Chapter 3 — Contract Analysis
Chapter 3 — Contract Analysis
3.1 Overview
Because U.S. GAAP contain several disparate sets of accounting requirements that might apply to a convertible debt instrument, an issuer can save time by organizing its accounting analysis into a framework that is broadly consistent with the order of precedence among those sets of requirements (see Section 3.2). The issuer’s accounting analysis should include a careful evaluation of an instrument’s contractual terms (see Section 3.3) and an assessment of whether a transaction comprises multiple freestanding financial instruments or should be combined with other items (see Section 3.4). Further, an issuer may be required to allocate the transaction amount among multiple freestanding financial instruments before applying any specific classification and measurement approach to a convertible debt instrument (see Section 3.5).
3.2 Framework for the Issuer’s Accounting Analysis
This section illustrates how an issuer may organize its accounting analysis into a sequential framework that is broadly consistent with the order of precedence among the different sets of accounting requirements that might apply to a convertible debt instrument. For example, an issuer can save time by evaluating whether the equity conversion feature is required to be bifurcated as a derivative under ASC 815-15 before considering whether the CCF or BCF guidance in ASC 470-20 applies, since the CCF or BCF guidance does not apply if the equity conversion feature must be bifurcated as an embedded derivative. Regardless of the order in which the different sets of requirements are considered, the ultimate accounting conclusions should not differ.
For debt that is convertible into the issuer’s equity shares (or equity that is
convertible into an issuer’s equity shares and is required to be classified as a
liability), an issuer may perform the following sequence of steps to determine the
appropriate accounting for the instrument at inception:
Step
|
Accounting Issues
|
Deloitte Guidance
|
---|---|---|
1. Identify each freestanding financial
instrument
|
Does the transaction represent (1) a
freestanding financial instrument (e.g., convertible debt),
(2) a bundle of freestanding financial instruments (e.g.,
debt with detachable warrants), or (3) a component of a
larger freestanding financial instrument (e.g., a debt
contract that is analyzed on a combined basis with a
warrant)?
|
Section 3.4 of this
Roadmap as well as Section 3.3 of Roadmap
Distinguishing Liabilities From
Equity and Section 3.2 of Roadmap
Contracts on an Entity’s Own
Equity
|
2. Allocate the transaction amount among
freestanding financial instruments and any other transaction
elements
|
If the transaction represents a bundle of
freestanding financial instruments or other elements (see
step 1 above), how should the proceeds and issuance costs be
allocated among the convertible debt and the other items
included in the transaction?
| |
3. Determine whether the embedded equity
conversion feature is required to be bifurcated as an
embedded derivative
|
Does the embedded equity conversion feature
require bifurcation as an embedded derivative under ASC
815-15? (If so, steps 5, 6, 7, 8, and 9 below are not
applicable to the feature, but the issuer should consider
steps 4, 10, and 13.)
|
Sections 2.3 and
2.4 and Appendix A of this
Roadmap and Chapters 2, 4,
and 5 of Roadmap Contracts on an Entity’s Own
Equity
|
4. Determine whether the convertible debt
contains any other features that require bifurcation as
embedded derivatives
|
Other than the equity conversion feature,
does any feature embedded in the convertible debt (e.g., a
put, call, redemption, or indexation provision) require
bifurcation as an embedded derivative under ASC 815-15?
| |
5. Determine whether the instrument contains
a CCF that requires the instrument to be separated into
liability and equity components
|
Is the instrument required to be separated
into liability and equity components under the CCF guidance
in ASC 470-20? (If so, steps 6, 7, 8, 9, and 10 below do not
apply to the instrument.)
| |
6. For convertible debt instruments without
a CCF, determine whether a BCF should be presented in
equity
|
Does the convertible debt contain a
noncontingent BCF that is required to be separately
recognized in equity at inception under the BCF guidance in
ASC 470-20? (If so, steps 8, 9, and 10 below do not apply to
the instrument.)
