3.4 Unit of Account

3.4.1 Overview

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.

When applying ASC 470-20, an entity should consider how to appropriately identify units of account (i.e., the “level at which an asset or liability is aggregated or disaggregated” for accounting purposes, as defined above). While a single convertible instrument may represent a unit of account, this is not always the case. To determine the appropriate units of account, the issuer should identify freestanding financial instruments (see Section 3.4.2) and any components or features that should be accounted for separately, such as certain registration payment arrangements (see Section 3.4.3), equity components (see Chapters 5, 6, and 7), and embedded derivatives (see Section 2.3).

3.4.2 Freestanding Financial Instruments

3.4.2.1 Overview

ASC Master Glossary

Convertible Security

A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred).

Freestanding Financial Instrument

A financial instrument that meets either of the following conditions:

It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

Sometimes, a single legal agreement or transaction consists of two or more components that each represent a freestanding financial instrument that should be analyzed separately under ASC 470-20 and other GAAP. For example, an agreement that is described as convertible debt might for accounting purposes need to be analyzed as a debt instrument with a separate, detachable warrant if the warrant is legally detachable and separately exercisable from the debt. Conversely, two separate agreements might represent a single freestanding financial instrument that should be accounted for as convertible debt under ASC 470-20. For example, if a debt instrument is issued contemporaneously with a warrant to the same counterparty, the issuing entity must account for them on a combined basis as a convertible debt instrument if the warrant is not legally detachable and separately exercisable from the debt instrument (see ASC 470-20-25-3 and Section 3.4.2.3).

ASC 470-20 contains limited guidance on the issuer’s identification of freestanding financial instruments in transactions involving convertible debt (see Section 3.4.2.2) and debt issued with warrants (see Section 3.4.2.3). In identifying such instruments under ASC 470-20, the issuer should also consider the definitions of a freestanding financial instrument in ASC 480-10 and a freestanding contract in ASC 815-40 (which is substantially equivalent to the definition of a freestanding financial instrument in ASC 480-10) as well as other relevant guidance (e.g., the embedded derivative and combination guidance in ASC 815).

Connecting the Dots

For additional discussion of how to identify freestanding financial instruments, see Section 3.3 of Deloitte’s Roadmap Distinguishing Liabilities From Equity and Section 3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

3.4.2.2 Convertible Debt Instruments

ASC 470-20

05-4 A convertible debt security is a complex hybrid instrument bearing an option, the alternative choices of which cannot exist independently of one another. The holder ordinarily does not sell one right and retain the other. Furthermore, the two choices are mutually exclusive; they cannot both be consummated. Thus, the security will either be converted into common stock or be redeemed for cash. The holder cannot exercise the option to convert unless he forgoes the right to redemption, and vice versa.

05-5 Convertible debt may offer advantages to both the issuer and the purchaser. From the point of view of the issuer, convertible debt has a lower interest rate than does nonconvertible debt. Furthermore, the issuer of convertible debt securities, in planning its long-range financing, may view convertible debt as essentially a means of raising equity capital. Thus, if the fair value of the underlying common stock increases sufficiently in the future, the issuer can force conversion of the convertible debt into common stock by calling the issue for redemption. Under these market conditions, the issuer can effectively terminate the conversion option and eliminate the debt. If the fair value of the stock does not increase sufficiently to result in conversion of the debt, the issuer will have received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost.

05-6 On the other hand, the purchaser obtains an option to receive either the face or redemption amount of the security or the number of common shares into which the security is convertible. If the fair value of the underlying common stock increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) benefits through appreciation. The purchaser may at that time require the issuance of the common stock at a price lower than the fair value. However, should the fair value of the underlying common stock not increase in the future, the purchaser has the protection of a debt security. Thus, in the absence of default by the issuer, the purchaser would receive the principal and interest if the conversion option is not exercised.

A debt instrument that is convertible into the issuer’s equity shares should be analyzed as a single freestanding financial instrument (rather than two separate freestanding financial instruments) if the holder’s alternative choices of (1) converting the debt into stock or (2) receiving a repayment of the debt are mutually exclusive and cannot exist independently of one another. The choices are mutually exclusive if the holder cannot both convert the debt into stock and redeem the debt for cash. Further, the choices cannot exist independently of each other if they cannot be sold separately.

Connecting the Dots

Although a convertible debt instrument is analyzed for accounting purposes as a single freestanding financial instrument (rather than two separate freestanding financial instruments), an entity may be required for recognition and measurement purposes to separate it into multiple components. For example, ASC 815-15 may require an embedded derivative to be separated from a convertible debt instrument and accounted for as a derivative asset or liability (see Section 2.3), and the Cash Conversion subsections of ASC 470-20 may require separation of a convertible debt instrument into liability and equity components (see Section 6.3.1). The fact that an entity separates such instruments for recognition purposes does not necessarily mean it would do so for balance sheet presentation purposes (see Section 2.3).

