Deloitte’s Roadmap: Contracts on an Entity’s Own Equity

Preface

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
Share-settleable contingent consideration arrangements in business combinations. Call options and warrants to purchase common stock or preferred stock. Forward contracts to purchase or sell common stock or preferred stock. Put options to sell common stock or preferred stock.	Embedded conversion options in convertible debt. Embedded conversion options in convertible preferred stock. Prepaid forward contracts to purchase or sell common stock or preferred stock. Prepaid options to purchase or sell common stock or preferred stock.

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

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?	Chapter 2
What are the terms of the instrument?	Chapter 3
Does the instrument meet the criteria to be considered indexed to the entity’s own stock?	Chapter 4
Does the instrument meet other conditions for equity classification?	Chapter 5

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

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.	Chapter 4
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.	Chapter 5

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.

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 3-1

Issuance of a Bond With a Warrant

An 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:
1. 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
2. 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:
1. An observable market other than the market for the issuer’s stock
2. 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

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

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
Stock price of the issuer. Stock price of a consolidated subsidiary that is a substantive entity. Revenue, net income, or EBITDA of the issuer. Net assets of the issuer. Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity. A change of control or merger involving the issuer. An IPO of the issuer. An exchange listing or filing of a registration statement by the issuer. Delisting of the issuer. An offering of additional securities by the issuer. A stock split or other dilutive event carried out by the issuer. Extraordinary dividends. The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor). Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow). Nationalization. Insolvency. Change in law (e.g., a change in law that makes it illegal to be a party to the contract). Hedging disruption or increased cost of hedging related to the entity’s shares. Counterparty’s level of ownership of the entity’s shares. Event of default. Market disruption event (e.g., extended closure of stock exchange). A parity provision (convertible instruments only).1 The credit rating of the issuer (convertible instruments only).2	Stock price of a third party. Delisting of the stock of a third party. Revenue, net income, or EBITDA of a third party. Stock market index (e.g., S&P 500). Commodity price (e.g., gold, natural gas, or oil). Foreign currency rate or index. Interest rate or index (e.g., LIBOR). CPI. The relation between the stock price of the issuer and a stock market index. The relation between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company.

Exercise Contingencies That Do Not Preclude Equity Classification

Exercise Contingencies That Preclude Equity Classification

Stock price of the issuer.
Stock price of a consolidated subsidiary that is a substantive entity.
Revenue, net income, or EBITDA of the issuer.
Net assets of the issuer.
Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity.
A change of control or merger involving the issuer.
An IPO of the issuer.
An exchange listing or filing of a registration statement by the issuer.
Delisting of the issuer.
An offering of additional securities by the issuer.
A stock split or other dilutive event carried out by the issuer.
Extraordinary dividends.
The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor).
Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow).
Nationalization.
Insolvency.
Change in law (e.g., a change in law that makes it illegal to be a party to the contract).
Hedging disruption or increased cost of hedging related to the entity’s shares.
Counterparty’s level of ownership of the entity’s shares.
Event of default.
Market disruption event (e.g., extended closure of stock exchange).
A parity provision (convertible instruments only).1
The credit rating of the issuer (convertible instruments only).2

Stock price of a third party.
Delisting of the stock of a third party.
Revenue, net income, or EBITDA of a third party.
Stock market index (e.g., S&P 500).
Commodity price (e.g., gold, natural gas, or oil).
Foreign currency rate or index.
Interest rate or index (e.g., LIBOR).
CPI.
The relation between the stock price of the issuer and a stock market index.
The relation between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company.

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

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.

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).

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?

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).

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 4-11

Use of Commercially Reasonable Means to Determine Adjustment

Assume 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 4-12

Assessment of Adjustment for Lost Time Value

There 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 4-13

Fixed Monetary Settlement

A 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:
1. The distribution of a stock dividend or ordinary cash dividend
2. The execution of a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend
3. The issuance of shares for an amount below the then-current market price
4. 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: Level 1 — The VWAP 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. Level 2 — The VWAP 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. Level 3 — The VWAP 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. Level 4 — The VWAP 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. 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: Level 1 — The VWAP 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. Level 2 — The VWAP 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. Level 3 — The VWAP 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. Level 4 — The VWAP 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. 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: If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that excludes the shares issuable under the earn-out share arrangement or other potentially issuable shares of the issuer, the arrangement is not considered indexed to the combined company’s stock under step 2 in ASC 815-40-15-7 and must be classified as a liability. If the price per share is calculated by dividing the transaction consideration by a number of outstanding shares that includes the shares issuable under the earn-out share arrangement and all other potentially issuable shares of the issuer, the arrangement is considered indexed to the combined company’s stock under step 2 in ASC 815-40-15-7 and may be classified as an equity instrument as long as no other condition in ASC 815-40 precludes such classification. 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

