authorized and unissued shares to settle the instrument.
Depending on the instrument’s terms, therefore, the condition may not apply to,
for example, a purchased call option on the entity’s own equity, in which the
entity will receive, not deliver, shares upon exercise.
5.3.3.1 Sequencing Considerations
If an entity concludes that it does not have sufficient authorized and unissued
shares to satisfy all its commitments to deliver
shares, it should apply a sequencing policy to
determine how to allocate any authorized and
unissued shares among those commitments. In
establishing a sequencing policy, an entity should
consider the guidance on reclassification methods
in ASC 815-40-35-11 through 35-13 (see Section
5.4). While that guidance addresses
“reclassifications,” it is also relevant in the
determination of the initial classification of
equity-linked instruments. Depending on how
authorized and unissued shares are allocated under
an entity’s sequencing policy, the entity may
conclude that it has a sufficient number of
authorized and unissued shares available to share
settle the instrument being evaluated.
5.3.4 Contract Contains an Explicit Share Limit
ASC 815-40
25-26 For certain contracts, the number of shares that could be required to be delivered upon net share settlement is essentially indeterminate. If the number of shares that could be required to be delivered to net share settle the contract is indeterminate, an entity will be unable to conclude that it has sufficient available authorized and unissued shares and, therefore, net share settlement is not within the control of the entity.
For equity classification to be appropriate, the number of shares the entity
might be required to deliver under the contract
must be limited (capped). If determining the
maximum number of such shares is not possible,
then equity classification is not permitted
because it would be impossible to establish
whether the entity has a sufficient number of
authorized and unissued shares available to settle
the instrument in shares. That is, an
equity-linked instrument that could require the
entity to deliver an unlimited number of shares
would not qualify as equity. The number of shares
that it expects to deliver is not relevant to this
determination, nor is whether there is only a
remote likelihood that the entity will deliver
more than some specific number of shares.
The SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006) notes that one of the most common causes of improper accounting for a conversion feature embedded in convertible debt or convertible preferred stock is that:
[T]he number of shares issuable upon conversion of the convertible instrument is variable, and there is no cap on the number of shares which could be issued. [Since] there is no explicit limit on the number of shares that are to be delivered upon exercise of the conversion feature, the registrant is not able to assert that it will have sufficient authorized and unissued shares to settle the conversion option. As a result, the conversion feature would be accounted for as a derivative liability, with changes in fair value recorded in earnings each period. Additionally, registrants should note that a variable share settled instrument that results in liability classification may impact the classification of previously issued instruments, as well as instruments issued in the future.
An equity-linked instrument’s terms do not necessarily need to use the words
“explicit share limit” — it may be possible for an entity to infer an explicit
share limit from the terms. For example, a convertible bond may have a par value
of 1,000, a fixed conversion price of $20, and no adjustment provisions that
could increase the number of shares that would be delivered. If the par value of
1,000 is divided by the conversion price of $20, it is implied that the entity
would never deliver more than 50 shares. Thus, 50 shares would be considered the
explicit share limit. If the issuer writes a freestanding call option on its own
outstanding shares, the terms of the option contract may similarly establish an
explicit share limit. For example, if the written call option has a fixed
notional amount of 100 shares and no adjustment provisions, the entity will
never deliver more than 100 shares irrespective of whether the contract provides
for physical settlement or net share settlement.
Many equity-linked instruments require adjustments to the number of shares to be
delivered upon the occurrence or nonoccurrence of a specified event (e.g., an
antidilution adjustment that specifies that the number of shares will be
increased in case of a stock split). A contractual provision that increases the
number of shares to be delivered upon the occurrence or nonoccurrence of an
event is not inconsistent with this condition if the event that triggers the
adjustment is within the entity’s control. If the triggering event is outside
the entity’s control (e.g., a merger or a consolidation), the instrument may
still meet this condition if the event causes the instrument to be settled and
all holders of the underlying shares receive the same form of consideration (see
Section 5.2.3.3).
If the issuer cannot be required to deliver any shares to settle the instrument,
the condition that the instrument contains an explicit share limit does not
apply. (Alternatively, the instrument could be analyzed as having a share limit
of zero since the entity could not be required to deliver any shares.) Depending
on the instrument’s terms, therefore, the condition may not apply to, for
example, a purchased call option on the entity’s own equity in situations in
which the entity would receive, not deliver, shares upon exercise.
An equity-linked instrument may contain a clause that limits the holder’s
ability to exercise and beneficially own more than
a specified percentage of the issuer’s outstanding
shares (e.g., the counterparty cannot exercise an
option contract if it owns or would obtain more
than 4.99 percent of outstanding shares). Such a
cap does not qualify as an explicit share limit
since the counterparty can sell the shares it
holds before exercise and any shares it receives
upon exercise.
If the entity is able, without shareholder approval, to increase the number of
authorized shares to make a sufficient number of
authorized and unissued shares available to share
settle an equity-linked instrument, the
requirement that the instrument must contain an
explicit share limit does not apply because the
entity could not be forced to cash settle the
instrument (see Section
5.3.3).
Including an explicit share limit in a contract’s terms solely to meet the
condition that the instrument have such a limit would not preclude a conclusion
that the instrument is a fixed-for-fixed forward or an option on the entity’s
equity shares (see Section
4.3.2).
5.3.4.1 Interaction Between the Sufficient Share and Explicit Share Limit Conditions
ASC 815-40
25-27 If a contract limits or caps the number of shares to be delivered upon expiration of the contract to a fixed number, that fixed maximum number can be compared to the available authorized and unissued shares (the available number after considering the maximum number of shares that could be required to be delivered during the contract period under existing commitments as addressed in paragraph 815-40-25-20 and including top-off or make-whole provisions as discussed in paragraph 815-40-25-30) to determine if net share settlement is within the control of the entity. A contract termination trigger alone (for example, a provision that requires that the contract will be terminated and settled if the stock price falls below a specified price) does not satisfy this requirement because, in that circumstance, the maximum number of shares deliverable under the contract is not known with certainty unless there is a stated maximum number of shares.
If an entity determines that an equity-linked instrument contains an explicit
share limit (i.e., it satisfies the condition in
ASC 815-40-25-26), the entity can then compare
that share limit with the number of available
shares. If there is a share limit but it exceeds
the number of available shares, the instrument
fails to meet the condition in ASC 815-40-25-19.
In this case, the entity classifies the instrument
as an asset or a liability. On the other hand, if
there is a share limit and the number of available
shares exceeds that limit, the instrument
potentially qualifies for equity classification if
the other conditions for equity classification are
met.
5.3.4.2 Equity-Linked Instrument With Share Limit and Best-Efforts Arrangement
ASC 815-40
25-28 This paragraph addresses a contract structure that caps the number of shares that must be delivered
upon net share settlement but would also provide that any contract valued in excess of that capped amount
may be delivered to the counterparty in cash or by delivery of shares (at the entity’s option) when authorized,
unissued shares become available. The structure requires the entity to use its best efforts to authorize
sufficient shares to satisfy the obligation. Under the structure, the number of shares specified in the cap is less
than the entity’s authorized, unissued shares less the number of shares that are part of other commitments
(see paragraph 815-40-25-20). Use of the entity’s best efforts to obtain sufficient authorized shares to settle
the contract is within the entity’s control. If the contract provides that the number of shares required to settle
the excess obligation is fixed on the date that net share settlement of the contract occurs, the excess shares
need not be considered when determining whether the entity has sufficient, authorized, unissued shares to
net share settle the contract pursuant to paragraph 815-40-25-20. However, the contract may provide that the
number of shares that must be delivered to settle the excess obligation is equal to a dollar amount that is fixed
on the date of net share settlement (which may or may not increase based on a stated interest rate on the
obligation) and that the number of shares to be delivered will be based on the market value of the stock at the
date the excess amount is settled. In that case, the excess obligation represents stock-settled debt and shall
preclude equity classification of the contract (or, if partial net share settlement is permitted under the contract
pursuant to paragraph 815-40-35-11, precludes equity classification of the portion represented by the excess
obligation).
The counterparty to an equity-linked instrument may be reluctant to accept an
explicit share limit that caps the gain it could
make on the instrument. In this case, the entity
may agree to (1) deliver the shares that are in
excess of the limit (the number of which becomes
fixed as of the instrument’s settlement date) only
once authorized, unissued shares become available,
and (2) use its best efforts to obtain such
shares. In this situation, the entity does not
need to consider the excess shares in determining
whether it has sufficient authorized and unissued
shares to net share settle the instrument because
it cannot be forced to deliver those shares.
However, if the contract specifies that the entity will deliver a variable
number of shares equal in value to that of the excess shares determined as
of the settlement date, the excess obligation is considered stock-settled
debt. In this case, the instrument must be classified as a liability either
for the part that exceeds the explicit share limit (if the contract permits
partial net share settlement) or in its entirety (if it cannot be partially
net share settled or otherwise does not meet the conditions for equity
classification). Once the monetary amount of the stock-settled debt becomes
fixed as of the instrument’s original settlement date, that obligation is
outside the scope of ASC 815-40 under ASC 815-40-15-3(e) and is instead
accounted for as a liability under ASC 480 (see Section 2.3 of this Roadmap and Chapter 6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity).
5.3.5 No Required Cash Payment if Entity Fails to File on a Timely Basis
ASC 815-40
25-29 The ability to make timely SEC filings is not within the control of the entity. Accordingly, if a contract permits share settlement but requires net cash settlement in the event that the entity does not make timely filings with the SEC, that contract shall be classified as an asset or a liability.
If an equity-linked instrument must be net cash settled in the event that the
entity does not file reports with the SEC on a
timely basis, the instrument cannot be accounted
for as equity. In the evaluation of whether this
condition is met, the likelihood of the entity’s
being unable to file in a timely manner is
irrelevant.
The reason for this requirement is that the ability to file reports with the SEC
in a timely manner is not solely within the
entity’s control. For example, an entity cannot
control whether its auditor will provide it with
an audit opinion that is required in filing the
entity’s annual financial statements. Some filings
may require the consent of the entity’s auditor or
third-party experts.
An equity-linked instrument might require the entity to make a cash payment for
failing to file financial statements with the SEC or other body in a timely
manner (e.g., an amount in cash equal to 2 percent of the instrument’s exercise
price on the day of a failure to file and on every 30th day thereafter until the
date such failure is cured). Such penalty payments do not preclude equity
classification since they do not cause the instrument to be settled (see
Section
5.2.3.7).
Connecting the Dots
Under ASC 815-40-25-10(d), one of the conditions for equity
classification is that there must be no required cash payment — except
for penalty payments — if the entity fails to file in a timely manner.
Although the exception for penalty payments is discussed solely in the
context of payments for an entity’s failure to file financial statements
on a timely basis, it is acceptable to apply this exception to other
cash payments that are (1) akin to penalty payments as opposed to a
partial settlement of the contract and (2) not made in conjunction with
the settlement of the contract (i.e., the equity-linked instrument must
continue to exist after the payment is made). If a cash payment is
required in connection with the settlement of an equity-linked
instrument, the exception for penalty payments does not apply and the
contract cannot be classified in equity.
A requirement that the entity use its best efforts to make timely filings is within its control and would not preclude equity classification.
Some hybrid financial instruments specify that the entity will pay cash
penalties or additional interest if the entity does not file on a timely basis.
