5.10 SEC Guidance on Temporary Equity

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

Background

1. This SEC staff announcement provides the SEC staff’s views regarding the application of Accounting Series Release No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks.”FN1

Scope

2. ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer. As noted in ASR 268, the Commission reasoned that “[t]here is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital.”

3. Although ASR 268 specifically describes and discusses preferred securities, the SEC staff believes that ASR 268 also provides analogous guidance for other redeemable equity instruments including, for example, common stock, derivative instruments, noncontrolling interests,FN2 securities held by an employee stock ownership plan,FN3 and share-based payment arrangements with employees.FN4 The SEC staff’s views regarding the applicability of ASR 268 in certain situations is described below. . . .

d. Share-based payment awards. Equity-classified share-based payment arrangements with employees are not subject to ASR 268 due solely to either of the following:

Net cash settlement would be assumed pursuant to Paragraphs 815-40-25-11 through 25-16 solely because of an obligation to deliver registered shares.FN7
A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s statutory tax withholding requirements (as discussed in Paragraph 718-10-25-18). . . .

Classification

4. ASR 268 requires equity instruments with redemption features that are not solely within the control of the issuer to be classified outside of permanent equity (often referred to as classification in “temporary equity”). The SEC staff does not believe it is appropriate to classify a financial instrument (or host contract) that meets the conditions for temporary equity classification under ASR 268 as a liability.FN10

5. Determining whether an equity instrument is redeemable at the option of the holder or upon the occurrence of an event that is solely within the control of the issuer can be complex. The SEC staff believes that all of the individual facts and circumstances surrounding events that could trigger redemption should be evaluated separately and that the possibility that any triggering event that is not solely within the control of the issuer could occur — without regard to probability — would require the instrument to be classified in temporary equity. . . .

Measurement

12. Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: FN12

For share-based payment arrangements with employees, the initial amount presented in temporary equity should be based on the redemption provisions of the instrument and the proportion of consideration received in the form of employee services at initial recognition. For example, upon issuance of a fully vested option that allows the holder to put the option back to the issuer at its intrinsic value upon a change in control, an amount representing the intrinsic value of the option at the date of issuance should be presented in temporary equity. . . .

13. Subsequent measurement. The SEC staff’s views regarding the subsequent measurement of a redeemable equity instrument that is subject to ASR 268 are included in paragraphs 14–16. Paragraphs 14 and 15 discuss the general views regarding subsequent measurement. Paragraph 16 discusses the application of those general views in the context of certain types of redeemable equity instruments.

14. If an equity instrument subject to ASR 268 is currently redeemable (for example, at the option of the holder), it should be adjusted to its maximum redemption amount at the balance sheet date. If the maximum redemption amount is contingent on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure). The redemption amount at each balance sheet date should also include amounts representing dividends not currently declared or paid but which will be payable under the redemption features or for which ultimate payment is not solely within the control of the registrant (for example, dividends that will be payable out of future earnings).FN13

15. If an equity instrument subject to ASR 268 is not currently redeemable (for example, a contingency has not been met), subsequent adjustment of the amount presented in temporary equity is unnecessary if it is not probable that the instrument will become redeemable. If it is probable that the equity instrument will become redeemable (for example, when the redemption depends solely on the passage of time), the SEC staff will not object to either of the following measurement methods provided the method is applied consistently:

Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates
Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.

16. The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15:

For share-based payment arrangements with employees, the amount presented in temporary equity at each balance sheet date should be based on the redemption provisions of the instrument and should take into account the proportion of consideration received in the form of employee services (that is, the pattern of recognition of compensation cost pursuant to Topic 718). FN14 . . .

Reclassifications Into Permanent Equity

18. If classification of an equity instrument as temporary equity is no longer required (if, for example, a redemption feature lapses, or there is a modification of the terms of the instrument), the existing carrying amount of the equity instrument should be reclassified to permanent equity at the date of the event that caused the reclassification. Prior financial statements are not adjusted. Additionally, the SEC staff believes that it would be inappropriate to reverse any adjustments previously recorded to the carrying amount of the equity instrument (pursuant to paragraphs 14–16) in conjunction with such reclassifications.

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FN1 ASR 268 (SEC Financial Reporting Codification, Section No. 211, Redeemable Preferred Stocks) is incorporated into SEC Regulation S-X, Articles 5-02.27, 7-03.21, and 9-03.19. Hereafter, reference is made only to ASR 268.

FN2 The Master Glossary defines noncontrolling interest as “The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.” ASR 268 applies to redeemable noncontrolling interests (provided the redemption feature is not considered a freestanding option within the scope of Subtopic 480-10). Where relevant, specific classification and measurement guidance pertaining to redeemable noncontrolling interests has been included in this SEC staff announcement.