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

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
The issuer’s decision to redeem, put, call, or convert a financial instrument Specified corporate transactions or events (e.g., a sale of substantially all of the assets) that the issuer’s management or board of directors may decide to undertake (assuming that the holders of equity-linked instruments do not control the issuer) A change in the issuer’s business strategy The issuer’s declaration of an extraordinary dividend The nonoccurrence of an IPO (usually an issuer is able to prevent an IPO from occurring but is unable to control whether it can successfully complete one) The issuer’s lack of achievement of a project milestone (usually, an issuer is able to prevent a milestone from being reached but is unable to control whether it can successfully meet one) The issuer’s future decision to not issue new equity securities Redemption upon mutual agreement by the parties The issuer’s execution of an agreement for the private placement of its equity securities on terms that are commercially reasonable and customary for such agreements unless the issuer is precluded from undertaking a private placement (e.g., because a failed registration occurred within the past six months) The issuer’s obligation to only undertake commercially reasonable best efforts to accomplish something (e.g., to deliver registered shares)	The counterparty’s decision to redeem, put, call, or convert a financial instrument The issuer’s ability to have a registration statement declared effective by the SEC The issuer’s ability to prevent an effective registration statement from lapsing Completion of an IPO by a certain date (the successful completion of an IPO depends in part on factors outside the issuer’s control, such as an effective registration statement) The issuer’s ability to submit SEC filings on a timely basis (ASC 815-40-25-29; see Section 5.3.5) The issuer’s ability to maintain compliance with specified financial covenants The issuer’s ability to achieve specified revenue or earnings targets The issuer’s ability to achieve a project milestone The issuer’s ability to pay specified dividends The attainment of a specific stock market price A change in the issuer’s credit rating The delisting of the issuer’s securities The instrument’s status as readily tradable on an established market The issuer’s ability to deliver publicly listed shares The existence of a public market A change in control of the issuer if (1) a purchaser could obtain such control without the approval of the issuer’s management or board (e.g., by purchasing shares from other investors) or (2) the issuer’s board is controlled by holders of equity-linked instruments The death or disability of the holder (however, see Section 9.4.3 of Deloitte’s Roadmap Distinguishing Liabilities From Equity) The termination, resignation, or retirement of an employee (e.g., a CEO) A specified change in an investor’s ownership interest (e.g., the board chairman or CEO ceases to beneficially own 20 percent of the outstanding voting stock) A vote by the issuer’s shareholders (e.g., shareholder approval to increase the number of authorized shares) A change in law A change in regulatory requirements A failed Dutch auction Events involving the counterparty’s ability to hedge the equity price risk of the instrument (e.g., a hedge disruption event, an increased cost of hedging, a loss of stock borrow, or an increased cost of stock borrow) The issuer’s ability to have available a sufficient number of authorized and unissued shares to share settle an instrument if the issuer does not currently have available a sufficient number of authorized and unissued shares to share settle the instrument (see Section 5.3.3) A third party’s consent (e.g., a stockholder’s waiver of a redemption requirement) The receipt of an unqualified audit opinion

Solely Within the Issuer’s Control

Not Solely Within the Issuer’s Control

The issuer’s decision to redeem, put, call, or convert a financial instrument
Specified corporate transactions or events (e.g., a sale of substantially all of the assets) that the issuer’s management or board of directors may decide to undertake (assuming that the holders of equity-linked instruments do not control the issuer)
A change in the issuer’s business strategy
The issuer’s declaration of an extraordinary dividend
The nonoccurrence of an IPO (usually an issuer is able to prevent an IPO from occurring but is unable to control whether it can successfully complete one)
The issuer’s lack of achievement of a project milestone (usually, an issuer is able to prevent a milestone from being reached but is unable to control whether it can successfully meet one)
The issuer’s future decision to not issue new equity securities
Redemption upon mutual agreement by the parties
The issuer’s execution of an agreement for the private placement of its equity securities on terms that are commercially reasonable and customary for such agreements unless the issuer is precluded from undertaking a private placement (e.g., because a failed registration occurred within the past six months)
The issuer’s obligation to only undertake commercially reasonable best efforts to accomplish something (e.g., to deliver registered shares)