For example, a convertible debt instrument may indicate that additional interest
is payable if the entity fails to file reports in a timely manner. Such a
feature may be attributed to the hybrid instrument and evaluated separately as
an embedded derivative provided that the penalty paid does not vary on the basis
of the value of the conversion option. Accordingly, it would not disqualify the
conversion option from being classified as equity.
5.3.6 No Cash-Settled Top-Off or Make-Whole Provision
ASC 815-40
25-30 A top-off or make-whole provision would not preclude equity classification if both of the following conditions exist:
- The provision can be net share settled.
- The maximum number of shares that could be required to be delivered under the contract (including any top-off or make-whole provisions) is both:
- Fixed
- Less than the number of available authorized shares (authorized and unissued shares less the maximum number of shares that could be required to be delivered during the contract period under existing commitments as discussed in paragraph 815-40-25-20).
If those conditions are not met, equity classification is precluded.
ASC 815-40 — Glossary
Make-Whole Provision
A cash payment to a counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due. While the exact terms of such provisions vary, they generally are intended to reimburse the counterparty for any losses it incurs or to transfer to the entity any gains the counterparty recognizes on the difference between the following:
- The settlement date value
- The value received by the counterparty in subsequent sales of the securities within a specified time after the settlement date.
Top-Off Provision
See Make-Whole Provision.
Some equity-linked instruments contain make-whole or top-off provisions that
reimburse the counterparty if it incurs a loss on
the sale of the shares it will receive upon
settlement of the instrument. The counterparty to
an equity-linked instrument (e.g., a warrant, a
written call option, or a convertible instrument)
may seek to include such a provision to ensure
that it does not stand to lose from declines in
the stock price following its exercise of the
instrument.
The existence of a top-off or a make-whole provision precludes equity
classification for the entire equity-linked
instrument unless both of the following conditions
are met:
-
The entity has the right to net share settle the make-whole or top-off obligation.
-
The maximum number of shares that is required to settle the instrument (including the top-off or make-whole provision) is both:
-
Fixed (i.e., there is an explicit share limit).
-
Less than the number of available authorized and unissued shares after deduction of the maximum number of shares for which delivery could be required during the contract period under other commitments (i.e., the entity has sufficient authorized and unissued shares to share settle the make-whole or top-off provision).
-
Example 5-5
Top-Off Provision
An entity writes a net-share-settled call option on 1,000 of the entity’s common
shares. The entity has the right to settle the
call option by delivering unregistered shares. On
a per-share basis, the option’s settlement amount
equals the difference between the quoted stock
price on the settlement date and $46. The option
contains a top-off provision that specifies that
if the holder sells the shares it receives upon
settlement of the option and such sale occurs
within 10 days of option settlement, the holder
will receive a variable number of shares equal in
value to the excess, if any, of (1) the stock
price used in settling the option divided by (2)
the price at which the holder subsequently sells
the shares. The entity has the right to settle the
top-off provision in unregistered shares. The
option also specifies that under no circumstances
will the entity deliver more than 1,000 shares to
satisfy both the option settlement and the top-off
provision. The entity has 2,000 authorized and
unissued shares available.
On the option’s settlement date, the
quoted stock price is $50. Because the option is net
share settled, the holder receives a variable number of
the entity’s shares equal in value to $4,000, or 1,000 ×
($50 – $46); that is, 80 shares ($4,000 ÷ $50). Ten days
later, the holder sells the shares in the market for $40
per share and incurs an aggregate loss of $800, or 80 ×
($50 – $40). Under the top-off provision, therefore, the
entity delivers an additional number of shares to the
counterparty equal in value to $800. At a stock price of
$40, the entity delivers an additional 20 shares ($800 ÷
$40) to the counterparty to satisfy the top-off
provision.
Even though this option contains a
top-off provision, the option is not precluded from
equity classification since the entity has the right to
net share settle the top-off provision, and the maximum
number of shares it might be required to deliver is both
fixed and less than the available authorized and
unissued shares. If the entity can be forced to net cash
settle the top-off provision, however, the entire option
is classified as a liability.
Footnotes
3
The conditions in ASC 815-40-25-10 do not apply to
certain conversion options embedded in a convertible debt instrument
(see Section
5.5).
4
An equity-linked instrument can qualify as
equity even if it must be settled in registered shares unless
the instrument explicitly states that the entity must cash
settle it if registered shares are unavailable; however, the
entity may be required to classify the instrument as temporary
equity (see Section
5.3.2).
5
In practice, equity-linked instruments generally do not
contain provisions that explicitly require cash settlement if the entity
is unable to deliver registered shares.
5.4 Ongoing Reassessment of Classification Requirements
ASC 815-40
35-8 The classification of a
contract (including freestanding financial instruments and
embedded features) shall be reassessed at each balance sheet
date. If the classification required under this Subtopic
changes as a result of events during the period (if, for
example, as a result of voluntary issuances of stock the
number of authorized but unissued shares is insufficient to
satisfy the maximum number of shares that could be required
to net share settle the contract [see discussion in
paragraph 815-40-25-20]), the contract shall be reclassified
as of the date of the event that caused the
reclassification. There is no limit on the number of times a
contract may be reclassified.
35-11 If a contract permits
partial net share settlement and the total notional amount
of the contract no longer can be classified as permanent
equity, any portion of the contract that could be net share
settled as of that balance sheet date shall remain
classified in permanent equity. That is, a portion of the
contract shall be classified as permanent equity and a
portion of the contract shall be classified as an asset, a
liability, or temporary equity, as appropriate.
35-12 If an entity has more than one contract subject to this Subtopic, and partial reclassification is required, there may be different methods that could be used to determine which contracts, or portions of contracts, shall be reclassified. Methods that would comply with this Section could include any of the following:
- Partial reclassification of all contracts on a proportionate basis
- Reclassification of contracts with the earliest inception date first
- Reclassification of contracts with the earliest maturity date first
- Reclassification of contracts with the latest inception or maturity date first
- Reclassification of contracts with the latest maturity date first.
35-13 The method of reclassification shall be systematic, rational, and consistently applied.
5.4.1 Overview
An entity is required to reassess its classification of both freestanding
equity-linked instruments and embedded features as of each reporting date.
Reclassification is required if an instrument either begins or ceases to meet
all the conditions for equity classification. If reclassification is required,
the entity reclassifies the instrument as of the date of the event that caused
the reclassification at its then-current fair value, and the new classification
is applied prospectively. For this reason, the entity may need to determine the
fair value of the instrument as of the date that reclassification is required,
even if that date is not a reporting date. Prior fair value gains and losses
recognized in earnings are not reversed.
Any of the following could affect an entity’s conclusion about whether an
equity-linked instrument qualifies as equity:
-
A strike price adjustment feature that prevented an option or warrant from being indexed to the entity's stock expires or lapses.
-
A modification of one of the instrument’s terms or conditions (e.g., the parties amend the terms of a contract to specify that the entity is not required to net cash settle the contract in case it does not have an effective registration statement).
-
A lapse in one of the instrument’s terms or conditions (e.g., immediately after an IPO if the terms provide for an adjustment to the settlement terms upon an IPO).
-
A change in the reporting entity’s functional currency.
-
The number of authorized shares increases or decreases as a result of a vote by shareholders.
-
The entity issues previously authorized equity shares.
-
The entity enters into commitments that could require it to deliver equity shares (e.g., warrants, options, forwards, share-based payment awards, or convertible instruments).
-
The entity has an option to settle the instrument either in shares or net in cash and elects to settle the instrument net in cash.
-
An event that is within the entity’s control occurs and triggers a requirement to net cash settle the instrument.
Example 5-6
Reassessment
Entity X issues a warrant on its own common stock. The warrant meets all
conditions for equity classification in ASC 815-40
except for the requirement that the entity has
sufficient authorized and unissued shares to settle the
instrument in shares (see Section 5.3.3).
Accordingly, the warrant is classified as a liability
and accounted for at fair value with changes in fair
value recognized in earnings.
Subsequently, X’s shareholders vote to approve an amendment to its certificate
of incorporation to increase the number of authorized
shares of common stock. Entity X files a certificate of
amendment with its state of incorporation. As a result,
X reassesses its prior conclusion and determines that it
now has sufficient authorized and unissued shares to
cover all its outstanding commitments to issue shares.
Entity X should therefore determine the fair value of
the warrant as of the date that the number of authorized
and unissued shares increased and recognize through
earnings any change in the fair value of the instrument
that had not been previously recognized up to that date.
The updated fair value carrying amount would be
reclassified from liabilities to equity.
A reassessment is required irrespective of whether the event that causes an equity classification condition to be met or no longer met is within the entity’s control (i.e., a reassessment is required once such an event occurs).
At the 2005 AICPA Conference on Current SEC and PCAOB Developments, the SEC
staff reiterated the requirement to continually reassess the classification of
equity-linked instruments. The staff presented an example of a contract that
requires settlement in a variable number of shares and in which the number of
shares to be delivered upon settlement is not limited. The staff concluded that
a company could not classify this uncapped contract within equity and that the
issuance of the uncapped contract could cause other instruments to fail the
criteria to be classified within equity.
Example 5-7
Continual Reassessment
Entity X issues freestanding warrants that allow the
holder to purchase 1,000 shares of X’s common stock for
$10 per share. The warrants have a 10-year term and are
exercisable at any time. However, the terms of the
warrants specify that if there is a change in control of
X at any time during the 18-month period after the
warrants’ issuance date, the exercise price of the
warrants is reduced to $1 per share.
The warrants are not considered indexed to X’s stock
because the adjustment in the event of a change in
control is inconsistent with the inputs used in the
pricing (fair value measurement) of a fixed-for-fixed
option on equity shares. However, when the provision
that may result in an adjustment to the exercise price
lapses (i.e., 18 months after the issuance date), X
should reconsider, as of that date, whether the warrants
should be treated as indexed to its own stock.
5.4.2 Sequencing Policy
One of the conditions for equity classification is that the entity have
sufficient authorized and unissued shares available after considering all other
commitments that may require it to deliver shares during the maximum period the
instrument could remain outstanding (see Section 5.3.3). Therefore, the entity may need
to reassess its classification of existing equity-linked instruments if it
issues shares, enters into new commitments to deliver shares, or reduces the
number of authorized shares. To determine whether the entity has sufficient
authorized and unissued shares available to share settle equity-linked
instruments being evaluated under ASC 815-40-25, the entity should adopt a
“sequencing policy” (also known as “reclassification policy” or “contract
ordering policy”) as an accounting policy election and disclose such policy
under ASC 235. The sequencing policy should be systematic and rational (i.e.,
understandable and reasonable) as well as consistently applied (i.e., the entity
must use the same sequencing policy for all instruments within the scope of the
guidance).
One acceptable sequencing policy would be for an entity to perform the following
two steps to evaluate whether equity-linked instruments, or portions of such
instruments, should be initially classified as equity or later reclassified from
equity to an asset or a liability:
-
Step 1 — Determine whether outstanding equity-linked instruments have overlapping settlement opportunities with respect to their exercise periods or settlement dates.In step 1, the entity determines whether the outstanding commitments to deliver shares have overlapping settlement opportunities with respect to their exercise periods or settlement dates. (For commitments with early settlement date provisions, the entity should consider the earliest possible settlement date.) If the settlement opportunities in the commitments do not overlap, the instrument with the earlier exercise date or settlement date would be considered first with regard to the availability of shares for settlement. If an entity determines in step 1 that two or more commitments have overlapping exercise periods or settlement dates, the entity should proceed to step 2.