| |
7. For convertible debt instruments without
a CCF, determine whether the instrument contains a
contingent BCF
|
Does the convertible debt contain a
contingent BCF that will need to be monitored for potential
recognition in equity under the BCF guidance in ASC 470-20
if the contingency is triggered?
| |
8. For convertible debt instruments without
a CCF or BCF, determine whether an in-substance premium
should be presented in equity
|
Was the convertible debt issued at a
substantial premium that should be presented in equity under
ASC 470-20? (If so, steps 9 and 10 below do not apply.)
| |
9. For convertible debt instruments without
a CCF or BCF or in-substance premium presented in equity,
apply the accounting guidance for traditional convertible
debt
|
Should the convertible debt be accounted for
as traditional convertible debt (i.e., as a liability in its
entirety) under ASC 470-20?
| |
10. Consider whether to elect the fair value
option
|
If the convertible debt contains no
separated equity component at inception (see steps 5, 6, and
8 above), does the issuer wish to elect the fair value
option in ASC 825-10?
| |
11. Allocate the transaction amount
attributable to the convertible debt between any liability
and equity components
|
If the convertible debt contains a separated
equity component at inception (see steps 5, 6, and 8), how
should the proceeds be allocated between the liability and
equity components?
| |
12. Determine whether the SEC’s requirements
related to temporary equity apply
|
If the convertible debt contains a separated
equity component (see steps 5, 6, 7, and 8), must some or
all of this amount be presented in temporary equity?
| |
13. Allocate the transaction amount
attributable to the convertible debt between the host
contract and any embedded derivatives
|
If the convertible debt contains a
bifurcated embedded derivative (see steps 3 and 4), how
should the issuer allocate proceeds attributable to the
convertible debt (or the liability component) between the
host debt contract and the embedded derivative?
|
Some of the steps above are interdependent. For example:
- An issuer cannot determine whether it can elect the fair value option (step 10) before it has determined whether the BCF guidance (applicable only if the convertible debt instrument is not required to be accounted for as a CCF under step 5) requires it to separately recognize an amount in equity at inception (step 6). Further, an issuer cannot determine whether a BCF exists (step 6) until it has allocated proceeds among any freestanding financial instruments (step 2). However, the appropriate method for such an allocation depends in part on whether the issuer has elected the fair value option (step 10). Accordingly, an entity may need to reperform the allocation of proceeds (step 2) if it elects the fair value option (step 10).
- The determination of whether the equity conversion feature (step 3) must be bifurcated may depend in part on whether the issuer elects to apply the fair value option (step 10), since one of the bifurcation criteria is that the hybrid contract not be accounted for at fair value, with changes in fair value recognized in earnings. Further, an issuer must determine whether the instrument contains an equity component at inception under the CCF or BCF guidance (steps 5 and 6) before it can determine whether the fair value option is available (step 10). However, an issuer cannot determine whether the CCF or BCF guidance applies (steps 5 and 6) until it has determined whether the equity conversion feature is required to be bifurcated as an embedded derivative (step 3). Accordingly, an entity may not be able to assume that it can elect the fair value option before it performs its embedded derivative analysis (step 3) unless it has already determined that it cannot apply the CCF or BCF guidance (steps 5 and 6).
3.3 Identifying and Evaluating Contractual Terms
When determining the appropriate accounting for a convertible debt instrument, an entity should devote adequate time to reading the underlying legal documents. Terms that could be significant to the accounting analysis may be buried deep within a contract’s fine print. To properly apply the appropriate accounting requirements, the entity needs to evaluate all the contractual terms, the legal and regulatory framework, and the relevant facts and circumstances.
In forming a view on the appropriate accounting, an entity cannot necessarily rely on the name given to
the transaction or how it is described in summary term sheets, slideshow presentations, and marketing
materials. Products with similar economics sometimes go by different names in the marketplace (e.g.,
products marketed by different banks), while products subject to different accounting may go by the
same or similar names (e.g., the applicability of the CCF guidance in ASC 470-20 to a convertible debt
instrument with a CCF depends on whether the equity conversion feature must be separated as an
embedded derivative under ASC 815-15). Furthermore, the names given to contractual provisions
in legal documents (e.g., conversion, exchange, share settlement, or redemption provisions) do not
necessarily reflect their economics or how they would be identified and analyzed for accounting
purposes (see, e.g., Sections 2.3 and 2.4 and Appendix A). Minor variations in the way contractual terms
are defined can have major accounting implications.