The counterparty’s decision to redeem, put, call, or convert a financial instrument
The issuer’s ability to have a registration statement declared effective by the SEC
The issuer’s ability to prevent an effective registration statement from lapsing
Completion of an IPO by a certain date (the successful completion of an IPO depends in part on factors outside the issuer’s control, such as an effective registration statement)
The issuer’s ability to submit SEC filings on a timely basis (ASC 815-40-25-29; see Section 5.3.5)
The issuer’s ability to maintain compliance with specified financial covenants
The issuer’s ability to achieve specified revenue or earnings targets
The issuer’s ability to achieve a project milestone
The issuer’s ability to pay specified dividends
The attainment of a specific stock market price
A change in the issuer’s credit rating
The delisting of the issuer’s securities
The instrument’s status as readily tradable on an established market
The issuer’s ability to deliver publicly listed shares
The existence of a public market
A change in control of the issuer if (1) a purchaser could obtain such control without the approval of the issuer’s management or board (e.g., by purchasing shares from other investors) or (2) the issuer’s board is controlled by holders of equity-linked instruments
The death or disability of the holder (however, see Section 9.4.3 of Deloitte’s Roadmap Distinguishing Liabilities From Equity)
The termination, resignation, or retirement of an employee (e.g., a CEO)
A specified change in an investor’s ownership interest (e.g., the board chairman or CEO ceases to beneficially own 20 percent of the outstanding voting stock)
A vote by the issuer’s shareholders (e.g., shareholder approval to increase the number of authorized shares)
A change in law
A change in regulatory requirements
A failed Dutch auction
Events involving the counterparty’s ability to hedge the equity price risk of the instrument (e.g., a hedge disruption event, an increased cost of hedging, a loss of stock borrow, or an increased cost of stock borrow)
The issuer’s ability to have available a sufficient number of authorized and unissued shares to share settle an instrument if the issuer does not currently have available a sufficient number of authorized and unissued shares to share settle the instrument (see Section 5.3.3)
A third party’s consent (e.g., a stockholder’s waiver of a redemption requirement)
The receipt of an unqualified audit opinion

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:
1. 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)
2. 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:
1. Contracts that require physical settlement or net share settlement
2. 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:
1. Net cash settlement or settlement in shares (including net share settlement and physical settlement that requires that the entity deliver shares)
2. 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
The instrument requires physical settlement. The instrument requires net share settlement. The instrument gives the entity a choice between net cash settlement and net share settlement. The instrument gives the entity a choice between physical settlement and net share settlement. The instrument gives the entity a choice between physical settlement and net cash settlement. The instrument gives the counterparty a choice between physical settlement and net share settlement.	The instrument requires net cash settlement. The instrument gives the counterparty a choice between net cash settlement and net share settlement. The instrument gives the counterparty a choice between net cash settlement and physical settlement.

Classification

Equity Provided All Other Conditions for Equity Classification Are Met

Asset or Liability

The instrument requires physical settlement.
The instrument requires net share settlement.
The instrument gives the entity a choice between net cash settlement and net share settlement.
The instrument gives the entity a choice between physical settlement and net share settlement.
The instrument gives the entity a choice between physical settlement and net cash settlement.
The instrument gives the counterparty a choice between physical settlement and net share settlement.

The instrument requires net cash settlement.
The instrument gives the counterparty a choice between net cash settlement and net share settlement.
The instrument gives the counterparty a choice between net cash settlement and physical settlement.

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

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.

It is uncommon that (1) the issuer has the unconditional right to reinstate the equity-linked instrument or (2) the instrument is automatically reinstated when such payments are made.

5.3 Additional Equity Classification Conditions

5.3.1 Overview

ASC 815-40

25-10

Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in 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:
1. Outstanding convertible debt that is convertible during the contract period
2. Outstanding stock options that are or will become exercisable during the contract period
3. 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:
1. Fixed
2. 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

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).

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).

In practice, equity-linked instruments generally do not contain provisions that explicitly require cash settlement if the entity is unable to deliver registered shares.