-
Step 2 — Apply a sequencing policy to determine which equity-linked instruments, or portions of such instruments, if any, qualify as equity.In step 2, the entity applies a sequencing policy under ASC 815-40-35-11 through 35-13 to determine which equity-linked instruments, or portions of such instruments, qualify as equity.ASC 815-40-35-12 lists several permissible methods of reclassification:
-
Partial reclassification of all contracts on a proportionate basis.
-
Reclassification of contracts with the earliest inception date first (i.e., first in, first out).
-
Reclassification of contracts with the earliest maturity date first.
-
Reclassification of contracts with the latest inception or maturity date first.
-
Reclassification of contracts with the latest maturity date first.
-
An entity should also consider any legal priority specified in the contracts’
terms. If an instrument has dedicated shares under a legally enforceable share
reservation clause, the instrument may be exempt from the sequencing exercise if
the dedicated shares would have highest priority, thereby ensuring share
settlement of the contract. In this case, the entity should subtract shares
related to the reservation clause from shares available for equity-settled
instruments before assessing share sufficiency for all remaining instruments.
Because this is a legal, rather than an accounting, consideration, it may
require the involvement of a legal specialist.
5.4.3 Commitments to Deliver a Potentially Unlimited Number of Shares
Some commitments may not explicitly limit the potential number of shares an entity could be required to deliver. In this case, the commitment could result in an obligation to deliver a potentially unlimited number of equity shares upon settlement. Examples of such commitments, which may fall outside the scope of ASC 815-40, include:
- A net-share-settled written put option or forward repurchase contract on an entity’s own stock (see ASC 480).
- An obligation to issue a variable number of shares worth a fixed monetary amount (see ASC 480).
- An obligation to issue a variable number of shares indexed to something other than the entity’s own stock (e.g., the price of gold) (see ASC 480 and ASC 815-40-15-7F).
- Share-settled interest deferral features in certain hybrid debt securities.
When an entity enters into a commitment that may require it to deliver a
potentially unlimited number of shares, it is possible that other equity-linked
instruments no longer meet the condition that the entity has sufficient
authorized and unissued shares to share settle the instrument. Nevertheless, an
entity is not necessarily precluded from classifying any or all of its other
instruments as equity. To determine whether share settlement is within the
entity’s control for equity-linked instruments other than the unlimited
contract, the entity should apply its sequencing policy. Such a policy may
indicate that sufficient authorized and unissued shares are available to share
settle some or all of the equity-linked instruments other than the contract that
does not limit the number of shares.
If the entity issues an uncapped contract, it would need to reevaluate the
classification of all its other outstanding equity-linked instruments classified
within equity. To do so, the entity may apply the two-step approach described in
Section 5.4.2 to
evaluate whether those other equity-linked instruments, or portions of such
instruments, should be reclassified from equity to an asset or a liability.
(This Roadmap does not take a view on whether an entity is permitted to use an
approach other than this two-step approach when it has issued one or more
uncapped contracts.)
Under the two-step approach, if a commitment that might require delivery of a
potentially unlimited number of shares has an earlier exercise period or
settlement date than the equity-linked instrument being evaluated, then the
instrument being evaluated does not qualify as equity until the contract with
the potentially unlimited number of shares has been settled. If several
equity-linked instruments are currently exercisable and the entity could not be
forced to settle the uncapped contract first, the entity should apply its
sequencing policy to determine which equity-linked instruments, or portions of
such instruments, qualify as equity.
However, equity classification of other equity-linked instruments may be
appropriate under the two-step approach if the other instruments will be settled
before the earliest possible date that the uncapped contract can be settled
(provided that these instruments meet all the criteria for equity
classification), or upon expiration of the uncapped contract. For example, if an
entity has an accounting policy of reclassifying contracts with the latest
inception or maturity date first, equity-linked instruments with an inception or
maturity date earlier than the unlimited contract would remain classified in
equity as long as the entity has a sufficient number of authorized and unissued
shares available to allow delivery under those instruments.
Example 5-8
Two-Step Approach: Latest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the latest maturity date first. Thus, any available shares are allocated first to contracts with the earliest maturity date. Entity A has two million shares of common stock authorized, with 200,000 shares unissued and a stock price of $25.
On January 1, 20X7, A acquires assets from Entity B and, as consideration, enters into a contract to provide a variable number of common shares of its stock to B in the amount of $2.5 million on December 31, 20X7.
On April 1, 20X7, A enters into a written call option contract to sell 150,000 shares of its stock to Entity C at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement, as determined by A. The call option expires on June 30, 20X7.
While the contract with B could require a potentially unlimited number of shares to be delivered by A, if A applies its sequencing policy only to contracts with overlapping settlement opportunities with respect to their exercise periods or settlement dates (as discussed in Section 5.4.2), it does not need to consider the contract with B in determining whether the call option qualifies for equity classification because the contract with B can be settled only after the entire term of the call option.
Under a sequencing policy that reclassifies contracts with the latest maturity date first, available shares are
allocated to contracts in order of increasing maturity dates. That is, the 200,000 available shares are first
compared with the potential share delivery requirement of 150,000 under the written call option contract
that matures on June 30, 20X7, since that contract has the earliest maturity date. Given the greater number
of available shares compared with the share delivery requirement (200,000 vs. 150,000), A would be able to
conclude that there are sufficient shares available to share settle the written call option contract and that it
has 50,000 remaining shares available to share settle other contracts with a later maturity date. Because of
the unlimited contract with B that matures on December 31, 20X7, however, A would be unable under this
sequencing policy to assert that it has any shares available to share settle contracts with a maturity date after
December 31, 20X7. The contract with B is not eligible for equity classification because of the unlimited share
exposure; nor is it eligible for partial classification in equity.
Example 5-9
Two-Step Approach: Earliest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the earliest maturity date first. Thus, any available shares are allocated first to contracts with the latest maturity date. Entity A has two million shares of common stock authorized with 200,000 shares unissued and a stock price of $25.
On January 1, 20X4, A enters into a six-month written call option contract to sell 150,000 shares of its stock to Entity B at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement as determined by A. The call option can be exercised at any time and expires on June 30, 20X4.
On April 1, 20X4, A issues a hybrid convertible debt instrument to Entity C with interest payments due quarterly. Entity A has the option to defer its scheduled interest payment, but such a deferral triggers an obligation to share settle all deferred interest after five years unless previously paid. Since any deferred interest will result in a fixed-dollar payable settled in a variable number of shares, this feature has the potential to result in the issuance of an unlimited number of shares.
Because the exercise period of the written call option (January 1, 20X4, to June 30, 20X4) does not overlap with the earliest possible settlement date of the share-settled interest payment (April 1, 20X9), the 200,000 available shares would first be allocated to the written call option before consideration of the potentially unlimited number of shares associated with the hybrid convertible debt instrument. Entity A would apply its sequencing policy only if the exercise periods or settlement dates overlap.
5.5 Application of the Equity Classification Conditions to Certain Convertible Debt Instruments
ASC 815-40
25-39 For purposes of
evaluating under paragraph 815-15-25-1 whether an embedded
derivative indexed to an entity’s own stock would be
classified in stockholders’ equity if freestanding, the
requirements of paragraphs 815-40-25-7 through 25-30 and
815-40-55-2 through 55-6 do not apply if the hybrid contract
is a convertible debt instrument in which the holder may
only realize the value of the conversion option by
exercising the option and receiving the entire proceeds in a
fixed number of shares or the equivalent amount of cash (at
the discretion of the issuer).
25-40 However, the requirements
of paragraphs 815-40-25-7 through 25-30 and 815-40-55-2
through 55-6 do apply if an issuer is evaluating whether any
other embedded derivative is an equity instrument and
thereby excluded from the scope of Subtopic 815-10.
25-41 Instruments that provide
the holder with an option to convert into a fixed number of
shares (or equivalent amount of cash at the discretion of
the issuer) for which the ability to exercise the option is
based on the passage of time or a contingent event shall
qualify for the exceptions included in paragraph
815-40-25-39. Standard antidilution provisions contained in
an instrument do not preclude a conclusion that the
instrument is convertible into a fixed number of shares.
25-42 Convertible preferred
stock with a mandatory redemption date may qualify for the
exception included in paragraph 815-40-25-39 if the economic
characteristics indicate that the instrument is more akin to
debt than equity. An entity shall consider the guidance in
paragraph 815-15-25-17 in assessing whether the instrument
is more akin to debt or equity. That paragraph explains
that, if the preferred stock is more akin to equity than
debt, an equity conversion feature would be clearly and
closely related to that host instrument.
ASC 815-40 — Glossary
Equity Restructuring
A nonreciprocal transaction between an entity and its shareholders that causes
the per-share fair value of the shares underlying an option
or similar award to change, such as a stock dividend, stock
split, spinoff, rights offering, or recapitalization through
a large, nonrecurring cash dividend.
Standard Antidilution Provisions
Standard antidilution provisions are those that result in adjustments to the
conversion ratio in the event of an equity restructuring
transaction that are designed to maintain the value of the
conversion option.
The conditions in ASC 815-40-25-10 (see Section 5.3) do not apply to an embedded
conversion option if the holder is only able to realize the option’s value by
exercising it “and receiving the entire proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of the issuer).” Thus, a conversion
option in such a convertible debt instrument may fail to meet one or more of those
conditions and still qualify for the own-equity scope exception to the derivative
accounting guidance. Convertible preferred stock may also qualify under this
exception if it has a mandatory redemption date and its economic characteristics
indicate that the instrument is more akin to debt than equity (ASC 815-40-25-42).
Because of the requirement related to a mandatory redemption date, convertible
preferred securities that are redeemable only at the option of the holder do not
qualify.
For an instrument to be exempt from the conditions in ASC 815-40-25-10, the
issuer must have the ability to settle it gross by delivering a fixed number of
shares, although the issuer might alternatively elect to settle the instrument in an
equivalent amount of cash. The holder’s ability to exercise the conversion option
may be “based on the passage of time or a contingent event” (ASC 815-40-25-41).
The following are examples of convertible debt instruments that do not qualify
for this exception because the number of shares to be delivered upon conversion is
not fixed:
-
A convertible debt instrument that contains a down-round provision (see Section 4.3.7.2).
-
A convertible debt instrument that contains a make-whole provision that adjusts the conversion rate so that the issuer is required to deliver additional shares if it fails to meet specified debt covenants.
The table below indicates whether certain adjustments to the conversion price
represent standard antidilution provisions and therefore would not prevent an entity
from applying the exception.
Examples of Adjustment to the Conversion Price | Type of Antidilution Provision |
---|---|
Subdivision (stock split, stock dividend) | Standard |
Combination (reverse stock split) of outstanding common shares | Standard |
Issuance of common shares at a lower price than the conversion price in effect immediately before such issuance | Nonstandard |
Recurring quarterly cash dividend to all common shareholders | Nonstandard |
Recapitalization through a large nonrecurring cash dividend | Standard |
If the exception applies, an entity does not need to evaluate whether the issuer would
be required to net cash settle the conversion option as a result of the
circumstances described in ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through
55-6. Therefore, even if cash settlement of the conversion option is required as a
result of one or more of the conditions in those paragraphs, the convertible debt
would still meet the equity classification conditions in ASC 815-40. However, the
conversion option would not meet the equity classification requirements of ASC
815-40 if the entity could be forced to cash settle the embedded conversion option
(1) upon the occurrence of an event that is outside its control that is not
addressed in ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through 55-6 or (2)
upon the passage of time.