FN3 ASR 268 applies to equity securities held by an employee stock ownership plan (whether or not allocated) that, by their terms, can be put to the registrant (sponsor) for cash or other assets. Where relevant, specific classification and measurement guidance pertaining to employee stock ownership plans has been included in this SEC staff announcement.

FN4 As indicated in Section 718-10-S99, ASR 268 applies to redeemable equity-classified instruments granted in conjunction with share-based payment arrangements with employees. Where relevant, specific classification and measurement guidance pertaining to share-based payment arrangements with employees has been included in this SEC staff announcement.

FN7 See footnote 84 of Section 718-10-S99.

FN10 At the June 14, 2007 EITF meeting, the SEC Observer stated that a financial instrument (or host contract) that otherwise meets the conditions for temporary equity classification may continue to be classified as a liability provided the financial instrument (or host contract) was classified and accounted for as a liability in fiscal quarters beginning before September 15, 2007 and has not subsequently been modified or subject to a remeasurement (new basis) event.

FN12 SAB Topic 3C, Redeemable Preferred Stock, states that the initial carrying amount of redeemable preferred stock should be its fair value at date of issue. The SEC staff believes this guidance should also be applied to other similar redeemable equity instruments. Consistent with Paragraph 820-10-30-3, the transaction price will generally represent the initial fair value of the equity instrument when the issuance occurs in an arm’s-length transaction with an unrelated party and there are no other unstated rights or privileges.

FN13 See also Section 260-10-45.

FN14 See also the Interpretative Response to Question 2 in Section E of Section 718-10-S99.

SEC Staff Accounting Bulletins

SAB Topic 14.E, FASB ASC Topic 718, Compensation — Stock Compensation, and Certain Redeemable Financial Instruments

Certain financial instruments awarded in conjunction with share-based payment arrangements have redemption features that require settlement by cash or other assets upon the occurrence of events that are outside the control of the issuer.77 FASB ASC Topic 718 provides guidance for determining whether instruments granted in conjunction with share-based payment arrangements should be classified as liability or equity instruments. Under that guidance, most instruments with redemption features that are outside the control of the issuer are required to be classified as liabilities; however, some redeemable instruments will qualify for equity classification.78 SEC Accounting Series Release No. 268, Presentation in Financial Statements of “Redeemable Preferred Stocks,”79 (“ASR 268”) and related guidance80 address the classification and measurement of certain redeemable equity instruments.

Facts: Under a share-based payment arrangement, Company F grants to an employee shares (or share options) that all vest at the end of four years (cliff vest). The shares (or shares underlying the share options) are redeemable for cash at fair value at the holder’s option, but only after six months from the date of share issuance (as defined in FASB ASC Topic 718). Company F has determined that the shares (or share options) would be classified as equity instruments under the guidance of FASB ASC Topic 718. However, under ASR 268 and related guidance, the instruments would be considered to be redeemable for cash or other assets upon the occurrence of events (e.g., redemption at the option of the holder) that are outside the control of the issuer.

Question 1: While the instruments are subject to FASB ASC Topic 718, is ASR 268 and related guidance applicable to instruments issued under share-based payment arrangements that are classified as equity instruments under FASB ASC Topic 718?

Interpretive Response: Yes. The staff believes that registrants must evaluate whether the terms of instruments granted in conjunction with share-based payment arrangements that are not classified as liabilities under FASB ASC Topic 718 result in the need to present certain amounts outside of permanent equity (also referred to as being presented in “temporary equity”) in accordance with ASR 268 and related guidance.81

When an instrument ceases to be subject to FASB ASC Topic 718 and becomes subject to the recognition and measurement requirements of other applicable GAAP, the staff believes that the company should reassess the classification of the instrument as a liability or equity at that time and consequently may need to reconsider the applicability of ASR 268.

Question 2: How should Company F apply ASR 268 and related guidance to the shares (or share options) granted under the share-based payment arrangements with employees that may be unvested at the date of grant?

Interpretive Response: Under FASB ASC Topic 718, when compensation cost is recognized for instruments classified as equity instruments, additional paid-in-capital82 is increased. If the award is not fully vested at the grant date, compensation cost is recognized and additional paid-in-capital is increased over time as services are rendered over the requisite service period. A similar pattern of recognition should be used to reflect the amount presented as temporary equity for share-based payment awards that have redemption features that are outside the issuer’s control but are classified as equity instruments under FASB ASC Topic 718. The staff believes Company F should present as temporary equity at each balance sheet date an amount that is based on the redemption amount of the instrument, but takes into account the proportion of consideration received in the form of employee services. Thus, for example, if a nonvested share that qualifies for equity classification under FASB ASC Topic 718 is redeemable at fair value more than six months after vesting, and that nonvested share is 75% vested at the balance sheet date, an amount equal to 75% of the fair value of the share should be presented as temporary equity at that date. Similarly, if an option on a share of redeemable stock that qualifies for equity classification under FASB ASC Topic 718 is 75% vested at the balance sheet date, an amount equal to 75% of the intrinsic83 value of the option should be presented as temporary equity at that date.

