3.4 Allocation of Proceeds to Units of Account

The appropriate allocation method depends on the accounting that applies to each freestanding financial instrument issued as part of the transaction (see Section 3.3.2). The issuer should also consider whether it is necessary to allocate an amount to any other rights or privileges included in the transaction (see Section 3.3.3). That is, in the application of these allocation methods, it is assumed that the proceeds received represent the aggregate fair value of the instruments issued.

Proceeds are allocated among the freestanding financial instruments that form part of the same transaction before any amounts are allocated to component parts of those freestanding financial instruments (such as an embedded derivative instrument that is bifurcated under ASC 815-15).

After applying the appropriate method for allocating proceeds among freestanding financial instruments, an entity would evaluate whether any of those instruments contain embedded derivatives that require separation under ASC 815-15 (see Chapter 8). If so, it would use the with-and-without method (see the next section) to separate them from the host contract (see Section 8.5.3.1).

When a debt issuance involves both the issuance and the receipt of noncash financial instruments (e.g., an entity issues debt in exchange for cash and a put option that permits it to sell its own equity shares), the fair value of the items received represents a component of the proceeds that are allocated among the financial instruments issued.

Under the with-and-without method, a portion of the proceeds equal to the fair value of the instrument (or instruments) measured at fair value on a recurring basis is first allocated to that instrument (or instruments) on the basis of its fair value as of the initial measurement date. The remaining proceeds are then allocated to the other instrument(s) issued in the same transaction either on a residual basis, if there is only one remaining instrument, or by using a relative fair value approach if there are multiple remaining instruments. The with-and-without allocation approach avoids the recognition of a “day 1” gain or loss in earnings that is not associated with a change in the fair value of the instrument(s) subsequently measured at its fair value. Under this approach, if there is only one freestanding financial instrument to which the residual proceeds are allocated, the issuer is not required to estimate that instrument’s fair value.

Under the relative fair value method, the issuer makes separate estimates of the fair value of each freestanding financial instrument and then allocates the proceeds in proportion to those fair value amounts (e.g., if the estimated fair value of one of the instruments is 20 percent of the sum of the estimated fair values of each of the instruments issued in the transaction, 20 percent of the proceeds would be allocated to that instrument). Because the issuer needs to independently measure each freestanding financial instrument issued as part of the transaction, more fair value estimates must be made under the relative fair value method than under the with-and-without method.

In some transactions involving the issuance of more than two freestanding financial instruments, both the with-and-without method and the relative fair value method will apply. For example, if one freestanding financial instrument is measured at fair value on a recurring basis and others are not, the freestanding financial instrument that is subsequently measured at fair value on a recurring basis should be initially measured at its fair value, and the remaining amount of proceeds should be allocated among the freestanding financial instruments not subsequently measured at fair value on the basis of their relative fair values.

When a debt transaction involves both the issuance of financial instruments and the receipt of noncash financial assets (e.g., tranche debt financings that include the issuance of debt and the receipt of loan commitments), the fair value of the noncash financial assets received may be treated as part of the total proceeds received. Under this approach, the sum of the amount of cash proceeds and the fair value of the noncash financial assets received is allocated on a relative fair value basis to the financial instruments issued.

After using the appropriate method(s) to allocate the proceeds to the freestanding financial instruments, the entity should separate any component parts from an individual freestanding financial instrument in accordance with applicable GAAP (e.g., embedded derivatives).

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Hillary Salo stated, in part:

Ms. Salo advised entities to apply judgment and perform the following steps in determining the appropriate accounting for “these types of unique fact patterns”:

1. “[V]erify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.”
    

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   An entity must apply the fair value measurement requirements in ASC 820 when calculating estimated values. For a detailed discussion of the requirements in ASC 820, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
2. “[E]valuate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under Topic 850.”
    

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   As noted in ASC 820-10-35-3, a “fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.” Under ASC 820-10-20, market participants are parties that are independent of each other (i.e., not related parties). Circumstances in which the transaction price may not represent fair value include transactions between related parties and those taking place under duress or in which the entity was forced to accept the transaction price because of financial difficulties.

   In practice, pro rata distributions to equity owners are recognized as equity transactions (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account), whereas non-pro-rata distributions are recognized as a charge to earnings in the period in which the distribution is declared. Accordingly, if a wholly owned subsidiary issues debt to its parent, any excess of the fair value of the instruments issued over the proceeds received might represent a deemed dividend from the subsidiary to the parent. If a related-party transaction represents a non-pro-rata distribution, however, expense recognition may be appropriate.

   In her speech, Ms. Salo emphasized that transactions that are not at arm’s length or are entered into with a related party “require significant judgment; therefore, [the SEC staff] would encourage consultation with OCA in those circumstances.”
3. “[E]valuate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.”
    

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   If a transaction is conducted on an arm’s-length basis and the total fair value of the liabilities measured at fair value exceeds the proceeds received, an entity should carefully evaluate whether the difference is attributable to some other transaction element that qualifies for accounting recognition (e.g., separate freestanding financial instruments, other rights or privileges, or transaction costs; see Section 3.3.3). If so, those elements should be recognized separately (e.g., as an asset or expense in accordance with other applicable GAAP). Under ASC 505-30, there is a presumption that a purchase of shares at a price significantly in excess of the open market price includes other elements for which separate accounting is required.

If an entity, after performing these steps, determines that no other transaction elements can be identified, the excess of the fair value over the proceeds is recognized as an expense (an up-front loss). Ms. Salo indicated that the SEC staff expects “clear and robust disclosure of the nature of the transaction, including reasons why the entity entered into the transaction and the benefits received.”

 

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The above guidance may also be relevant when the aggregate fair value of the debt and other instruments issued exceeds the proceeds and some of the instruments issued are not subsequently accounted for at fair value.

When an entity issues debt together with detachable stock purchase warrants that represent separate freestanding financial instruments (see Section 3.3.2), the proceeds received must be allocated between the debt and the warrants. Although ASC 470-20-25-2 may appear to suggest that the relative fair value method should always be applied to debt issued together with detachable warrants, the scope of this guidance is limited to situations in which (1) the warrants are classified as equity and the debt is not subsequently measured at fair value on a recurring basis and (2) there are no other transaction elements that must be accounted for separately (e.g., other stated or unstated rights or privileges). While ASC 470-20-25-2 suggests that the amounts allocated to detachable warrants should be accounted for as paid-in capital, that guidance conflicts with other GAAP under which entities must classify certain contracts on the entity’s own equity as assets or liabilities (e.g., ASC 480 and ASC 815). Neither ASC 480 nor ASC 815 exempts detachable warrants on the issuer’s equity shares that are classified as assets or liabilities from the initial recognition guidance within those topics.

An entity should account for the portion of the proceeds allocated to the warrants as paid-in capital only if the warrants qualify for classification as equity instruments. If warrants must be classified as a liability under ASC 480, ASC 815-40, or other GAAP, the entity should account for the amount attributable to them under that guidance. Accordingly, an entity should not rely solely on the guidance in ASC 470-20-25-2 and 25-3 when classifying detachable warrants as liabilities or equity or when allocating proceeds between debt and detachable warrants. For a discussion of how to determine the appropriate classification and measurement of a detachable warrant, see Deloitte’s Roadmaps Contracts on an Entity’s Own Equity and Distinguishing Liabilities From Equity.