5.5 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

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	Accounting
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

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

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.

Chapter 7 — Presentation and Disclosure

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

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

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.	Section 2.3
	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.	Section 2.4
	The contract is not a lock-up option.	Section 2.5.2
	If the contract is on the equity shares of a subsidiary, the subsidiary is a consolidated, substantive entity.	Section 2.6.1
	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.	Section 2.6.4
	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.	Section 4.2
	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).	Section 4.2
	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.	Section 4.3
	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).	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	The contract otherwise is a fixed-for-fixed forward or option on the entity’s equity shares.	Section 4.3
	Equity Classification Conditions
	The only circumstance (if any) in which the entity could be forced to net cash settle the contract is: An event that is solely within the entity’s control or The final liquidation of the entity or An event that results in a change of control of the entity (and that meets certain other conditions) or An event that would cause all of the holders of the underlying shares to receive the same form of consideration.	Section 5.2.3
	The economic substance of the contract is not that of an asset or a liability because: The settlement alternatives have different economic values or One of the settlement alternatives is fixed or contains caps or floors. (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.)	Section 5.2.5
	If the settlement alternatives differ in gain and loss positions, the contract: Permits the entity to net share settle in a loss position and Is not predominantly a purchased option.	Section 5.2.6
	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.	Section 5.3.3
	The contract contains an explicit share limit.	Section 5.3.4
	The contract does not require net cash settlement if the entity fails to timely file.	Section 5.3.5
	If the contract includes a top-off or make-whole provision, it: Can be net share settled and Is subject to a fixed share limit that is less than the number of available authorized and unissued shares.	Section 5.3.6

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.	Section 2.4
	The embedded feature is not a lock-up option.	Section 2.5.2
	If the embedded feature is on the equity shares of a subsidiary, the subsidiary is a consolidated, substantive entity.	Section 2.6.1
	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.	Section 2.6.4
	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.	Section 4.2
	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).	Section 4.2
	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.	Section 4.3
	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).	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	The embedded feature otherwise is a fixed-for-fixed forward or option on the entity’s equity shares.	Section 4.3
	Equity Classification Conditions
	The only circumstance (if any) in which the entity could be forced to net cash settle the embedded feature is: An event that is solely within the entity’s control or The final liquidation of the entity or An event that results in a change of control of the entity (and that meets certain other conditions) or An event that would cause the all of holders of the underlying shares to receive the same form of consideration.	Section 5.2.3
	The economic substance of the embedded feature is not that of an asset or a liability because: The settlement alternatives have different economic values or One of the settlement alternatives is fixed or contains caps or floors. (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.)	Section 5.2.5
	If the settlement alternatives differ in gain and loss positions, the embedded feature: Permits the entity to net share settle in a loss position and Is not predominantly a purchased option.	Section 5.2.6
	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.	Section 5.3.3
	The embedded feature contains an explicit share limit.	Section 5.3.4
	The embedded feature does not require net cash settlement if the entity fails to timely file.	Section 5.3.5
	If the embedded feature includes a top-off or make-whole provision, it: Can be net share settled and Is subject to a fixed share limit that is less than the number of available authorized and unissued shares.	Section 5.3.6

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.	Section 2.4
	The embedded feature is not a lock-up option.	Section 2.5.2
	If the embedded feature is on the equity shares of a subsidiary, the subsidiary is a consolidated, substantive entity.	Section 2.6.1
	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.	Section 2.6.4
	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.	Section 4.2
	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).	Section 4.2
	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.	Section 4.3
	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).	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	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.	Section 4.3
	The embedded feature otherwise is a fixed-for-fixed forward or option on the entity’s equity shares.	Section 4.3
	Equity Classification Conditions
	The only circumstance (if any) in which the entity could be forced to net cash settle the embedded feature is: An event that is solely within the entity’s control or The final liquidation of the entity or An event that results in a change of control of the entity (and that meets certain other conditions) or An event that would cause all of the holders of the underlying shares to receive the same form of consideration or One of the conditions in ASC 815-40-25-10.	Section 5.2.3
	The economic substance of the embedded feature is not that of an asset or a liability because: The settlement alternatives have different economic values or One of the settlement alternatives is fixed or contains caps or floors. (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.)	Section 5.2.5
	If the settlement alternatives differ in gain and loss positions, the embedded feature: Permits the entity to net share settle in a loss position and Is not predominantly a purchased option.	Section 5.2.6

Appendix C — Glossary of Selected Terms

Appendix D — Titles of Standards and Other Literature

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

The table below summarizes the substantive changes made in the 2024 edition of this Roadmap.