Question 3: Would the methodology described for employee awards in the Interpretive Response to Question 2 above apply to nonemployee awards to be issued in exchange for goods or services with similar terms to those described above?

Interpretive Response: The staff believes it would generally be appropriate to apply the methodology described in the Interpretive Response to Question 2 above to nonemployee awards.

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77 The terminology “outside the control of the issuer” is used to refer to any of the three redemption conditions described in Rule 5-02.27 of Regulation S-X that would require classification outside permanent equity. That rule requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer.

78 FASB ASC paragraphs 718-10-25-6 through 718-10-25-19A.

79 ASR 268, July 27, 1979, Rule 5-02.27 of Regulation S-X.

80 Related guidance includes EITF Topic No. D-98, “Classification and Measurement of Redeemable Securities,” included in the FASB ASC in paragraph 480-10-S99-3A.

81 Instruments granted in conjunction with share-based payment arrangements with employees that do not by their terms require redemption for cash or other assets (at a fixed or determinable price on a fixed or determinable date, at the option of the holder, or upon the occurrence of an event that is not solely within the control of the issuer) would not be assumed by the staff to require net cash settlement for purposes of applying ASR 268 in circumstances in which FASB ASC Section 815-40-25, Derivatives and Hedging — Contracts in Entity’s Own Equity — Recognition, would otherwise require the assumption of net cash settlement. See FASB ASC paragraph 815-40-25-11 (See FASB ASC paragraph 815-10-65-1 for the transition and effective date information related to FASB ASU No. 2020-06, Debt — Debt With Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, which superseded FASB ASC paragraph 815-40-25-11.), which states, in part: “ . . . the events or actions necessary to deliver registered shares are not controlled by an entity and, therefore, except under the circumstances described in FASB ASC paragraph 815-40-25-16, if the contract permits the entity to net share or physically settle the contract only by delivering registered shares, it is assumed that the entity will be required to net cash settle the contract.” See also FASB ASC subparagraph 718-10-25-15(a).

82 Depending on the fact pattern, this may be recorded as common stock and additional paid in capital.

83 The potential redemption amount of the share option in this illustration is its intrinsic value because the holder would pay the exercise price upon exercise of the option and then, upon redemption of the underlying shares, the company would pay the holder the fair value of those shares. Thus, the net cash outflow from the arrangement would be equal to the intrinsic value of the share option. In situations where there would be no cash inflows from the share option holder, the cash required to be paid to redeem the underlying shares upon the exercise of the put option would be the redemption value.

To determine the classification of an award otherwise classified as equity under ASC 718, SEC registrants must consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E, on redeemable securities. SEC registrants must present outside of permanent equity (i.e., as temporary or mezzanine equity) share-based payment awards (otherwise classified as equity) that are subject to redemption features not solely within the control of the issuer (e.g., upon the occurrence of a triggering event such as a change in control of the issuer). Temporary-equity classification may be required even if the share-based payment awards otherwise qualify for equity classification under ASC 718 (e.g., a stock award that is contingently puttable by the grantee more than six months after vesting at the then-current fair value). Exceptions include the following:

The award does not require redemption for cash or other assets, and cash settlement would be possible only upon the issuer’s inability to deliver registered shares (as described in ASC 815-40-25-11 through 25-16).
The award permits direct or indirect share repurchases only to satisfy the issuer’s statutory tax withholding requirements (as described in ASC 718-10-25-18).

The following are examples of situations in which awards would be classified in temporary equity (provided that liability classification would not be required because of other features):

A stock award that may allow the grantee the right to require the issuer to repurchase shares for fair value at any time after six months from the date on which the shares are fully vested.
A stock award that would be settled in cash upon a triggering event that is not solely within the control of the issuer (e.g., upon a change in control of the issuer).
A stock option that may give the grantee the right to require the issuer to repurchase the option at the current intrinsic value upon a change in control.

ASC 480-10-S99-3A and SAB Topic 14.E require that SEC registrants recognize and measure an award with redemption features not solely within the control of the issuer in temporary equity as follows:

At the award’s issuance, the entity should base the carrying value on its redemption value and the proportion attributed to the employee requisite service rendered or nonemployee’s vesting period recognized to date. This view is consistent with the treatment of compensation cost that increases over time as services are rendered over the requisite service period, which is addressed in the SEC staff’s response to Question 2 of SAB Topic 14.E.
Until the award’s settlement, the entity should remeasure the award at the end of the reporting period on the basis of its redemption value and the proportion attributed to the employee requisite services rendered or nonemployee’s vesting period recognized to date. In other words, as the award begins to vest, the redemption amount would be accreted to temporary equity in accordance with the employee requisite services rendered or the nonemployee’s vesting period. Note that remeasurement is not required for an award issued with contingent repurchase features if it is not considered probable that the contingency would occur. The assessment of probability is generally performed on an individual-grantee basis.
The amount of compensation cost recognized should be based on the award’s grant-date fair-value-based measure. Changes in the redemption value after the award is granted are recorded in equity and not as compensation cost recognized in earnings.