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:
- 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
- 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:
- An observable market other than the market for the issuer’s stock
- 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.
3.5 Allocation of Proceeds and Issuance Costs
3.5.1 Overview
This section discusses how an issuer should allocate proceeds (see Section 3.5.2) and issuance costs (see Section 3.5.3) among
freestanding financial instruments when those instruments are issued in a single
transaction as well as the guidance in ASC 470-20 on the issuer’s allocation of
proceeds between debt and detachable warrants (see Section 3.5.2.3.1). The allocation of such
amounts to components or features contained in a freestanding convertible
instrument is briefly addressed in Section 3.5.4.
3.5.2 Allocation of Proceeds
3.5.2.1 Overview
The amount of proceeds attributable to a financial instrument affects the determination of its initial carrying amount. ASC 835-30-25-4 specifies that if a debt instrument is issued solely for cash and the transaction does not involve any other stated or unstated rights or privileges, its present value at initial recognition is presumed to equal the amount of cash proceeds received from the investor. As indicated in ASC 820-10-30-3, if a financial instrument is measured at fair value upon initial recognition (e.g., derivative instruments and financial liabilities for which the issuer has elected the fair value option in ASC 825-10), “[i]n many cases, the transaction price [such as cash proceeds received] will equal the fair value,” although not always (see also ASC 820-10-30-3A for further guidance).
Generally, one of the following two approaches applies to the issuer’s allocation of proceeds received among freestanding financial instruments that are part of the same transaction:
- A with-and-without method (also known as a residual method; see Section 3.5.2.2).
- A relative fair value method (see Section 3.5.2.3).
The appropriate allocation method depends on the accounting that applies to each
freestanding financial instrument issued as part of the transaction. 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 3.5.2.4).
Proceeds must be allocated among freestanding financial instruments before
any amounts can be allocated to component parts of a freestanding financial
instrument such as a convertible debt instrument (e.g., to an equity
component that is separately recognized under ASC 470-20 or an embedded
derivative instrument that is bifurcated under ASC 815-15; see Section 3.5.4).1
3.5.2.2 With-and-Without Method
If one or more, but not all, of the freestanding financial instruments issued as part of a single transaction
must be recognized as assets or liabilities measured at fair value on a recurring basis (e.g., one of
the instruments is accounted for as a derivative instrument under ASC 815 or at fair value under the
fair value option in ASC 825-10), the with-and-without method should be applied in the allocation of
proceeds among the freestanding financial instruments. This approach is analogous to the allocation
method for bifurcated embedded derivatives in ASC 815-15-30-2 and 30-3.
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 (or instruments) 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 one” gain or loss in earnings that is not associated with a change in the fair value
of the instrument (or instruments) that is 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.
Example 3-1
Debt Issued With Liability-Classified Warrants
Company C issues debt to Company B, together with a detachable and separately transferable warrant, for
total proceeds of $10,000, which is also the par amount of the debt. The warrant gives the holder the right to
purchase shares issued by C, which are redeemable for cash at the holder’s option. Company C determines
that the debt and the warrant represent separate freestanding financial instruments.
Rather than electing to account for the debt by using the fair value option in
ASC 825-10, C will account for it by using the
interest method in ASC 835-30. In evaluating whether
the warrant is within the scope of ASC 480-10, C
determines that the warrant is a freestanding
financial instrument that embodies an obligation to
repurchase the issuer’s equity shares and may
require the issuer to settle the obligation by
transferring assets. In a manner consistent with the
guidance in ASC 480-10, C will account for the
warrant as a liability that is measured both
initially and subsequently at fair value, with
changes in fair value recognized in earnings (see
Deloitte’s Roadmap Distinguishing
Liabilities From Equity). Company C
estimates that the initial fair value of the warrant
is $2,000.