Section	Title	Description
2.1	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.
2.2.1	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.
2.2.2	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.
2.4	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.
2.5.1	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.
2.5.3	Share-Settleable Earn-Out Arrangements	Reorganized section and moved discussion of indexation to Sections 4.2.3.2 and 4.3.7.4.
2.6.2	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.
4.2.3.2	Share-Settleable Earn-Out Arrangements	Added new section that includes the guidance that was previously in Section 2.5.3.
4.3.2	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.
4.3.3	Provisions That Adjust the Settlement Amount	Removed discussion of the accounting before the adoption of ASU 2020-06.
4.3.5.5.1	Side Letters That Modify Volatility Assumptions or Other Settlement Provisions	Renumbered section and expanded discussion to address other types of side letters that modify the volatility assumptions used in an early settlement.
5.2.1	Overview	Removed discussion of the accounting before adoption of ASU 2020-06.
5.2.2.1	Cash Settlement Outside the Entity’s Control	Revised guidance on cash payments that do not result in settlement of an equity-linked instrument.
5.2.3.2	Net Cash Settlement Upon Final Liquidation of the Entity	Removed discussion of the accounting before adoption of ASU 2020-06.
5.2.4	Settlement Alternatives: General Requirements	Removed discussion of the accounting before adoption of ASU 2020-06.
5.2.4.3	Application to Certain Embedded Features	Removed discussion of the accounting before adoption of ASU 2020-06.
5.2.5	Settlement Alternatives With Different Economic Value	Removed discussion of the accounting before adoption of ASU 2020-06.
5.3.1	Overview	Simplified discussion of the equity classification conditions and removed discussion of the accounting before adoption of ASU 2020-06.
5.3.2	Settlement Required in Registered Shares	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.
5.3.2.1	Interaction With the Guidance on Registration Payment Arrangements	Renumbered from Section 5.3.2.6 and updated to reflect adoption of ASU 2020-06.
5.3.7	No Counterparty Rights Rank Higher Than Shareholder Rights	Deleted section; guidance superseded by ASU 2020-06.
5.3.8	No Collateral Required	Deleted section; guidance superseded by ASU 2020-06.
5.4	Ongoing Reassessment of Classification Requirements	Removed discussion of the accounting before adoption of ASU 2020-06.
5.5	Application of the Equity Classification Conditions to Certain Convertible Debt Instruments	Simplified discussion of the exception for certain convertible debt instruments and removed discussion of the accounting before adoption of ASU 2020-06.
6.1.1	Initial and Subsequent Measurement	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.
6.1.5	Down-Round Features	Removed discussion of the accounting before adoption of ASU 2020-06.
6.2	Freestanding Instruments Classified as Assets or Liabilities	Removed discussion of the accounting before adoption of ASU 2020-06.
6.3.1	Instrument Meets the Definition of a Derivative Instrument	Deleted section; guidance superseded by ASU 2020-06.
6.3.2	Instrument Does Not Meet the Definition of a Derivative Instrument	Deleted section; guidance superseded by ASU 2020-06.
6.4	Embedded Features	Removed discussion of the accounting before adoption of ASU 2020-06.
7.1.1.2	Diluted EPS	Removed discussion of the accounting before adoption of ASU 2020-06.
7.1.2	Disclosure	Removed discussion of the accounting before adoption of ASU 2020-06.
8.4.2	Separation of Equity Components	Removed discussion of the accounting before adoption of ASU 2020-06.
Appendix B	Checklists for Determining Whether Freestanding Contracts or Embedded Features Qualify as Equity	Removed discussion of the accounting before adoption of ASU 2020-06.

	Ashley Carpenter Audit & Assurance Partner Deloitte & Touche LLP +1 203 761 3197 ascarpenter@deloitte.com		Jonathan Howard Audit & Assurance Partner Deloitte & Touche LLP +1 203 761 3235 jonahoward@deloitte.com
	Magnus Orrell Audit & Assurance Managing Director Deloitte & Touche LLP +1 203 761 3402 morrell@deloitte.com