5.2 ASC 480

ASC 718-10

25-7 Topic 480 excludes from its scope instruments that are accounted for under this Topic. Nevertheless, unless paragraphs 718-10-25-8 through 25-19A require otherwise, an entity shall apply the classification criteria in Section 480-10-25 and paragraphs 480-10-15-3 through 15-4 in determining whether to classify as a liability a freestanding financial instrument given to a grantee in a share-based payment transaction. Paragraphs 718-10-35-9 through 35-14 provide criteria for determining when instruments subject to this Topic subsequently become subject to Topic 480 or to other applicable GAAP.

25-8 In determining the classification of an instrument, an entity shall take into account the classification requirements as established by Topic 480. In addition, a call option written on an instrument that is not classified as a liability under those classification requirements (for example, a call option on a mandatorily redeemable share for which liability classification is not required for the specific entity under the requirements) also shall be classified as equity so long as those equity classification requirements for the entity continue to be met, unless liability classification is required under the provisions of paragraphs 718-10-25-11 through 25-12.

ASC 480-10

Mandatorily Redeemable Financial Instruments

25-4 A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.

25-5 A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.

25-6 In determining if an instrument is mandatorily redeemable, all terms within a redeemable instrument shall be considered. The following items do not affect the classification of a mandatorily redeemable financial instrument as a liability:

A term extension option
A provision that defers redemption until a specified liquidity level is reached
A similar provision that may delay or accelerate the timing of a mandatory redemption.

25-7 If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.

Obligations to Repurchase Issuer’s Equity Shares by Transferring Assets

25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:

It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
It requires or may require the issuer to settle the obligation by transferring assets.

25-9 In this Subtopic, indexed to is used interchangeably with based on variations in the fair value of. The phrase requires or may require encompasses instruments that either conditionally or unconditionally obligate the issuer to transfer assets. If the obligation is conditional, the number of conditions leading up to the transfer of assets is irrelevant.

25-10 Examples of financial instruments that meet the criteria in paragraph 480-10-25-8 include forward purchase contracts or written put options on the issuer’s equity shares that are to be physically settled or net cash settled.

25-11 All obligations that permit the holder to require the issuer to transfer assets result in liabilities, regardless of whether the settlement alternatives have the potential to differ.

25-12 Certain financial instruments that embody obligations that are liabilities within the scope of this Subtopic also may contain characteristics of assets but be reported as single items. Some examples include the following:

Net-cash-settled or net-share-settled forward purchase contracts
Certain combined options to repurchase the issuer’s shares.

Those instruments are classified as assets or liabilities initially or subsequently depending on the instrument’s fair value on the reporting date.

25-13 An instrument that requires the issuer to settle its obligation by issuing another instrument (for example, a note payable in cash) ultimately requires settlement by a transfer of assets, accordingly:

When applying paragraphs 480-10-25-8 through 25-12, this also would apply for an instrument settled with another instrument that ultimately may require settlement by a transfer of assets (warrants for puttable shares).
It is clear that a warrant for mandatorily redeemable shares would be a liability under this Subtopic.

Certain Obligations to Issue a Variable Number of Shares

25-14 A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:

A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled). . . .

Although share-based payment awards subject to ASC 718 are outside the scope of ASC 480, ASC 718-10-25-7 requires entities to apply the classification criteria in ASC 480-10-25 and in ASC 480-10-15-3 and 15-4 unless ASC 718-10-25-8 through 25-19A require otherwise. Under ASC 480-10-25 and ASC 480-10-15-3 and 15-4, liability classification is required if an award meets any of the criteria in the table below. In addition, ASC 718-10-25-8 clarifies that the scope exceptions in ASC 480 for certain mandatorily redeemable financial instruments also apply to share-based payment awards within the scope of ASC 718. See Section 5.2.1 for more information.

ASC 480 Instruments	Examples of Share-Based Payment Awards	Comments
Mandatorily redeemable financial instruments described in ASC 480-10-25-4 through 25-7, and defined in the ASC master glossary as “financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.”	An entity issues to a grantee common stock or restricted shares that must be repurchased by the entity as of specified or determinable dates (e.g., upon the employee’s death or any termination event). An entity issues to a grantee redeemable preferred stock that must be repurchased as of specified or determinable dates. If an entity offers a deferred compensation plan to employees under which an employee is forced into a diversified account (i.e., a rabbi trust), such a plan would most likely be considered mandatorily redeemable in accordance with ASC 480 (see Section 2.7).	The repurchase or redemption feature must be unconditional (i.e., the entity and grantee cannot choose the method of settlement). In addition, no other features of the instrument’s terms can exist that would cause the shares not to be redeemed. For example, preferred shares that may be converted into common shares before the specified redemption date(s) would not result in liability classification for the preferred shares if the conversion feature is substantive. ASC 480 includes a scope exception for certain mandatorily redeemable financial instruments of nonpublic entities and certain mandatorily redeemable noncontrolling interests of all entities (public and nonpublic). See Section 5.2.1.
A financial instrument, other than an outstanding share, that embodies (or is indexed to) an obligation to repurchase shares (conditionally or unconditionally) by transferring cash or other assets as described in ASC 480-10-25-8 through 25-13.	An entity issues to a grantee a freestanding written put option to sell the entity’s shares back to it at a fixed price. An entity enters into a forward contract to repurchase shares of its common stock from a grantee on a specified date in the future at a fixed price.	The guidance in ASC 480 only applies if the repurchase feature is considered “freestanding” (e.g., a legally detachable written put option). Most share repurchase features are embedded and not legally detachable. Under ASC 718, the following exceptions apply to certain awards with repurchase features that would otherwise be classified as liabilities under ASC 480: ASC 718-10-25-11 and 25-12 provide explicit guidance on the impact of repurchase and cash settlement features contained in options or similar instruments issued to grantees that include conditions that permit equity classification (see Section 5.3). ASC 718-10-25-18 contains an exception to liability classification for awards that are net settled to meet the employer’s statutory withholding requirements resulting from the grantee’s exercise of an option share (see Section 5.7.2).
A financial instrument that embodies certain obligations to issue a variable number of shares when the obligation’s monetary value is based, solely or predominantly, on any one of the following items described in ASC 480-10-25-14: “A fixed monetary amount known at inception.“ “Variations in something other than the fair value of the issuer’s equity shares.“ “Variations inversely related to changes in the fair value of the issuer’s equity shares.“	An entity grants a bonus to its chief executive for services to be rendered over the next two years. The obligation will be settled by issuing to the grantee a variable number of the entity’s shares valued at $100,000 on the basis of the entity’s share price at the end of the second year (see Example 2-2). ESPPs that require the employee to purchase a specific dollar amount of the employer’s stock on the purchase date; the amount of compensation cost is fixed and known on the service inception date (see Section 8.4).	Awards that are based on monetary values at inception unrelated to increases in the fair value of an entity’s equity and settled in a variable number of shares will most likely result in share-settled debt arrangements, accounted for as share-based liabilities.