In determining the initial carrying amounts, C allocates the proceeds received between the debt and the
warrant. Because the warrant, but not the debt, will be measured at fair value, with changes in fair value
recognized in earnings, C should first measure the fair value of the warrant ($2,000) and allocate that amount
to the warrant liability. The amount of proceeds allocated to the debt is the difference between the total
proceeds received ($10,000) and the fair value of the warrant ($2,000). The resulting discount from the par
amount of the debt ($2,000) is accreted to par by using the effective-interest method in ASC 835-30.
3.5.2.2.1 Estimated Fair Values Exceed Proceeds Received
In some circumstances, the initial fair value of the items that must be
subsequently measured at fair value exceeds the proceeds received. At
the 2014 AICPA Conference on Current SEC and PCAOB Developments, then
SEC Office of the Chief Accountant (OCA) Professional Accounting Fellow
Hillary Salo addressed the allocation of proceeds related to the
issuance of a hybrid instrument in situations in which the initial fair
value of the financial liabilities that must be measured at fair value
(such as embedded derivatives) exceeds the net proceeds received. She
provided an example in which “a reporting entity that wants to align
itself with a specific investor issues $10 million of convertible debt
at par and is required to bifurcate an in the money conversion option
with a fair value of $12 million.” Ms. Salo’s remarks are also
applicable by analogy to freestanding financial instruments (e.g., debt
issued with detachable warrants) when (1) one or more instruments are
measured at fair value, with changes in fair value recognized in
earnings, and (2) the initial fair value of items that must be
remeasured at fair value exceeds the amount of the proceeds received.
Example 3-2
Debt With Detachable Warrants
Entity Y issues debt and detachable warrants for
$100 million of cash proceeds. The entity elects
to account for the debt at fair value under the
fair value option in ASC 825-10. In accordance
with ASC 815, Y must account for the warrants as
derivatives at fair value. The total estimated
fair value of the debt and the warrants is $120
million as of the issuance date.
Ms. Salo made the following remarks:
[T]he staff believes that when reporting
entities analyze these types of unique fact patterns, they
should first, and most importantly, verify that the fair values
of the financial liabilities required to be measured at fair
value are appropriate under Topic 820. [Footnote omitted] If
appropriate, then the reporting entity should evaluate 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. [Footnote omitted] Lastly, if
at arm’s length between unrelated parties, a reporting entity
should evaluate 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.
In the fact patterns analyzed by the staff, we
concluded that if no other rights or privileges that require
separate accounting recognition as an asset could be identified,
the financial liabilities that are required to be measured at
fair value (for example, embedded derivatives) should be
recorded at fair value with the excess of the fair value over
the net proceeds received recognized as a loss in earnings.
Furthermore, given the unique nature of these transactions, we
would expect reporting entities to provide clear and robust
disclosure of the nature of the transaction, including reasons
why the entity entered into the transaction and the benefits
received.
Additionally, some people may wonder whether the
staff would reach a similar conclusion if a transaction was not
at arm’s length or was entered into with a related party. We
believe those fact patterns require significant judgment;
therefore, we would encourage consultation with OCA in those
circumstances.
Accordingly, an entity should perform the following steps in
determining the appropriate accounting (unless otherwise noted, the quoted
text is from Ms. Salo’s speech):
-
Step 1 — “[V]erify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.”If the entity has not complied with the fair value measurement requirements in ASC 820 regarding its estimated values, it should adjust those values to ensure its compliance. For a detailed discussion of the requirements in ASC 820, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
-
Step 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.”As noted in ASC 820-10-35-2, 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.” ASC 820-10-20 defines market participants, in part, as parties that are independent of each other (i.e., not related parties). A transaction price may not represent fair value if, for example, (1) the transaction was between related parties or took place under duress or (2) the entity was forced to accept the transaction price because of financial difficulties.In practice, a pro rata distribution to equity owners is recognized as an equity transaction (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account), whereas a non-pro-rata distribution is recognized as a charge to earnings in the period in which the distribution is declared. Thus, 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.