The redemption value at issuance is based on the redemption feature of the award. For example, the redemption value of an award that is redeemable at intrinsic value is the intrinsic value of the award. Thus, if a stock option is granted at-the-money, its initial redemption value is zero. This is because when an option is settled, the grantee receives the difference between the fair value of the underlying shares and the exercise price (which are the same for an at-the-money option). Alternatively, the redemption value of an option that is redeemable at fair value is the fair value of the option. In a situation in which a stock option is granted and the underlying share is redeemable at fair value, the redemption value of the stock option is the intrinsic value and, after exercise, the redemption value of the share is the fair value of the share. Subsequent remeasurement (if required under ASC 480-10-S99-3A) will be based on the fair value of the issuer’s shares in each period, less the exercise price of the award, if any. For guidance on reclassifications between permanent and temporary equity, see Section 9.7.4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

The example below illustrates the application of ASR 268 and ASC 480-10-S99-3A to stock awards with repurchase features. Example 5-21 illustrates the application of ASR 268 and ASC 480-10-S99-3A to stock options with a contingent cash settlement feature.

Example 5-20

On January 1, 20X1, Entity A, an SEC registrant, grants 100,000 shares of restricted stock to an employee. The stock awards vest at the end of the fourth year of service (cliff vesting). The stock awards give the employee the right to require A to buy back A’s shares at their then-current fair value any time after six months from the date the stock awards are fully vested. The fair value of the shares is as follows:

$10 on January 1, 20X1.
$12 on December 31, 20X1.
$7 on December 31, 20X2.
$11 on December 31, 20X3.
$14 on December 31, 20X4.

The repurchase feature will not result in liability classification of the stock awards since the employee will bear the risks and rewards of share ownership for a period of more than six months after the stock awards have vested. However, as an SEC registrant, A must apply ASR 268 and ASC 480-10-S99-3A. That guidance requires an SEC registrant to present outside of permanent equity (i.e., as temporary or mezzanine equity) share-based payment awards (otherwise classified as equity) that are subject to redemption features not solely within the control of the issuer.

Entity A should record the following journal entries:

Example 5-21

On January 1, 20X1, Entity A, an SEC registrant, grants 100,000 stock options to an employee, each with a grant-date fair-value-based measure of $8. The options are granted with a $10 exercise price when A’s share price is $15 (i.e., the options have an intrinsic value of $5 per share on the grant date). The options vest at the end of the second year of service (cliff vesting) and give the employee the right to require A to net cash settle the options upon a change in control. On February 1, 20X3, when the fair-value-based measure of the options is $15, a change in control becomes probable. Note that in accordance with ASC 805-20-55-50 and 55-51, which discuss liabilities that are triggered upon the consummation of a business combination, a change in control is generally not considered probable until it occurs.

From the date of issuance, January 1, 20X1, to January 31, 20X3, the cash settlement feature will not result in liability classification of the options since the change in control is not considered probable. However, on February 1, 20X3, when the change in control becomes probable (i.e., the date it occurs), the options must be reclassified as a share-based liability. The reclassification is accounted for in a manner similar to a modification that changes the awards’ classification from equity to liability. That is, on the date the change in control occurs, A recognizes a share-based liability for the portion of the options that are related to prior service, multiplied by the options’ fair-value-based measure on that date. If the amount recognized as a share-based liability is less than or equal to the amount previously recognized in equity, the offsetting amount is recorded to APIC (i.e., final compensation cost cannot be less than the grant-date fair-value-based measure). If, on the other hand, the amount recognized as a share-based liability is greater than the amount previously recognized in equity, the excess is recognized as compensation cost either immediately (for vested options) or over the remaining service (vesting) period (for unvested options). Because the options are now classified as a liability, they are remeasured at a fair-value-based measure in each reporting period until settlement.

In addition, as an SEC registrant, A must apply ASR 268 and ASC 480-10-S99-3A. As a result, from the date of issuance, January 1, 20X1, to January 31, 20X3, A must classify any grant-date intrinsic value outside of permanent equity (i.e., as temporary or mezzanine equity). ASC 480-10-S99-3A does not require subsequent remeasurement in temporary equity unless it is probable that the triggering event will occur. However, as noted above, on February 1, 20X3, when the change in control becomes probable, the options must be reclassified as a share-based liability.

Entity A should record the following journal entries:

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.