Although the equity classification conditions in ASC 815-40-25-10 do not apply to
convertible debt that is eligible for the exception, the embedded conversion option
still needs to be indexed to the entity’s stock to meet the scope exception in ASC
815-10-15-74(a).
Chapter 6 — Initial and Subsequent Accounting
Chapter 6 — Initial and Subsequent Accounting
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 815-40-15 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. While the total proceeds
approximate the fair value of the package of
instruments, 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 must 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 the
“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.
Connecting the Dots
It is appropriate to allocate the proceeds received to
multiple freestanding financial instruments issued as part of a single
transaction when the proceeds represent the fair value of the package of
financial instruments issued. In this situation, an entity should
allocate the proceeds by using one of the two methods discussed above
(i.e., the relative fair value approach or the with-and-without method).
However, if the entity issues multiple freestanding financial
instruments and receives proceeds that differ from the fair value of the
package of financial instruments issued (i.e., the transaction is not at
arm’s length), the entity must appropriately account for the other
rights, privileges, or elements included in the transaction. For
example, if an entity issues two freestanding financial instruments to a
related party and the price paid exceeds the aggregate fair value of the
package of instruments issued, the entity may have received a capital
contribution from the investor. Alternatively, if an entity issues
multiple financial instruments and receives proceeds that are less than
the fair value of the package of instruments issued, the entity may have
a recognizable asset or may need to record a dividend or expense. The
accounting for proceeds that differ from the fair value of the package
of financial instruments issued will depend on the particular facts and
circumstances.
It is never appropriate to recognize a financial instrument that
represents an obligation or equity of the entity at a negative amount.
Furthermore, it is generally not appropriate to recognize no amount for
a financial instrument that represents an obligation or equity of the
entity.
The initial carrying amount of a freestanding equity-classified
instrument also 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).
There may be situations in which a freestanding equity-classified
instrument must be classified as temporary equity. In such cases, 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. 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 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. Note that in the journal
entries, it is assumed that the instrument being modified or exchanged is a
liability before or after such modification or exchange. If the instrument
were an asset, the journal entries would be reversed.
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. For example,
the entity 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).
|
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.
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 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 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 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. 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 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 calculating 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. 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 815-40-15 or Section
815-40-25 . . . .
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.
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.
6.2.1.2 Allocation of Proceeds
If a freestanding equity-linked instrument is issued with
debt or stock, the issuance proceeds received may need to be allocated
between the items. In these circumstances, an entity allocates proceeds to
the items that will be measured at fair value on a recurring basis 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.2
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, then Professional Accounting Fellow Hillary Salo
addressed the allocation of proceeds
related to an 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. Her comments may also be relevant to proceeds received
for the issuance of multiple financial instruments that are less than the
fair value of the package of instruments that were issued. Ms. Salo stated,
in part:
[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. If so, an entity would need to provide the
disclosures required by ASC 815 for derivatives.
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. 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 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 4.3.5.8 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).3 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.4 The proceeds received from the investor are reflected and any residual
amount must be charged (or credited) to earnings.5 This accounting is consistent with the guidance in ASC 815 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.
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
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.
3
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 and ASC 820.
4
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.
5
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
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. . . .
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). The subsequent measurement guidance in ASC 815-40-35-4
applies to a freestanding equity-linked instrument that is not classified as an
asset or as a liability because it is not indexed to the entity’s stock. Under this
guidance, such a contract must be initially and subsequently measured at fair value,
with changes in fair value reported in earnings in each reporting period, regardless
of whether the contract meets the characteristics of a derivative instrument in ASC
815-10-15-83. The disclosure requirements in ASC 815 apply only if the equity-linked
instrument meets the definition of a derivative.
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.
6.4 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.
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).
An embedded feature that was bifurcated from its host contract subsequently and
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)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). 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 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.
Chapter 7 — Presentation and Disclosure
Chapter 7 — Presentation and Disclosure
7.1 Requirements Under U.S. GAAP
7.1.1 Earnings per Share
7.1.1.1 Basic EPS
As noted in ASC 260-10-45-10, basic EPS is calculated “by dividing income
available to common stockholders (the numerator) by the weighted-average
number of common shares outstanding (the denominator) during the period.”
Although freestanding equity-linked instruments that are within the scope of
ASC 815-40 do not represent outstanding common shares, they can affect
income available to common stockholders in the calculation of basic EPS. In
particular:
-
The two-class method of calculating EPS applies to contracts that participate on a nondiscretionary basis in the entity’s undistributed earnings. Examples of freestanding equity-linked instruments that may trigger application of the two-class method include (1) those that entitle the holder to participate in cash dividends on the entity’s common stock and (2) forward contracts to issue common shares that include a reduction to the forward price or an increase in the number of shares when the entity declares a cash dividend. For further discussion, see Sections 5.3.3.4 and 5.3.3.5 of Deloitte’s Roadmap Earnings per Share.
-
For freestanding equity-classified contracts that contain a down-round feature, an adjustment to income available to common stockholders is required when the down-round feature is triggered (see Section 6.1.5 of this Roadmap and Section 3.2.5.3 of Deloitte’s Roadmap Earnings per Share).
-
Modifications, exchanges, reclassifications, and settlements of equity-classified contracts on the entity’s own equity may cause the recognition of a dividend or expense. For further discussion, see Section 6.1.4 of this Roadmap and Sections 3.2.5.2, 3.2.6.4, and 3.2.6.5 of Deloitte’s Roadmap Earnings per Share.
7.1.1.2 Diluted EPS
Diluted EPS is a per-share performance measure under which it is assumed that (1) all dilutive potential common shares within an entity’s capital structure were outstanding during the reporting period and (2) net income was calculated by using a consistent assumption. Specifically, an entity makes various adjustments to the numerator and denominator in the calculation of basic EPS to reflect the impact of potential common shares.
Unless an exception applies (see discussion below), the treasury stock method of calculating diluted EPS applies to the following types of potential common shares if the effect is dilutive:
- Written call options (warrants) on common stock.
- Written call options (warrants) on convertible securities.
- Forward sale contracts on common stock.
- Forward sale contracts on convertible securities.
Under the treasury stock method, it is assumed that the proceeds that would be
received upon settlement are used to repurchase common shares at the average
market price for common stock during the period. Because the contract is
assumed to be classified as equity under the treasury stock method, the
entity must, in addition to adding the incremental shares to the
denominator, make a numerator adjustment if the contract is classified as an
asset or a liability under ASC 815-40, which would reverse the
mark-to-market adjustment net of any associated income tax effects. Special
considerations are necessary if the contract requires or permits net share
settlement or is subject to adjustments to the number of shares or to the
exercise price or forward price. For further discussion, see Section 4.2.2 of
Deloitte’s Roadmap Earnings per Share.
An entity should not apply the treasury stock method, however, if the contract
must be net cash settled (i.e., no common shares or potential common shares
would be issued upon settlement). Further, if a potential common share is a
participating security, an entity is required to use the more dilutive of
the treasury stock method or the two-class method of calculating diluted EPS
(see Section
5.5.4 of Deloitte’s Roadmap Earnings per Share).
Contracts that give the entity the right to purchase or sell
its common stock, such as purchased put options and purchased call options
on the entity’s own equity, are not included in the calculation of diluted
EPS because they would only be exercised when they are in-the-money and the
resulting effect would be antidilutive under the treasury stock method or
the reverse treasury stock method. For further discussion, see Section 4.1.1.1 of
Deloitte’s Roadmap Earnings per Share.
7.1.2 Disclosure
ASC 815-40
50-1A The disclosure guidance
in this Section should help a user of financial
statements understand the following:
-
Information about the terms and features of contracts in an entity’s own equity within the scope of this Subtopic
-
How those instruments have been reflected in the issuer’s statement of financial position and statement of financial performance
- Information about events, conditions, and circumstances that can affect how to assess the amount or timing of an entity’s future cash flows but has not yet been reflected in the financial statements.
50-2 The
disclosure guidance in this Subtopic applies to
freestanding instruments that are potentially indexed
to, and potentially settled in, an entity’s own equity,
regardless of whether the contract meets the criteria to
qualify for the scope exception in Sections 815-40-15
and 815-40-25. Some contracts that are classified as
assets or liabilities meet the definition of a
derivative instrument under the provisions of Subtopic
815-10. The related disclosures that are required by
Sections 815-10-50, 815-25-50, 815-30-50, and 815-35-50
also are required for those contracts. Equity-classified
contracts under the provisions of this Subtopic are not
required to provide the disclosures required by Section
505-10-50, other than those described in paragraph
815-40-50-5.
50-2A Changes in the fair value
of all contracts classified as assets or liabilities
shall be disclosed in the financial statements as long
as the contracts remain classified as assets or
liabilities.
Reclassifications and Related Accounting Policy Disclosures
50-3 Contracts within the scope of this Subtopic may be required to be reclassified into (or out of) equity during the life of the instrument (in whole or in part) pursuant to the provisions of paragraphs 815-40-35-8 through 35-13. An issuer shall disclose contract reclassifications (including partial reclassifications), the reason for the reclassification, and the effect on the issuer’s financial statements.
50-4 The determination of how to partially reclassify contracts subject to this Subtopic is an accounting policy decision that shall be disclosed pursuant to Topic 235.
50-5 The
disclosures required by Section 505-10-50 apply to all
contracts within the scope of this Subtopic as
follows:
-
In the case of an option or forward contract indexed to the issuer’s equity, the pertinent information to be disclosed under Section 505-10-50 about the contract includes all of the following:
-
The forward rate
-
The option strike price
-
The number of issuer’s shares to which the contract is indexed
-
The settlement date or dates of the contract
-
The issuer’s accounting for the contract (that is, as an asset, liability, or equity).
-
-
If the terms of the contract provide settlement alternatives, those settlement alternatives shall be disclosed under Section 505-10-50, including all of the following:
-
Who controls the settlement alternatives and a description of those alternatives
-
The maximum number of shares that could be required to be issued to net share settle a contract, if applicable. Paragraph 505-10-50-3 requires additional disclosures for actual issuances and settlements that occurred during the accounting period.
-
-
If a contract does not have a fixed or determinable maximum number of shares that may be required to be issued, the fact that a potentially infinite number of shares could be required to be issued to settle the contract shall be disclosed under Section 505-10-50.
-
For each settlement alternative, the amount that would be paid, or the number of shares that would be issued and their fair value, determined under the conditions specified in the contract if the settlement were to occur at the reporting date and how changes in the fair value of the issuer’s equity shares affect those settlement amounts (for example, the issuer is obligated to issue an additional X shares or pay an additional Y dollars in cash for each $1 decrease in the fair value of one share) shall be disclosed under Section 505-10-50. (For some issuers, a tabular format may provide the most concise and informative presentation of these data.)
-
The disclosures required by paragraph 505-10-50-11 shall be made for any equity instrument in the scope of this Subtopic that is (or would be if the issuer were a public entity) classified as temporary equity. (That paragraph applies to redeemable stock issued by nonpublic entities, regardless of whether the private entity chooses to classify those securities as temporary equity.)
- The disclosures required by paragraph 505-10-50-18 also shall be made for an equity-classified contract within the scope of this Subtopic that is entered into in connection with the issuance of convertible preferred stock.