-
Step 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.”If the transaction was conducted at arm’s length 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 or other rights or privileges). If so, those elements should be recognized separately (e.g., as an asset or expense in accordance with other applicable GAAP). By analogy, under paragraph 3 of FTB 85-6 (partially codified in ASC 505-30), it is presumed that a purchase of shares at a price significantly in excess of the open market price includes amounts attributable to other items:A purchase of shares at a price significantly in excess of the current market price creates a presumption that the purchase price includes amounts attributable to items other than the shares purchased. For example, the selling shareholder may agree to abandon certain acquisition plans, forego other planned transactions, settle litigation, settle employment contracts, or restrict voluntarily the ability to purchase shares of the company or its affiliates within a stated time period.If, after performing these steps, an entity 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). In this circumstance, the SEC staff expects the entity “to provide clear and robust disclosure of the nature of the transaction, including reasons why the entity entered into the transaction and the benefits received.”
3.5.2.3 Relative Fair Value Method
The relative fair value method is appropriate if either of the following applies: (1) none of the freestanding financial instruments issued as part of a single transaction are measured at fair value, with changes in fair value recognized in earnings on a recurring basis, or (2) after the entity measures freestanding financial instruments at fair value under the with-and-without method, more than one freestanding financial instrument is not subsequently measured at fair value on a recurring basis. To apply this method, the entity allocates the proceeds (or remaining proceeds after application of the with-and-without method) on the basis of the fair values of each freestanding financial instrument at the time of issuance. ASC 470-20-25-2 requires an entity to use the relative fair value allocation approach to allocate proceeds in certain transactions involving debt and detachable warrants. The approach is also appropriate for other transactions that involve freestanding financial instruments not measured at fair value on a recurring basis.
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 an issuer needs to independently measure each freestanding financial instrument issued as part of the transaction, more fair value estimates are required 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.
After allocating the proceeds to the freestanding financial instruments under the appropriate method
or methods, as described above, the entity should separate any component parts from an individual
freestanding financial instrument in accordance with applicable GAAP (see Section 3.5.4).
3.5.2.3.1 Debt With Detachable Warrants
ASC 470-20
25-2 Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options)
shall be allocated to the two elements based on the relative fair values of the debt instrument without the
warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the
warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt
instrument portion of the transaction. This usually results in a discount (or, occasionally, a reduced premium),
which shall be accounted for under Topic 835.
25-3 The same accounting treatment applies to issues of debt instruments (issued with detachable warrants)
that may be surrendered in settlement of the exercise price of the warrant. However, if 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 and the accounting specified in paragraph 470-20-25-12 shall apply.
30-1 The allocation of
proceeds under paragraph 470-20-25-2 shall be
based on the relative fair values of the two
instruments at time of issuance. If a commitment
date must be identified in accordance with
paragraphs 470-20-30-9 through 30-12 for purposes
of applying the guidance on beneficial conversion
features, that commitment date shall be used also
to determine the relative fair values of all
instruments issued together with a convertible
instrument when allocating the proceeds to the
separate instruments pursuant to this
paragraph.
30-2 When detachable warrants (detachable call options) are issued in conjunction with a debt instrument
as consideration in purchase transactions, the amounts attributable to each class of instrument issued shall
be determined separately, based on values at the time of issuance. The debt discount or premium shall be
determined by comparing the value attributed to the debt instrument with the face amount thereof.
When an entity issues debt together with detachable stock purchase warrants that
represent separate freestanding financial instruments (see Section 3.4.2),
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 the warrants are classified as equity and the
debt is not subsequently measured at fair value on a recurring basis.
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 that require entities to classify certain
contracts on the entity’s own equity as assets or liabilities (e.g., ASC
480-10 and ASC 815).
Before the FASB’s codification of U.S. GAAP, the guidance on debt and detachable warrants in ASC 470-20 was contained in APB Opinion 14. When the FASB and EITF subsequently issued guidance on evaluating whether warrants and other contracts on an entity’s own equity should be classified as equity or liabilities (e.g., FASB Statement 150 and EITF Issue 00-19), they did not make consequential amendments to APB Opinion 14. However, in practice, it is generally understood and accepted that the guidance in APB Opinion 14 (as codified in ASC 470-20-25-2) on the classification of detachable stock purchase warrants should be interpreted in light of that subsequent guidance. Neither ASC 480-10 nor ASC 815 exempts detachable warrants on the issuer’s equity shares from its scope.
