2.6 The SEC’s Guidance on Temporary Equity

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities S99-3A

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(e). Convertible debt instruments that contain a separately classified equity component. Other applicable GAAP may require a convertible debt instrument to be separated into a liability component and an equity component.FN8 In these situations, the equity-classified component of the convertible debt instrument should be considered redeemable if at the balance sheet date the issuer can be required to settle the convertible debt instrument for cash or other assets (that is, the instrument is currently redeemable or convertible for cash or other assets). For these instruments, an assessment of whether the convertible debt instrument will become redeemable or convertible for cash or other assets at a future date should not be made. For example, a convertible debt instrument that is not redeemable at the balance sheet date but could become redeemable by the holder of the instrument in the future based on the passage of time or upon the occurrence of a contingent event is not considered currently redeemable at the balance sheet date.

FN8 See Subtopics 470-20 and 470-50; and Paragraph 815-15-35-4.

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: . . .

d. For convertible debt instruments that contain a separately classified equity component, an amount should initially be presented in temporary equity only if the instrument is currently redeemable or convertible at the issuance date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the issuance date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the issuance date.

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

d. For convertible debt instruments that contain a separately classified equity component, an amount should be presented in temporary equity only if the instrument is currently redeemable or convertible at the balance sheet date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the balance sheet date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the balance sheet date.FN15

FN15 ASR 268 does not impact the application of other applicable GAAP to the accounting for the liability component or the accounting upon derecognition of the liability and/or equity component.

23. Convertible debt instruments that contain a separately classified equity component. For convertible debt instruments subject to ASR 268 (see paragraph 3(e)), there should be no incremental earnings per share accounting from the application of this SEC staff announcement. Subtopic 260-10 addresses the earnings per share accounting.

In financial statements filed with the SEC under Regulation S-X, issuers of equity-classified instruments that are redeemable for cash or other assets in circumstances that are not under the issuers’ sole control must (1) present such instruments on the face of the balance sheet in a caption that is separate from both liabilities and stockholders’ equity (i.e., as “temporary equity”) and (2) apply specific measurement, disclosure, and EPS guidance to them. In addition, an issuer that is subject to the SEC’s requirements should consider whether it must classify as temporary equity all or a portion of the equity component of a convertible debt instrument that contains such a component, including each of the following:

Convertible debt instruments separated into a liability and equity component under the Cash Conversion subsections of ASC 470-20 (i.e., CCF convertible debt instruments; see Chapter 6).
Convertible debt instruments that contain a separately recognized BCF (see Chapter 7).
Convertible debt instruments that contain a separately recognized equity component as a result of a previous modification or exchange involving the instrument that (1) was not accounted for as an extinguishment and (2) increased the fair value of the conversion option (see ASC 470-50-40-15 and Section 4.5.6).
Convertible debt instruments that contain a separately recognized equity component as a result of a reclassification of a previously bifurcated embedded conversion feature (see ASC 815-15-35-4).

Terms and features that could trigger classification as temporary equity are not limited to those that are explicitly described as redemption or put features but also include, for example, certain call, conversion, and liquidation features that could force the issuer to redeem an instrument for cash or assets in circumstances that are not solely within its control.

For convertible debt instruments that contain a separately recognized equity component, ASC 480-10-S99-3A(3)(e) limits the scope of the application of the guidance on temporary equity to scenarios in which the convertible instrument is currently redeemable or convertible by the investor for cash or other assets. Unlike its application to other redeemable equity instruments (e.g., equity-classified redeemable convertible preferred stock with a BCF), the guidance on classifying a convertible debt instrument with a separately recognized equity component as temporary equity must be applied only at the ends of reporting periods in which the instrument is currently redeemable for cash or other assets.3 Thus, the guidance does not need to be applied at the ends of reporting periods in which the instrument will become redeemable or convertible only on a future date. As a result of this guidance, an entity that has an outstanding convertible debt instrument with a separately recognized equity component must assess, in each financial reporting period, whether the equity component (or a portion thereof) must be classified in temporary equity. As indicated in ASC 480-10-S99-3A(12)(d) and ASC 480-10-S99-3A(16)(d), the amount that must be classified in temporary equity is limited to the excess (if any) of “(1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion . . . over (2) the carrying amount of the liability-classified component of the convertible debt instrument” both at initial measurement and on subsequent balance sheet dates.

Connecting the Dots

For further discussion of the application of the SEC’s guidance on temporary equity, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

Footnotes

A convertible debt instrument that is only currently convertible would meet this condition if the issuer does not control the ability to settle the entire conversion value in shares. See Section 9.4.6 of 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.