Issuer’s Accounting
for Modifications or Exchanges of Freestanding
Equity-Classified Written Call Options
50-6 For a freestanding
equity-classified written call option modified or
exchanged during any of the periods presented and for
which an entity has recognized the effect in accordance
with paragraph 815-40-35-17, an entity shall disclose
the following:
-
Information about the nature of the modification or exchange transaction (see paragraph 815-40-35-15)
-
The amount of the effect of the modification or exchange (see paragraph 815-40-35-16)
-
The manner in which the effect of the modification or exchange has been recognized (see paragraph 815-40-35-17).
ASC 505-10
50-3 An entity shall
explain, in summary form within its financial
statements, the pertinent rights and privileges of the
various securities outstanding. Examples of information
that shall be disclosed are dividend and liquidation
preferences, participation rights, call prices and
dates, conversion or exercise prices or rates and
pertinent dates, sinking-fund requirements, unusual
voting rights, and significant terms of contracts to
issue additional shares or terms that may change
conversion or exercise prices (excluding standard
antidilution provisions). An entity shall disclose
within its financial statements the number of shares
issued upon conversion, exercise, or satisfaction of
required conditions during at least the most recent
annual fiscal period and any subsequent interim period
presented. An entity also shall disclose within the
financial statements actual changes to conversion or
exercise prices that occur during the reporting period
(excluding changes due to standard antidilution
provisions).
50-3A For a financial
instrument with a down round feature that has been
triggered during the reporting period and for which an
entity has recognized the effect in accordance with
paragraph 260-10-25-1, an entity shall disclose the
following:
-
The fact that the feature has been triggered
-
The value of the effect of the down round feature that has been triggered.
ASC 815-40 requires disclosure of the following for freestanding equity-linked
financial instruments:
-
Changes in the fair value of contracts on an entity’s own equity classified as assets or liabilities.
-
Information related to contracts on own equity reclassified into or out of equity (in whole or in part), such as:
-
Contract reclassifications (including partial reclassifications).
-
The reason for reclassifications.
-
The effect of reclassifications on the issuer’s financial statements.
-
The entity’s accounting policy for determining how to partially reclassify contracts.
-
-
Information related to modifications or exchanges of equity-classified written call options.
-
Information related to the entity’s capital structure, including:
-
For options or forwards indexed to the issuer’s equity, the forward rate, the option strike price, the number of underlying shares, the settlement date or dates, and the accounting for the contract (i.e., as an asset, a liability, or equity).
-
For contracts that contain settlement alternatives (e.g., physical, net share, or net cash), those settlement alternatives, which party controls the settlement alternatives (i.e., the entity or the counterparty), and the maximum number of shares that the entity could be required to deliver to net share settle the contract, if applicable.
-
If a contract could require the entity to issue a potentially infinite number of shares, that fact.
-
For each settlement alternative, the amount that would be paid, or the number of shares that would be issued and their fair value, determined under the conditions specified in the contract if the settlement were to occur on the reporting date, and how changes in the fair value of the issuer’s equity shares affect those settlement amounts.
-
ASC 505-10-50 requires disclosure of:
-
Contractual terms that might adjust conversion or exercise prices as well as actual changes to such prices that occurred during the reporting period. An entity should therefore disclose contractual adjustments that are subject to evaluation under the indexation guidance in ASC 815-40-15 (see Chapter 4). However, disclosure is not required for standard antidilution provisions (see Section 5.5 for the definition of such provisions).
-
Information about financial instruments with down-round features that have been triggered during the reporting period, including the fact that the feature was triggered and the value of the feature’s effect (see Sections 4.3.7.2 and 6.1.5).
An entity should also consider disclosure requirements in other
Codification topics and subtopics that may be applicable to freestanding
equity-linked financial instruments. For example, contracts on own equity that
must be accounted for as derivatives under ASC 815-10 or ASC 815-15 are subject
to any applicable disclosure requirements in ASC 815-10, ASC 815-15, ASC 815-25,
ASC 815-30, and ASC 815-35. Further, freestanding equity-linked financial
instruments that are accounted for at fair value under ASC 815-40 are subject to
disclosures about fair value measurements under ASC 820.
The disclosure requirements in ASC 815-40 discussed above do not
apply to embedded equity-linked financial instruments. Rather, the disclosure
guidance in ASC 470-20, ASC 505-10, and ASC 815 applies to embedded
equity-linked derivatives in hybrid contracts.
ASC 470-20
50-2A An entity that enters into a share-lending arrangement on its own shares in contemplation of a convertible debt offering or other financing shall disclose all of the following. The disclosures must be made on an annual and interim basis in any period in which a share-lending arrangement is outstanding.
- A description of any outstanding share-lending arrangements on the entity’s own stock
- All significant terms of the share-lending arrangement including all of the following:
- The number of shares
- The term
- The circumstances under which cash settlement would be required
- Any requirements for the counterparty to provide collateral.
- The entity’s reason for entering into the share-lending arrangement
- The fair value of the outstanding loaned shares as of the balance sheet date
- The treatment of the share-lending arrangement for the purposes of calculating earnings per share
- The unamortized amount of the issuance costs associated with the share-lending arrangement at the balance sheet date
- The classification of the issuance costs associated with the share-lending arrangement at the balance sheet date
- The amount of interest cost recognized relating to the amortization of the issuance cost associated with the share-lending arrangement for the reporting period
- Any amounts of dividends paid related to the loaned shares that will not be reimbursed.
50-2B An entity that enters into a share-lending arrangement on its own shares in contemplation of a
convertible debt offering or other financing shall also make the disclosures required by Topic 505.
50-2C In the period in which
an entity concludes that it is probable that the
counterparty to its share-lending arrangement will
default, the entity shall disclose the amount of expense
reported in the statement of earnings related to the
default. The entity shall disclose in any subsequent
period any material changes in the amount of expense as
a result of changes in the fair value of the entity’s
shares or the probable recoveries. If default is
probable but has not yet occurred, the entity shall
disclose the number of shares related to the
share-lending arrangement that will be reflected in
basic and diluted earnings per share when the
counterparty defaults.
ASC 470-20-50-2A through 50-2C include incremental disclosure requirements related to own-share lending arrangements executed in contemplation of a convertible debt offering or other financing (see Section 2.9).
7.2 SEC Requirements
SEC registrants should consider any applicable disclosure requirements issued by the SEC. For example, Regulation S-X, Rule 4-08 (reproduced in ASC 235-10-S99-1), requires disclosure of warrants or rights outstanding as of the balance sheet date, including:
- Title of issue of securities called for by warrants or rights.
- Aggregate amount of securities called for by warrants or rights outstanding.
- Date from which warrants or rights are exercisable.
- Price at which warrants or rights are exercisable.
The temporary-equity disclosures required by SEC registrants must be
provided for any freestanding equity-linked instrument that is classified in
temporary equity. See further discussion in Chapters 5 and 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Further, SEC Regulation S-K requires registrants to disclose in MD&A certain
information about off-balance-sheet arrangements (including equity-classified
contracts on own equity).
Chapter 8 — Differences Between U.S. GAAP and IFRS Accounting Standards
Chapter 8 — Differences Between U.S. GAAP and IFRS Accounting Standards
8.1 Background
8.1.1 IFRS Guidance
Under IFRS Accounting Standards, an entity evaluates contracts on its own equity
(including equity features embedded in other contracts) in accordance with IAS
32 to determine whether they qualify for equity classification or must be
classified as assets or liabilities.
IAS 32 has a broader scope than does ASC 815-40. For example, IAS 32 contains
guidance on forward repurchase contracts and
written put options on an entity’s shares. Under
U.S. GAAP, freestanding forward repurchase
contracts and freestanding written put options on
an entity’s shares are outside the scope of ASC
815-40. The discussion of key differences below
applies only to contracts within the scope of ASC
815-40, not to freestanding forward purchase
contracts or written put options on the entity’s
shares that are within the scope of ASC 480 (both
IAS 32 and ASC 480 require such contracts to be
classified as liabilities, but the measurement
guidance differs).
8.1.2 Key Differences
The table below summarizes key differences between U.S. GAAP and IFRS Accounting
Standards in the accounting for contracts on own equity that are within the
scope of ASC 815-40. The table is followed by a detailed explanation of each
difference.
U.S. GAAP | IFRS Accounting Standards | |
---|---|---|
Exercise contingencies | Exercise contingencies must be evaluated to determine whether they preclude equity classification. | Not addressed by IAS 32. In practice, exercise contingencies that would preclude
equity classification under U.S. GAAP may not do so
under IFRS Accounting Standards. |
Settlement amount | To qualify as equity, the contract must be a fixed-for-fixed forward or option on equity shares, or the only variables that can adjust the settlement amount are inputs to a fixed-for-fixed forward or option. | A contract must be fixed for fixed to qualify as equity. Unlike U.S. GAAP, IAS 32 does not provide detailed guidance on contracts with adjustment provisions (e.g., antidilution provisions). |
Strike price denominated in foreign currency | Preclude equity classification. | Preclude equity classification with one exception. Certain contracts offered on a pro rata basis to holders of the entity’s shares can qualify as equity even if the strike price is denominated in a foreign currency. |
Net cash settlement provisions | Do not preclude equity classification if the entity cannot be forced to net cash settle the contract. Contain detailed guidance on how to assess whether an entity is able to settle in shares (e.g., whether the entity has sufficient authorized and unissued shares available to share settle the contract). | Preclude equity classification. Unlike U.S. GAAP, IFRS Accounting Standards do
not contain detailed guidance on how to evaluate whether
an entity might be required to net cash settle a
contract that specifies share settlement. |
Net share settlement provisions | Do not preclude equity classification if the entity cannot be forced to net cash settle the contract. | Preclude equity classification. |
Settlement alternatives | Do not preclude equity classification if the entity cannot be forced to net cash settle the contract. | Preclude equity classification (unless all settlement alternatives are consistent with equity classification). |
Embedded equity-linked features that do not qualify as equity | Not separated as embedded derivatives if they do not meet the net settlement
characteristic in the definition of a
derivative. | May be required to be separated as embedded derivatives even if they do not meet
the net settlement characteristic. |
Embedded equity-linked features that qualify as equity | Not separated from liabilities except in specified circumstances. | Separated from liabilities. |
8.2 Indexation Guidance
8.2.1 Exercise Contingencies
Under U.S. GAAP, exercise contingencies preclude equity classification if they
are based on an observable market other than the market for the issuer’s stock
or an observable index other than one calculated or measured solely by reference
to the issuer’s own operations (see Section 4.2). IFRS Accounting Standards do not
contain requirements for exercise contingencies like those in ASC 815-40-15.
Therefore, exercise contingencies that would have precluded a contract from
being classified as equity under U.S. GAAP (e.g., an option contract that can be
exercised only if the S&P 500 reaches a certain level) would not disqualify
a contract from equity classification under IFRS Accounting Standards.
8.2.2 Fixed-for-Fixed Requirement
Under paragraph 22 of IAS 32, “a contract that will be settled by the entity
(receiving or) delivering a fixed number of its
own equity instruments in exchange for a fixed
amount of cash or another financial asset is an
equity instrument” unless the equity instruments
to be received or delivered are equity-classified
puttable instruments. Accordingly, a contract must
provide for the exchange of a fixed number of
equity instruments for a fixed monetary amount of
cash or other assets to qualify as equity under
IFRS Accounting Standards. This guidance is
comparable to the requirement under ASC 815-40-15
that to qualify as equity, a contract on an
entity’s own equity must be a fixed-for-fixed
forward or option on equity shares, or the only
variables that could adjust the settlement amount
must be inputs to a fixed-for-fixed forward or
option (see Section 4.3).