The portion of the proceeds allocated to the warrants should therefore be accounted for as paid-in capital only if the warrants qualify for classification as equity under ASC 815-40 and other applicable GAAP. If warrants must be classified as an asset or liability under ASC 480-10 or other GAAP, the amount attributable to the warrants should be accounted for under that other 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.
Connecting the Dots
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.
The following table provides an overview of the appropriate allocation of
proceeds between debt and detachable warrants at initial
recognition:
|
Warrant Accounted for at Fair
Value, With Fair Value Changes Recognized in
Earnings
|
Warrant Classified as Equity
|
---|---|---|
Debt accounted for at amortized
cost
|
With-and-without method under
which the warrant is measured initially at fair
value and the debt is measured as the residual
(see Section
3.5.2.2).
|
Relative fair value method
|
Debt accounted for at fair
value, with changes in fair value recognized in
earnings
|
If the estimated fair values
exceed the proceeds received, special
considerations apply (see Section
3.5.2.2.1). If it is determined that
the transaction price does not represent fair
value, additional considerations are also
necessary. Otherwise, a relative fair value method
may be reasonable.
|
With-and-without method under
which the debt is measured initially at fair value
and the warrant is measured as the residual (see
Section 3.5.2.2)
|
3.5.2.4 Other Transaction Components
The issuer should consider whether U.S. GAAP require allocation of any amount to stated or unstated rights or privileges included in the transaction other than the freestanding financial instruments issued. Although ASC 470-20 explicitly requires entities to evaluate whether this allocation is required only for instruments subject to the CCF guidance (see Section 6.3.5), the guidance applies equally to other instruments within the scope of ASC 470-20. For example, if a company issues a three-year note that pays no interest in exchange for cash equal to the face amount of the note and the holder’s right to purchase products at a below-market price, the company might be required to recognize those rights separately in a manner consistent with the guidance in ASC 835-30-25-6.
3.5.3 Allocation of Issuance Costs
3.5.3.1 Concept of Issuance Costs
Issuance costs are specific incremental costs that are (1) paid to third parties
and (2) directly attributable to the issuance of a debt or equity
instrument. Thus, issuance costs represent costs incurred with third parties
that result directly from and are essential to the financing transaction and
would not have been incurred by the issuer had the financing transaction not
occurred. Examples of costs that may qualify as issuance costs include
underwriting fees, professional fees paid to attorneys and accountants,
printing and other document preparation costs, travel costs, and
registration and listing fees directly related to the issuance of the
instrument. In accordance with ASC 470-20-30-13, however, “[a]ny amounts
paid to the investor when the transaction is consummated represent a
reduction in the proceeds received by the issuer (not issuance costs).” For
example, commitment fees, origination fees, and other amounts paid to the
investor (such as reimbursement of the investor’s expenses) represent a
reduction of the proceeds, not an issuance cost.2
Costs that would have been incurred irrespective of whether there is a proposed
or actual offering do not qualify as issuance costs. For example, in
accordance with SAB
Topic 5.A (reproduced in ASC 340-10-S99-1), allocated
management salaries and other general and administrative expenses do not
represent an issuance cost. Similarly, legal and accounting fees that would
have been incurred irrespective of whether the instrument was issued are not
issuance costs (see AICPA Technical Q&As Section 4110.01). Further, the
SEC staff believes that if a proposed offering is aborted (including the
postponement of an offering for more than 90 days), its associated costs do
not represent issuance costs of a subsequent offering.