In accordance with ASC 480-10-25-14, an entity must classify a share-based payment award as a liability if the award requires the entity to issue a variable number of shares when the obligation’s monetary value is fixed. An obligation of this nature does not expose the grantee to the risks and rewards of a typical equity ownership in an entity because the monetary value of the award is not indexed to the fair value of the underlying shares that will be provided upon settlement. In the examples below, the entity’s obligation related to awards granted to employees would meet the criteria under ASC 480-10-25-14 and thus liability classification would be required.

Example 5-1

Variations in Something Other Than the Fair Value of the Issuer’s Equity Shares

Entity A grants employee stock options with an exercise price established on the grant date equal to a fixed multiple of its trailing 12 months EBITDA. It is assumed that the EBITDA multiple does not represent a reasonable approximation of the fair value of A’s equity shares. The settlement price of the options as of the vesting date is also established according to a fixed multiple of the same trailing 12 months EBITDA of A. Any excess of the options’ settlement price as of the vesting date over the options’ exercise price as of the grant date is paid to the employees in a variable number of A’s shares on the basis of the fair value of A’s shares on the vesting date. Because the monetary value of the options (1) is indexed solely to variations in an operating performance measure of A (i.e., EBITDA) and (2) will be settled in a variable number of A’s shares, the options will be classified as a share-based liability.

Example 5-2

Settlement in a Variable Number of Shares on the Basis of a Fixed Monetary Amount

Entity B is a real estate brokerage firm that has a network of real estate agents who are employees. Upon hiring an agent as an employee, B and the employee enter into a share-based payment arrangement. The terms of the agreement specify that upon the closing of the employee’s first real estate sale, B will issue to the employee shares of common stock equal to $1,000 on the basis of the fair value of B’s common stock as of the date of the closing. The agent will vest in the award at the end of the second year of service following the date of the closing (cliff vesting). Because B has granted an award for a fixed monetary amount to be settled in a variable number of shares, the award is initially classified as a liability. Once the number of shares of common stock to be issued under the award is fixed (upon the closing of the employee’s first real estate sale), and as long as all criteria for equity classification are met, the award would be reclassified as equity.

Example 5-3

Variable Number of Shares Based on Earnings That Exceed a Specified Amount

Entity A grants employees an award of options on A’s common stock. The number of options that vest is based on A’s earnings over a 12-month period. The award cliff-vests at the end of the 12-month period. The number of awards that vest is calculated as follows: for each $500,000 increment of A’s earnings that exceed $2 million, not to exceed $5 million for the 12-month period after the grant date, 25,000 options will vest.

Although awards subject to ASC 718 are outside the scope of ASC 480, ASC 718-10-25-7 requires entities to apply the classification criteria in ASC 480-10-25 and in ASC 480-10-15-3 and 15-4 unless ASC 718-10-25-8 through 25-19A require otherwise. A similar arrangement in which awards are not within the scope of ASC 718 would meet the criteria for classification as a liability under ASC 480-10-25-14(b) because under such an arrangement, the entity would be required to issue a variable number of options on its common shares that derive their value from something other than the fair value of the entity’s equity shares (e.g., value derived from earnings over a 12-month period). However, ASC 718 does not require these awards to be classified as a liability because the issuance of a variable number of shares is indexed to A’s earnings, which represents a performance condition under ASC 718. Accordingly, as long as all other criteria for equity classification are met, the award would be classified as equity.

5.2.1 ASC 480 Scope Exceptions That Apply to Share-Based Payments Within the Scope of ASC 718

In determining the classification of share-based payment awards under ASC 480, nonpublic entities should consider the scope exceptions related to ASC 480 described in ASC 718-10-25-8. The exceptions apply to certain mandatorily redeemable financial instruments that either represent noncontrolling interests or are issued by nonpublic entities that are not SEC registrants. For example, the classification guidance in ASC 480 does not apply to mandatorily redeemable financial instruments of nonpublic entities that are not SEC registrants unless they are mandatorily redeemable on fixed dates for amounts that are either fixed or are determined by reference to an external index (e.g., an interest rate index or currency index).

In addition, if a mandatorily redeemable financial instrument qualifies for one of the exceptions in ASC 480-10, the issuer should consider the applicability of ASC 480-10-S99-3A to that instrument. See Section 5.10 for a discussion and examples of the application of ASR 268 and ASC 480-10-S99-3A to certain redeemable securities. For detailed guidance on the application of ASC 480, see Deloitte’s Roadmap Distinguishing Liabilities From Equity.

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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.