However, unlike ASC 815-40, IAS 32 does not
provide detailed guidance on determining whether a
contract should be considered fixed for fixed when
it contains adjustments to the settlement amount
(e.g., antidilution provisions). In practice,
certain adjustments are viewed as acceptable under
IAS 32 (e.g., when the purpose is to give the
counterparty the same protection from a dilutive
event as holders of the underlying shares
have).
8.2.3 Foreign Currency Provisions
To meet the fixed-for-fixed requirement under IAS 32, the monetary amount must
be specified in the issuing entity’s functional
currency; however, there is one exception.
Paragraph 11 of IAS 32 states that “rights,
options or warrants to acquire a fixed number of
the entity’s own equity instruments for a fixed
amount of any currency are equity instruments if
the entity offers the rights, options or warrants
pro rata to all of its existing owners of the same
class of its own non-derivative equity
instruments.”
Under U.S. GAAP, there is no such exception. An equity-linked financial instrument (or embedded feature) is not considered indexed to the entity’s own stock if the strike price is denominated in a currency other than the issuer’s functional currency (see Section 4.3.8).
8.3 Classification Guidance
8.3.1 Net Cash Settlement Provisions
Like ASC 815-40, IAS 32 does not permit equity classification for contracts that the entity could be forced to net cash settle. IAS 32 precludes equity classification for any contract that permits the entity to net cash settle or could require the entity to deliver cash or another financial asset or otherwise to settle the contract in such a manner that it would be a financial liability under IAS 32 (e.g., a contract that is net share settled).
Unlike ASC 815-40-25, IFRS Accounting Standards do not provide detailed guidance
on how an entity should evaluate whether it could be forced to net cash settle a
contract (e.g., a contract that requires or permits physical settlement in
shares when the issuer does not have sufficient authorized and unissued shares
to settle the contract in shares; see Chapter 5). Therefore, it is possible that
practitioners might reach different conclusions under ASC 815-40 and IAS 32
regarding whether a contract that specifies physical settlement qualifies as
equity when any of the equity classification conditions in ASC 815-40-25 are not
met.
8.3.2 Net Share Settlement Provisions
Unlike under ASC 815-40, contracts on own equity that require or permit the
issuer to net share settle do not qualify as equity under IAS 32. Only contracts
that require physical settlement could qualify for equity classification under
IFRS Accounting Standards.
8.3.3 Settlement Alternatives
If a contract gives either party a choice about how the contract is settled, IAS 32 requires the contract to be classified as an asset or a liability unless all the settlement alternatives would result in its being an equity instrument. Unlike ASC 815-40, IAS 32 precludes equity classification for contracts that permit the issuer to net cash settle or net share settle, even if the issuer could not be forced to settle in such a manner.
8.4 Embedded Features
8.4.1 Separation of Embedded Derivatives
While both U.S. GAAP and IFRS Accounting Standards contain requirements about
separation of embedded derivatives, they define a
derivative differently. Unlike that under ASC 815,
the definition of a derivative under IFRS
Accounting Standards does not include a
requirement for net settlement. Therefore, the
accounting for an equity-linked feature that is
embedded in a host liability and does not qualify
as equity under IAS 32 and ASC 815-40 may differ
depending on whether the feature meets the net
settlement characteristic in the definition of a
derivative under ASC 815. If the liability is not
accounted for at fair value with changes in fair
value recognized in net income, an embedded
feature that neither qualifies as equity nor meets
the net settlement characteristic (e.g., because
it involves physical settlement in private company
stock) would be separated from its host contract
and accounted for as a derivative at fair value
under IFRS Accounting Standards but not under U.S.
GAAP.
8.4.2 Separation of Equity Components
Under IFRS Accounting Standards, if a liability contains a component that
qualifies as equity in IAS 32 (e.g., an equity conversion feature embedded in a
debt security), that component is always required to be separately recognized in
equity by the issuer. Under U.S. GAAP, allocation of an amount to equity is
generally precluded when the embedded feature qualifies as equity under ASC
815-40.
Appendix A — Overview of Examples in ASC 815-40-55
Appendix A — Overview of Examples in ASC 815-40-55
ASC 815-40-55-26 through 55-48 contain 20 examples (numbered from 2 to 21) of the application of the guidance on indexation in ASC 815-40-15. The table below gives an overview of those examples. Chapter 4 discusses related accounting considerations.
Example Number (ASC Paragraph) | Contract
Type | Step 1: Exercise
Contingency? | Step 2: Settlement Adjustments? | Indexed
to Own
Equity? |
---|---|---|---|---|
2 (ASC 815-40-55-26) | Warrant | Yes. IPO. | No | Yes |
3 (ASC 815-40-55-27) | Warrant | Yes. $100 million
in sales to third
parties. | No | Yes |
4 (ASC 815-40-55-28) | Warrant | Yes. Increase of 500
points in S&P 500. | No | No |
5 (ASC 815-40-55-29) | Warrant | Yes. IPO. | Yes. The strike price varies on the
basis of the price of gold. | No |
6 (ASC 815-40-55-30) | Warrant | No | Yes. Adjustment to offset effect of
merger announcement. | Yes |
7 (ASC 815-40-55-31) | Warrant | No | Yes. The strike price is reduced
by $0.50 after any year in which
revenue does not exceed $100
million. | No |
8 (ASC 815-40-55-32) | Option | No | Yes. The share price is capped. | Yes |
9 (ASC 815-40-55-33 and 55-34) | Warrant | No | Yes. Down-round protection. | Yes |
10 (ASC 815-40-55-35) | Warrant | No | Yes. Investor put option settleable
in shares and for a fixed monetary
amount if regulatory approval of a
drug compound is not obtained. | No |
11 (ASC 815-40-55-36) | Warrant | No | Yes. The strike price is denominated
in a currency other than the entity’s
functional currency. | No |
12 (ASC 815-40-55-37) | Forward | No | Yes. The strike price is adjusted if
dividends differ from expectations or
the cost of stock borrow increases. | Yes |
13 (ASC 815-40-55-38) | Forward | No | Yes. The strike price includes
interest that varies on the basis of
the Federal Funds rate plus a fixed
spread. The share price is specified
as a 30-day weighted average. | Yes |
14 (ASC 815-40-55-39) | Forward | No | Yes. The strike price includes interest
that varies inversely with changes in
LIBOR. | No |
15 (ASC 815-40-55-40) | Forward | No | Yes. The share price is subject to
both a floor and a cap. | Yes |
16 (ASC 815-40-55-41) | Forward | No | Yes. The number of shares depends
on the stock price. | Yes |
17 (ASC 815-40-55-42
and 55-43) | Forward | No | Yes. The strike price is subject to
antidilution adjustments (related
to stock dividend, ordinary cash
dividend, stock split, spinoff, rights
offering, recapitalization through a
large nonrecurring cash dividend,
below-market price issue of shares,
or above-market price repurchase of
shares). | Yes |
18 (ASC 815-40-55-44) | Forward | No | Yes. The strike price is denominated
in a currency other than the entity’s
functional currency. | No |
19 (ASC 815-40-55-45
and 55-46) | Convertible
debt | Yes. The debt
is convertible
contingent on
the entity’s stock
price (market
price trigger), the
debt’s trading price
(parity provision),
or a merger
announcement. | Yes. Additional make-whole shares
may be delivered on the basis of a
table with axes of stock price and
time (see Section 4.3.7.10). | Yes |
20 (ASC 815-40-55-47) | Convertible
debt | No | No. The debt is denominated in the
entity’s functional currency. (The
shares trade only on an exchange in
which trades are denominated in a
foreign currency.) | Yes |
21 (ASC 815-40-55-48) | Stock option
valuation
instrument | Maybe | Yes. Payments vary on the basis
of stock option exercise
behavior. | No |
Appendix B — Checklists for Determining Whether Freestanding Contracts or Embedded Features Qualify as Equity
Appendix B — Checklists for Determining Whether Freestanding Contracts or Embedded Features Qualify as Equity
The three checklists in this appendix are intended to help a practitioner determine whether the following types of contracts or features qualify as equity under ASC 815-40:
- Freestanding contracts.
- Features embedded in hybrid contracts other than certain types of convertible debt.
- Features embedded in certain types of convertible debt.
B.1 Freestanding Contracts
A freestanding contract is classified as equity under ASC 815-40 only if it meets all the requirements outlined in the table below. In determining whether those requirements are met, an entity:
- Does not consider the contingent obligation to transfer consideration under a registration payment arrangement even if it is embedded in the contract (see Section 3.2.4).
- Disregards any uneconomic settlement alternatives (see Section 5.2.5).
√ If Met
| Requirement
| Roadmap
Discussion |
---|---|---|
|
Within the Scope of ASC 815-40
| |
The contract is not required to be classified as a liability under ASC 480. | ||
If the contract was originally issued to a grantee in a share-based payment
arrangement that is within the scope of ASC 718, it becomes
subject to ASC 815-40. | ||
The contract is not a lock-up option. | ||
If the contract is on the equity shares of a subsidiary, the subsidiary is a consolidated, substantive entity. | ||
The contract does not represent the combination of a written put option and a purchased call option embedded in the shares of a noncontrolling interest. | ||
|
Indexed to the Entity’s Own Equity
| |
If the contract contains an exercise contingency that is based on an observable market, it is the market for the issuer’s stock. | ||
If the contract contains an exercise contingency that is based on an observable index, it is an index calculated or measured solely by reference to the entity’s own operations (e.g., sales revenue, EBITDA, net income, or total equity). | ||
If the settlement amount is adjusted in response to changes in an explicit input, that input is not extraneous but rather an input in the pricing of a fixed-for-fixed forward or option on the entity’s equity shares. | ||
If the settlement amount is adjusted in response to changes in an explicit input (other than the entity’s stock price), the adjustment is not inconsistent with how a change in the input would affect the pricing of a fixed-for-fixed forward or option on the entity’s equity shares (e.g., it is not leveraged). | ||
If the settlement amount is adjusted in response to changes in an explicit or an implicit input (other than the entity’s stock price), the change in the input cannot result in a settlement at a fixed monetary amount. | ||
If the settlement amount is adjusted in response to the occurrence or
nonoccurrence of a specified event, the event invalidates an
implicit assumption used in the pricing of a fixed-for-fixed
forward or option on the entity’s equity shares (e.g., no
dilutive event) or the adjustment is triggered by a
down-round feature. | ||
If the settlement amount is adjusted in response to an implicit input, the adjustment is consistent with the effect that the occurrence or nonoccurrence of the event had on the fair value of the instrument. | ||
The contract otherwise is a fixed-for-fixed forward or option on the entity’s equity shares. | ||
|
Equity Classification Conditions
|
|
The only circumstance (if any) in which the entity could be forced to net cash settle the contract is:
| ||
The economic substance of the contract is not that of an asset or a liability because:
(Note that this requirement does not apply if the reason for the difference is to limit the number of shares that must be delivered in a net share settlement.) | ||
If the settlement alternatives differ in gain and loss positions, the contract:
| ||
If the entity does not have sufficient authorized and unissued shares
available to share settle the contract and all other contracts that may
require share settlement during the contract period, the entity has the
ability to increase the number of authorized shares without shareholder
approval. | ||
The contract contains an explicit share limit. | ||
The contract does not require net cash settlement if the entity fails to timely
file. | ||
If the contract includes a top-off or make-whole provision, it:
|
B.2 Features Embedded in Hybrid Contracts Other Than Certain Types of Convertible Debt
An embedded feature other than one embedded in certain types of convertible debt (see
Section 5.5) qualifies as
equity under ASC 815-40 only if it meets all the requirements outlined in the table
below. In determining whether those requirements are met, an entity:
-
Does not consider the contingent obligation to transfer consideration under a registration payment arrangement even if it is embedded in the contract (see Section 3.2.4).