Unless a debt instrument is subsequently measured at fair value on a recurring
basis, any issuance costs attributable to the initial sale of the instrument
should be offset against the associated proceeds in the determination of the
instrument’s initial net carrying amount (see ASC 835-30-45-1A). Similarly,
issuance costs attributable to the initial sale of an equity instrument
should be deducted from the related proceeds (see SAB Topic 5.A and AICPA
Technical Q&As Section 4110.01). (See Section
3.5.3.2 for a discussion of the allocation of issuance costs
to multiple freestanding financial instruments issued as part of the same
transaction.)
However, as indicated in ASC 825-10-25-3, if the fair value option has been
elected for a debt instrument, “[u]pfront costs and fees [are] recognized in
earnings as incurred and not deferred” (see Section 2.5). Any issuance costs
allocated to other instruments that are subsequently measured at fair value,
with changes in fair value recognized in earnings (e.g., derivative
instruments), also are recognized in the period incurred since they are not
a characteristic of the asset or liability (see ASC 820-10-35-9B).
3.5.3.2 Allocation Methods
Entities should consistently apply a systematic and rational method for allocating issuance costs among
freestanding financial instruments that form part of the same transaction. In limited circumstances, U.S.
GAAP prescribe a specific allocation method for such costs (e.g., for allocating issuance costs between
the liability and equity components of instruments subject to the CCF guidance in ASC 470-20; see
Section 6.3.4). Otherwise, the allocation method depends on the specific facts and circumstances. If
the proceeds are allocated solely on the basis of the relative fair value method, issuance costs should
also be allocated on that basis, which is consistent with the guidance in SAB Topic 2.A.6 (reproduced in
ASC 340-10-S99-2). We generally believe that if an entity uses the with-and-without method (including allocation to a freestanding financial instrument that contains an embedded derivative that must be bifurcated from its host contract), one of the following two methods is appropriate:
- The relative fair value method — The issuer would allocate issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to the allocation of proceeds to debt instruments with detachable warrants in ASC 470-20-25-2. SAB Topic 2.A.6 (reproduced in ASC 340-10-S99-2) states that this method should be applied in the allocation of costs between services received “[w]hen an investment banker provides services in connection with a business combination or asset acquisition and also provides underwriting services associated with the issuance of debt or equity securities.” However, if no proceeds are allocated to the debt under the with-and-without method, any issuance costs allocated to the debt under the relative fair value method should be expensed as incurred because it would be inappropriate to present a debt liability as an asset.
- An approach that is consistent with the allocation of proceeds — The issuer would allocate issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments (see Section 3.5.2). ASC 470-20-30-31 requires entities to use this approach when allocating issuance costs between the liability and equity components of convertible instruments within the scope of the CCF guidance in ASC 470-20.
The method used should be applied consistently to similar transactions. Any issuance costs allocated to a freestanding or an embedded financial instrument that is subsequently measured at fair value through earnings must be expensed as of the issuance date (see, e.g., ASC 825-10-25-3).
3.5.3.3 Transactions That Involve the Receipt of Noncash Financial Assets
If an entity issuing debt receives consideration that includes
noncash financial assets (e.g., tranche debt financings that include the
issuance of debt and the receipt of loan commitments), the related transaction
costs (i.e., incremental direct issuance costs) may be allocated in one of two
ways:
- The costs are allocated only to the financial liabilities or equity issued. No costs are allocated to the noncash financial assets received since they form part of the proceeds received, which are allocated to the financial instruments issued.
- The costs are allocated to both the noncash financial assets received and the financial liabilities or equity issued without regard to whether the fair values are positive or negative (i.e., by using absolute values). Costs and fees are allocated to the noncash financial assets on the basis that transaction costs would have been incurred in a stand-alone transaction for those assets.
Example 3-3
Tranche Debt Financing
With Warrants
Entity S enters into a tranche debt
financing arrangement with an investment firm. On the
initial closing date, S issues to the investment firm a note
payable with a principal amount of $30 million and warrants
on its own stock. In exchange, S receives cash proceeds of
$30 million and a loan commitment under which it may draw up
to $200 million of additional notes if certain business
milestones are met. In addition, S incurs $3.2 million of
third-party costs directly attributable to the financing
arrangement.