3.4.2.3 Debt Instruments Issued With Warrants

ASC 470-20

05-2 Unlike convertible debt, debt with detachable warrants (detachable call options) to purchase stock is usually issued with the expectation that the debt will be repaid when it matures. The provisions of the debt agreement are usually more restrictive on the issuer and more protective of the investor than those for convertible debt. The terms of the warrants are influenced by the desire for a successful debt financing. Detachable warrants often trade separately from the debt instrument. Thus, the two elements of the security exist independently and may be treated as separate securities.

05-3 From the point of view of the issuer, the sale of a debt security with warrants results in a lower cash interest cost than would otherwise be possible or permits financing not otherwise practicable. The issuer usually cannot force the holders of the warrants to exercise them and purchase the stock. The issuer may, however, be required to issue shares of stock at some future date at a price lower than the market price existing at that time, as is true in the case of the conversion option of convertible debt. Under different conditions the warrants may expire without exercise. The outcome of the warrant feature thus cannot be determined at time of issuance. In either case the debt must generally be paid at maturity or earlier redemption date whether or not the warrants are exercised.

25-3 . . . [I]f stock purchase warrants are not detachable from the 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 . . . .

As indicated in ASC 470-20-05-2 and 05-3, a transaction that includes the issuance of both a debt instrument and a warrant on the issuer’s equity shares should be treated as if it contains two separate freestanding financial instruments provided that both of the following apply:

The “warrants . . . trade separately from the debt instrument.”
The “warrants may expire without exercise,” whereas “the debt must . . . be paid at maturity or [an] earlier redemption date whether or not the warrants are exercised.”

Satisfying these two conditions is considered equivalent to meeting condition (b) in the ASC master glossary definition of a freestanding financial instrument (see Section 3.4.2.1).

Conversely, in accordance with ASC 470-20-25-3, if a warrant on an issuer’s equity shares is not detachable from a debt instrument and the warrant cannot be exercised unless the debt is surrendered, the debt and warrant are treated as a single combined freestanding financial instrument since they “are substantially equivalent to a convertible debt instrument” (see also Section 4.5.2.3).

3.4.3 Registration Payment Arrangements

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. (Subtopic 470-20 provides guidance on accounting for convertible instruments with contingently adjustable conversion ratios.)
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 on registration payment arrangements. When issuing a convertible debt instrument, an issuer may agree to pay specified amounts if it is unable to deliver registered shares or maintain an effective registration. For example, a convertible debt 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 it to make cash payments to the counterparty unless and until a registration statement is declared effective. For example, the contract may require that after the 180-day grace period, the entity must pay the investor 2 percent of the contract purchase price for each month in which there is no registration statement in effect that covers the shares that will be delivered under the contract.

A registration payment arrangement that meets the ASC master glossary definition thereof is treated as a unit of account that is separate from the related convertible instrument even if the registration payment arrangement is included in the terms of the convertible debt instrument. However, payment arrangements that do not meet the definition of a registration payment arrangement are not within the scope of the ASC 825-20 guidance on registration payment arrangements; ASC 825-20-15-5 specifically states that the guidance in ASC 825-20 “shall not be applied by analogy to the accounting for contracts that are not registration payment arrangements” under ASC 825-20.

A registration payment arrangement that is within the scope of ASC 825-20 is treated as a contingent liability (see 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 (see ASC 825-20-30-4). If the obligation becomes probable and can be reasonably estimated after inception, a contingent liability is then recognized, with an offset to earnings. Any subsequent change in the amount of the contingent liability is also recognized in earnings (see 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 (see ASC 825-20-30-5).

An arrangement would not be accounted for as a separate unit of account under ASC 825-20 if it contains any of the following provisions:

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 convertible instrument under ASC 470-20, including the assessment of whether the equity conversion feature must be bifurcated as a derivative instrument under ASC 815-10.

Connecting the Dots

Some convertible debt instruments issued in accordance with an exemption from registration under the Securities Act of 1933 contain provisions that require the issuing entity to pay additional interest at a specified time after the issuance date if (1) the convertible debt instrument is not freely tradable by its holders or (2) the issuer has not timely filed any report or document that must be filed with the SEC under Section 13 or 15(d) of the Exchange Act of 1934. Because these payment provisions do not pertain to the filing or maintenance of either an effective registration statement or an exchange listing, they do not meet the definition of a registration payment arrangement. While such payment provisions may be attributed to the hybrid debt contract and therefore may not affect the classification of the embedded conversion option as equity under ASC 815-40 (see Section 3.2.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity), they must be separately evaluated as embedded derivative features under ASC 815-15. In practice, such features generally are bifurcated from the host contract, although they may have minimal fair value.

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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.