-
Disregards any uneconomic settlement alternatives (see Section 5.2.5).
√ If Met | Requirement | Roadmap
Discussion |
---|---|---|
|
Within the Scope of ASC 815-40
|
|
If the contract was originally issued to a grantee in a
share-based payment arrangement that is within the scope of
ASC 718, it becomes subject to ASC 815-40.
| ||
The embedded feature is not a lock-up option. | ||
If the embedded feature is on the equity shares of a subsidiary, the subsidiary
is a consolidated, substantive entity. | ||
The embedded feature does not involve the combination of a written put option
and a purchased call option embedded in the shares of a
noncontrolling interest. | ||
|
Indexed to the Entity’s Own Equity
|
|
If the embedded feature contains an exercise contingency that is based on an
observable market, it is the market for the issuer’s
stock. | ||
If the embedded feature contains an exercise contingency that is based on an
observable index, it is an index calculated or measured
solely by reference to the entity’s own operations (e.g.,
sales revenue, EBITDA, net income, or total equity). | ||
If the settlement amount is adjusted in response to changes in an explicit input, that input is not extraneous but rather an input in the pricing of a fixed-for-fixed forward or option on the entity’s equity shares. | ||
If the settlement amount is adjusted in response to changes in an explicit input (other than the entity’s stock price), the adjustment is not inconsistent with how a change in the input would affect the pricing of a fixed-for-fixed forward or option on the entity’s equity shares (e.g., it is not leveraged). | ||
If the settlement amount is adjusted in response to changes in an explicit or an implicit input (other than the entity’s stock price), the change in the input cannot result in a settlement at a fixed monetary amount. | ||
If the settlement amount is adjusted in response to the occurrence or
nonoccurrence of a specified event, the event invalidates an
implicit assumption used in the pricing of a fixed-for-fixed
forward or option on the entity’s equity shares (e.g., no
dilutive event) or the adjustment is triggered by a
down-round feature. | ||
If the settlement amount is adjusted in response to an implicit input, the adjustment is consistent with the impact that the occurrence or nonoccurrence of the event had on the fair value of the instrument. | ||
The embedded feature otherwise is a fixed-for-fixed forward or option on the
entity’s equity shares. | ||
|
Equity Classification Conditions
|
|
The only circumstance (if any) in which the entity could be forced to net cash
settle the embedded feature is:
| ||
The economic substance of the embedded feature is not that of an asset or a
liability because:
(Note that this requirement does not apply if the reason for the difference is to limit the number of shares that must be delivered in a net share settlement.) | ||
If the settlement alternatives differ in gain and loss positions, the embedded
feature:
| ||
If the entity does not have sufficient authorized and unissued shares available to share settle the contract and all other contracts that may require share settlement during the contract period, the entity has the ability to increase the number of authorized shares without shareholder approval. | ||
The embedded feature contains an explicit share limit. | ||
The embedded feature does not require net cash settlement if the entity fails to
timely file. | ||
If the embedded feature includes a top-off or make-whole provision, it:
|
B.3 Features Embedded in Certain Types of Convertible Debt
A feature embedded in certain types of convertible debt (see Section 5.5) qualifies as equity
under ASC 815-40 only if it meets all the requirements specified in the table below.
In determining whether those requirements are met, an entity:
-
Does not consider the contingent obligation to transfer consideration under a registration payment arrangement even if it is embedded in the contract (see Section 3.2.4).
-
Disregards any uneconomic settlement alternatives (see Section 5.2.5).
√ If Met | Requirement | Roadmap
Discussion |
---|---|---|
|
Within the Scope of ASC 815-40
|
|
If the contract was originally issued to a grantee in a
share-based payment arrangement that is within the scope of
ASC 718, it becomes subject to ASC 815-40.
| ||
The embedded feature is not a lock-up option. | ||
If the embedded feature is on the equity shares of a subsidiary, the subsidiary
is a consolidated, substantive entity. | ||
The embedded feature does not involve the combination of a written put option
and a purchased call option embedded in the shares of a
noncontrolling interest. | ||
Indexed to the Entity’s Own Equity
| ||
If the embedded feature contains an exercise contingency that is based on an
observable market, it is the market for the issuer’s
stock. | ||
If the embedded feature contains an exercise contingency that is based on an
observable index, it is an index calculated or measured
solely by reference to the entity’s own operations (e.g.,
sales revenue, EBITDA, net income, or total equity). | ||
If the settlement amount is adjusted in response to changes in an explicit input, that input is not extraneous but rather an input in the pricing of a fixed-for-fixed forward or option on the entity’s equity shares. | ||
If the settlement amount is adjusted in response to changes in an explicit input (other than the entity’s stock price), the adjustment is not inconsistent with how a change in the input would affect the pricing of a fixed-for-fixed forward or option on the entity’s equity shares (e.g., it is not leveraged). | ||
If the settlement amount is adjusted in response to changes in an explicit or an implicit input (other than the entity’s stock price), the change in the input cannot result in a settlement at a fixed monetary amount. | ||
If the settlement amount is adjusted in response to the occurrence or
nonoccurrence of a specified event, the event invalidates an
implicit assumption used in the pricing of a fixed-for-fixed
forward or option on the entity’s equity shares (e.g., no
dilutive event) or the adjustment is triggered by a
down-round feature. | ||
If the settlement amount is adjusted in response to an implicit input, the adjustment is consistent with the impact that the occurrence or nonoccurrence of the event had on the fair value of the instrument. | ||
The embedded feature otherwise is a fixed-for-fixed forward or option on the
entity’s equity shares. | ||
|
Equity Classification Conditions
|
|
The only circumstance (if any) in which the entity could be forced to net cash
settle the embedded feature is:
| ||
The economic substance of the embedded feature is not that of an asset or a
liability because:
(Note that this requirement does not apply if the reason for the difference is to limit the number of shares that must be delivered in a net share settlement.) | ||
If the settlement alternatives differ in gain and loss positions, the embedded
feature:
|
Appendix C — Glossary of Selected Terms
Appendix C — Glossary of Selected Terms
Selected terms from the ASC master glossary are included below.
ASC Master Glossary
Antidilution
An increase in earnings per share amounts or a decrease in loss per share amounts.
Cashless Exercise
See Net Share Settlement.
Common Stock
A stock that is subordinate to all other stock of the issuer. Also called common shares.
Consolidated Financial Statements
The financial statements of a consolidated group of entities that include a parent and all its subsidiaries presented as those of a single economic entity.
Consolidated Group
A parent and all its subsidiaries.
Consolidation
The presentation of a single set of amounts for an entire reporting entity. Consolidation requires elimination of intra-entity transactions and balances.
Contingent Consideration
Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
Conversion Rate
The ratio of the number of common shares issuable upon conversion to a unit of a convertible security. For example, $100 face value of debt convertible into 5 shares of common stock would have a conversion ratio of 5:1. Also called conversion ratio.
Convertible Security
A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred).
Derivative Instrument
Paragraphs 815-10-15-83 through 15-139 define the term derivative instrument.
Dilution
A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon the satisfaction of certain conditions.
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.
Earnings per Share
The amount of earnings attributable to each share of common stock. For convenience, the term is used to refer to either earnings or loss per share.
Embedded Derivative
Implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.
Equity Restructuring
A nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying an option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend.
Equity Shares
Equity shares refers only to shares that are accounted for as equity.
Exercise Contingency
A provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity’s (or the counterparty’s) ability to exercise an instrument and provisions that extend the length of time that an instrument is exercisable are examples of exercise contingencies.
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.
Financial Instrument
Cash, evidence of an ownership interest in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.
Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements — that is, they may be off-balance-sheet — because they fail to meet some other criterion for recognition.
For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity.
Firm Commitment
An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
- The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
- The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.
Foreign Currency
A currency other than the functional currency of the entity being referred to (for example, the dollar could be a foreign currency for a foreign entity). Composites of currencies, such as the Special Drawing Rights, used to set prices or denominate amounts of loans, and so forth, have the characteristics of foreign currency.
Freestanding Contract
A freestanding contract is entered into either:
- Separate and apart from any of the entity’s other financial instruments or equity transactions
- In conjunction with some other transaction and is legally detachable and separately exercisable.
Freestanding Financial Instrument
A financial instrument that meets either of the following
conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Functional Currency
An entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. (See paragraphs 830-10-45-2 through 830-10-45-6 and 830-10-55-3 through 830-10-55-7.)
Hybrid Instrument
A contract that embodies both an embedded derivative and a host contract.
Intrinsic Value
The amount by which the fair value of the underlying stock
exceeds the exercise price of an option. For example, an
option with an exercise price of $20 on a stock whose
current market price is $25 has an intrinsic value of $5. (A
nonvested share may be described as an option on that share
with an exercise price of zero. Thus, the fair value of a
share is the same as the intrinsic value of such an option
on that share.)
Liquidation
The process by which an entity converts its assets to cash or other assets and settles its obligations with creditors in anticipation of the entity ceasing all activities. Upon cessation of the entity’s activities, any remaining cash or other assets are distributed to the entity’s investors or other claimants (albeit sometimes indirectly). Liquidation may be compulsory or voluntary. Dissolution of an entity as a result of that entity being acquired by another entity or merged into another entity in its entirety and with the expectation of continuing its business does not qualify as liquidation.
Lock-Up Options
Contingently exercisable options to purchase equity securities of another party to a business combination, at favorable prices, to encourage successful completion of that combination. If the merger is consummated as proposed, the options expire unexercised. If, however, a specified event occurs that interferes with the planned business combination, the options become exercisable.
Make-Whole Provision
A cash payment to a counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due. While the exact terms of such provisions vary, they generally are intended to reimburse the counterparty for any losses it incurs or to transfer to the entity any gains the counterparty recognizes on the difference between the following:
- The settlement date value
- The value received by the counterparty in subsequent sales of the securities within a specified time after the settlement date.
Management
Persons who are responsible for achieving the objectives of the entity and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice presidents in charge of principal business functions (such as sales, administration, or finance), and other persons who perform similar policy making functions. Persons without formal titles also may be members of management.
Market Participants
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
- They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms
- They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary
- They are able to enter into a transaction for the asset or liability
- They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.
Modification
A change in the terms or conditions of a share-based payment
award.
Net Cash Settlement
The party with a loss delivers to the party with a gain a cash payment equal to the gain, and no shares are exchanged.
Net Share Settlement
The party with a loss delivers to the party with a gain shares with a current fair value equal to the gain.
Noncontrolling Interest
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.
Notional Amount
A number of currency units, shares, bushels, pounds, or other units specified in a derivative instrument. Sometimes other names are used. For example, the notional amount is called a face amount in some contracts.
Orderly Transaction
A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
Parent
An entity that has a controlling financial interest in one or more subsidiaries. (Also, an entity that is the primary beneficiary of a variable interest entity.)