Entity S determines that the note payable,
the warrants, and the loan commitment represent separate
units of account. It engages a valuation specialist, who
provides the following fair value estimates:
- Note payable — $16,532,595.
- Loan commitment asset — $38,385,821.
- Warrants — $51,853,226.
Entity S does not elect to account for the
note payable by using the fair value option in ASC 825-10.
Its policy is to allocate issuance costs on a relative fair
value basis by analogy to ASC 470-20-25-2 (see Section
3.5.3.2). Accordingly, S can elect to
allocate the third-party issuance costs in one of the
following two ways:
Allocation Approach 1
— Allocate Third-Party Issuance Costs Only to the
Debt and Warrants
Under this approach, an entity allocates the
proceeds received, after deducting third-party costs, to the
debt and warrants on the basis of their relative fair
values. No third-party costs are allocated to the loan
commitment asset since that asset forms part of the proceeds
received.
Allocation Approach 2
— Allocate Third-Party Issuance Costs to the Debt,
the Warrants, and the Loan Commitment Asset
Under this approach, an entity allocates
third-party costs to the debt, warrants, and loan commitment
asset on the basis of their relative fair values without
regard to whether the fair values are positive or negative
(i.e., by using absolute values). The allocation of some
third-party costs to the loan commitment asset is consistent
with the treatment of transaction costs associated with
financial assets that are not classified as held for trading
(i.e., if only a loan commitment had been obtained, there
could have been third-party costs that would be
capitalizable).
Note that to allocate the costs under this
approach, an entity determines the relative fair values on
the basis of the absolute amounts of the items since it
would be inappropriate to allocate negative third-party
costs to the loan commitment asset. Because the fair value
of the proceeds received equals that of the financial
instruments issued, the use of a relative fair value
allocation methodology does not affect the allocation of
proceeds to the financial instruments issued in this
example.
3.5.4 Allocation to Components or Features Contained in a Freestanding Convertible Debt Instrument
The following table summarizes the approaches for allocating proceeds
attributable to a freestanding convertible debt instrument to components or
features contained in the instrument:
|
Allocation Approach
|
Allocation Objective
|
---|---|---|
Convertible instrument with a bifurcated
embedded derivative (see Section 2.3)
|
With-and-without method. The embedded
derivative is measured first at fair value, and the
residual amount is allocated to the host contract.
|
To measure the embedded derivative at
fair value in a manner similar to a freestanding
derivative instrument
|
Traditional convertible debt (see
Chapter 4)
|
Not applicable. All of the proceeds are
recorded as debt.
|
To reflect the mutual exclusivity of
debt repayment and conversion option exercise (i.e.,
both cannot happen)
|
Debt issued at a substantial premium
(see Chapter 5)
|
With-and-without method. The debt is
measured first at its principal amount, and the residual
amount is allocated to equity.
|
To record a substantial premium received
in equity
|
Instrument with a CCF (see Chapter
6)
|
With-and-without method. The liability
component is measured first at fair value, and the
residual amount is allocated to the equity
component.
|
To reflect interest cost that is paid
with the conversion feature
|
Instrument with a BCF (see Chapter
7)
|
With-and-without method. The BCF is
measured first at its intrinsic value, and the residual
amount is allocated to the instrument.
|
To record the intrinsic value of the
conversion feature in equity
|
An entity may also need to allocate any amount presented in equity between temporary and permanent
equity on the basis of the instrument’s redemption amount (e.g., for debt with a CCF; see Section 2.6)
to highlight that some or all of that amount may not be available to the issuer as a permanent source of
equity financing.
Footnotes
1
After applying the appropriate method for allocating
proceeds among multiple freestanding financial instruments, an
entity would evaluate whether any of those instruments contain
embedded derivatives that require separation under ASC 815-15. The
separation of an embedded derivative from its host contract is
performed by using the with-and-without method as described in ASC
815-15-30-2 and 30-3.
2
Depending on the relationship between the issuer and
the investor, amounts paid to the investor could represent a
dividend or other distribution as opposed to an issuance cost. An
entity should use judgment and consider the particular facts and
circumstances when determining what these amounts represent.