Physical Settlement
The party designated in the contract as the buyer delivers the full stated amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer.
Preferred Stock
A security that has preferential rights compared to common stock.
Probable
The future event or events are likely to occur.
Public Business Entity
A public business entity is a business entity meeting any one
of the criteria below. Neither a not-for-profit entity nor
an employee benefit plan is a business entity.
-
It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
-
It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
-
It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
-
It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
-
It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity
solely because its financial statements or financial
information is included in another entity’s filing with the
SEC. In that case, the entity is only a public business
entity for purposes of financial statements that are filed
or furnished with the SEC.
Registration Payment Arrangement
An arrangement with both of the following characteristics:
- It specifies that the issuer will endeavor to do either of the following:
- File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period.
- Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
- It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).
Related Parties
Related parties include:
- Affiliates of the entity
- Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
- Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
- Principal owners of the entity and members of their immediate families
- Management of the entity and members of their immediate families
- Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
- Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
Securities and Exchange Commission (SEC) Filer
An entity that is required to file or furnish its financial
statements with either of the following:
-
The Securities and Exchange Commission (SEC)
-
With respect to an entity subject to Section 12(i) of the Securities Exchange Act of 1934, as amended, the appropriate agency under that Section.
Financial statements for other entities that are not
otherwise SEC filers whose financial statements are included
in a submission by another SEC filer are not included within
this definition.
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
Also called share-based compensation arrangements.
Shares
Shares includes various forms of ownership that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. (Business entities have interest holders that are commonly known by specialized names, such as stockholders, partners, and proprietors, and by more general names, such as investors, but all are encompassed by the descriptive term owners. Equity of business entities is, thus, commonly known by several names, such as owners’ equity, stockholders’ equity, ownership, equity capital, partners’ capital, and proprietorship. Some entities [for example, mutual organizations] do not have stockholders, partners, or proprietors in the usual sense of those terms but do have participants whose interests are essentially ownership interests, residual interests, or both.)
Standard Antidilution Provisions
Standard antidilution provisions are those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction that are designed to maintain the value of the conversion option.
Stock Dividend
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. A stock dividend takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation’s property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same.
Stock Split
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, of obtaining wider distribution and improved marketability of the shares. Sometimes called a stock split-up.
Subsidiary
An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.)
Top-Off Provision
See Make-Whole Provision.
Transaction
An external event involving transfer of something of value (future economic benefit) between two (or more) entities. (See FASB Concepts Statement No. 6, Elements of Financial Statements.)
Underlying
A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument.
Volatility
A measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility also may be defined as a probability-weighted measure of the dispersion of returns about the mean. The volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period. That is the same as the standard deviation of the differences in the natural logarithms of the stock prices plus dividends, if any, over the period. The higher the volatility, the more the returns on the shares can be expected to vary — up or down. Volatility is typically expressed in annualized terms.
Warrant
A security that gives the holder the right to purchase shares of common stock in accordance with the terms of the instrument, usually upon payment of a specified amount.
Appendix D — Titles of Standards and Other Literature
Appendix D — Titles of Standards and Other Literature
AICPA Literature
Technical Questions and Answers
Section 4110, “Issuance of Capital Stock”
FASB Literature
ASC Topics
ASC 235, Notes to
Financial Statements
ASC 260, Earnings per
Share
ASC 340, Other Assets and Deferred Costs
ASC 460,
Guarantees
ASC 470, Debt
ASC 480, Distinguishing
Liabilities From Equity
ASC 505, Equity
ASC 606, Revenue From
Contracts With Customers
ASC 718, Compensation —
Stock Compensation
ASC 740, Income
Taxes
ASC 805, Business
Combinations
ASC 810,
Consolidation
ASC 815, Derivatives and
Hedging
ASC 820, Fair Value
Measurement
ASC 825, Financial
Instruments
ASC 830, Foreign Currency
Matters
ASC 835, Interest
ASC 850, Related Party
Disclosures
ASUs
ASU 2019-08, Compensation — Stock
Compensation (Topic 718) and Revenue From Contracts With Customers
(Topic 606): Codification Improvements — Share-Based Consideration
Payable to a Customer
ASU 2020-06, Debt — Debt
With Conversion and Other Options (Subtopic 470-20) and Derivatives and
Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting
for Convertible Instruments and Contracts in an Entity’s Own
Equity
ASU 2021-04, Earnings per
Share (Topic 260), Debt — Modifications and Extinguishments (Subtopic
470-50), Compensation — Stock Compensation (Topic 718), and Derivatives
and Hedging — Contracts in Entity’s Own Equity: Issuer’s Accounting for
Certain Modifications or Exchanges of Freestanding Equity-Classified
Written Call Options — a consensus of the FASB Emerging Issues Task
Force
Concepts Statement
No. 6, Elements of
Financial Statements
IFRS Literature
IFRS Standard
IAS 32, Financial
Instruments: Presentation
ISDA Literature
2002 ISDA Equity
Derivatives Definitions
SEC Literature
Regulation S-X
Rule 4-08, “General Notes to
Financial Statements”
SAB Topics
No. 2.A, “Business Combinations; Acquisition
Method”
No. 5.A, “Miscellaneous Accounting; Expenses
of Offering”
Superseded Literature
EITF Abstract
Issue No. 00-19, “Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in,
a Company’s Own Stock”
Appendix E — Abbreviations
Appendix E — Abbreviations
Abbreviation
|
Description
|
---|---|
AICPA
|
American Institute of Certified Public
Accountants
|
APIC
|
additional paid-in capital
|
ASC
|
FASB Accounting Standards Codification
|
ASR
|
accelerated share repurchase
|
ASU
|
FASB Accounting Standards Update
|
BRRD
|
Bank Recovery and Resolution Directive
|
CAD
|
Canadian dollars
|
CEO
|
chief executive officer
|
CNY
|
Chinese yuan
|
CPI
|
consumer price index
|
EBITDA
|
earnings before interest, taxes,
depreciation, and amortization
|
EITF
|
Emerging Issues Task Force
|
EPS
|
earnings per share
|
EU
|
European Union
|
EUR
|
euro
|
FASB
|
Financial Accounting Standards Board
|
FDA
|
U.S. Food & Drug Administration
|
GAAP
|
generally accepted accounting principles
|
IAS
|
International Accounting Standard
|
IFRS
|
International Financial Reporting
Standard
|
IPO
|
initial public offering
|
ISDA
|
International Swaps and Derivatives
Association Inc.
|
LIBOR
|
London Interbank Offered Rate
|
MD&A
|
Management’s Discussion and Analysis
|
OCA
|
SEC Office of the Chief Accountant
|
PCAOB
|
Public Company Accounting Oversight
Board
|
SAB
|
SEC Staff Accounting Bulletin
|
S&P 500
Index
|
Standard and Poor’s 500 stock market
index
|
SEC
|
U.S. Securities and Exchange Commission
|
SEPA
|
standby equity purchase agreement
|
SPAC
|
special-purpose acquisition company
|
USD
|
U.S. dollars
|
VWAP
|
volume-weighted average daily market
price
|
Appendix F — Roadmap Updates for 2024
Appendix F — Roadmap Updates for 2024
The table below summarizes the substantive
changes made in the 2024 edition of this Roadmap.
Section
|
Title
|
Description
|
---|---|---|
Instruments Potentially Indexed to, and Potentially Settled
in, the Entity’s Own Equity
|
Simplified discussion of the scope of ASC
815-40 and removed discussion of the accounting before
adoption of ASU 2020-06.
| |
Interaction With the Derivative Accounting Requirements
|
Simplified discussion of the scope of ASC 815-40 and removed
discussion of the accounting before adoption of ASU
2020-06.
| |
Hybrid Instruments and Embedded Features
|
Simplified discussion of the scope of ASC
815-40 and added Connecting the Dots to
address the interaction between the temporary equity
guidance in ASC 480-10-S99-3A and the equity classification
guidance in ASC 815-40.
| |
Share-Based Payments
|
Simplified discussion of the scope of ASC 718 and ASC 815-40
and removed discussion of the accounting before adoption of
ASU 2020-06.
| |
Contingent Consideration
|
Simplified discussion of the scope of ASC 805 and ASC 815-40
and removed discussion of the accounting before adoption of
ASU 2020-06.
| |
Share-Settleable Earn-Out Arrangements
|
Reorganized section and moved discussion of
indexation to Sections 4.2.3.2
and
4.3.7.4.
| |
Contracts on the Stock of a Parent or Other Entity That Is
Not Consolidated
|
Added Connecting the Dots to
address the accounting for a subsidiary that holds shares of
stock of its parent or an affiliate.
| |
Share-Settleable Earn-Out Arrangements
|
Added new section that includes the guidance
that was previously in Section 2.5.3.
| |
The Concept of a Fixed-for-Fixed Forward or Option on Equity
Shares
|
Removed discussion of the accounting before
the adoption of ASU 2020-06.
| |
Provisions That Adjust the Settlement Amount
|
Removed discussion of the accounting before the adoption of
ASU 2020-06.
| |
Side Letters That Modify Volatility
Assumptions or Other Settlement Provisions
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Renumbered section and expanded discussion
to address other types of side letters that modify the
volatility assumptions used in an early settlement.
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Overview
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Cash Settlement Outside the Entity’s Control
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Revised guidance on cash payments that do
not result in settlement of an equity-linked instrument.
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Net Cash Settlement Upon Final Liquidation of the Entity
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Settlement Alternatives: General Requirements
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Application to Certain Embedded Features
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Settlement Alternatives With Different Economic Value
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Overview
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Simplified discussion of the equity
classification conditions and removed discussion of the
accounting before adoption of ASU 2020-06.
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Settlement Required in Registered Shares
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Amended discussion to focus on the
accounting considerations after adoption of ASU 2020-06.
Also, deleted the previous guidance in Sections 5.3.2.1
through 5.3.2.5 since it is no longer relevant after
adoption of ASU 2020-06.
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Interaction With the Guidance on Registration Payment
Arrangements
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Renumbered from Section 5.3.2.6 and updated
to reflect adoption of ASU 2020-06.
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5.3.7
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No Counterparty Rights Rank Higher Than Shareholder Rights
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Deleted section; guidance superseded by ASU
2020-06.
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5.3.8
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No Collateral Required
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Deleted section; guidance superseded by ASU 2020-06.
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Ongoing Reassessment of Classification Requirements
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Application of the Equity Classification Conditions to
Certain Convertible Debt Instruments
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Simplified discussion of the exception for certain
convertible debt instruments and removed discussion of the
accounting before adoption of ASU 2020-06.
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Initial and Subsequent Measurement
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Added Connecting the Dots to
discuss the initial recognition of an equity-linked
instrument issued with other financial instruments at an
aggregate amount that differs from the fair value of the
instruments issued; removed discussion of the accounting
before adoption of ASU 2020-06.
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Down-Round Features
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Freestanding Instruments Classified as Assets or
Liabilities
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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6.3.1
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Instrument Meets the Definition of a Derivative Instrument
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Deleted section; guidance superseded by ASU 2020-06.
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6.3.2
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Instrument Does Not Meet the Definition of a Derivative
Instrument
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Deleted section; guidance superseded by ASU 2020-06.
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Embedded Features
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Diluted EPS
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Disclosure
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Separation of Equity Components
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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Checklists for Determining Whether Freestanding Contracts or
Embedded Features Qualify as Equity
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Removed discussion of the accounting before
adoption of ASU 2020-06.
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