2.2 Instruments
ASC
480-10
10-1 The
objective of this Subtopic is to require issuers to classify
as liabilities (or assets in some circumstances) three
classes of freestanding financial instruments that embody
obligations for the issuer.
15-3 The
guidance in the Distinguishing Liabilities from Equity Topic
applies to any freestanding financial instrument, including
one that has any of the following attributes:
- Comprises more than one option or forward contract
- Has characteristics of both a liability and equity and, in some circumstances, also has characteristics of an asset (for example, a forward contract to purchase the issuer’s equity shares that is to be net cash settled). Accordingly, this Topic does not address an instrument that has only characteristics of an asset.
15-4 For
example, an instrument that consists of a written put option
for an issuer’s equity shares and a purchased call option
and nothing else is a freestanding financial instrument
(paragraphs 480-10-55-18 through 55-20 provide examples of
such instruments). That freestanding financial instrument
embodies an obligation to repurchase the issuer’s equity
shares and is subject to the requirements of this
Topic.
ASC 480-10 applies only to items that have all of the following
characteristics:
- They embody one or more obligations of the issuer (see Section 2.2.1).
- They meet the definition of a financial instrument (see Section 2.2.2).
- They meet the definition of a freestanding financial instrument (see Sections 2.2.3 and 3.3); that is, they are not features embedded in a freestanding financial instrument.
- Their legal form is that of a share, or they could result in the receipt or delivery of shares or are indexed to an obligation to repurchase shares (see Section 2.2.4).
ASC 480-10 requires an instrument that has all of the above
characteristics to be classified outside of equity if it falls within one of the
following classes of instruments:
The fact that an instrument is not required to be classified as an
asset or a liability under ASC 480-10 does not necessarily mean that it qualifies
for equity classification. To determine whether an instrument qualifies for
classification in equity in whole or in part, an entity must also consider other
GAAP (e.g., ASC 470-20, ASC 815-10, ASC 815-15, and ASC 815-40). Further, under ASC
480-10-S99-3A, an entity that is subject to SEC guidance should consider whether an
equity-classified instrument must be classified outside of permanent equity (see
Chapter 9).
2.2.1 Obligations of the Issuer
2.2.1.1 The Concept of an Obligation
ASC 480-10 — Glossary
Obligation
A conditional or unconditional duty
or responsibility to transfer assets or to issue
equity shares. Because Topic 480 relates only to
financial instruments and not to contracts to
provide services and other types of contracts, but
includes duties or responsibilities to issue equity
shares, this definition of obligation differs from
the definition found in FASB Concepts Statement No.
6, Elements of Financial Statements, and is
applicable only for items in the scope of that
Topic.
ASC 480-10
05-2 All of the following are
examples of an obligation:
- An entity incurs a conditional obligation to transfer assets by issuing (writing) a put option that would, if exercised, require the entity to repurchase its equity shares by physical settlement. (Further, an instrument that requires the issuer to settle its obligation by issuing another instrument [for example, a note payable in cash] ultimately requires settlement by a transfer of assets.)
- An entity incurs a conditional obligation to transfer assets by issuing a similar contract that requires or could require net cash settlement.
- An entity incurs a conditional obligation to issue its equity shares by issuing a similar contract that requires net share settlement.
05-3 In contrast, by issuing
shares of stock, an entity generally does not incur
an obligation to redeem the shares, and, therefore,
that entity does not incur an obligation to transfer
assets or issue additional equity shares. However,
some issuances of stock (for example, mandatorily
redeemable preferred stock) do impose obligations
requiring the issuer to transfer assets or issue its
equity shares.
ASC 480-10 applies to a freestanding financial instrument only if it embodies one or more obligations of the issuer. Therefore, in evaluating whether the instrument must be classified outside of equity under ASC 480-10, the issuer should determine whether it contains at least one obligation. Paragraph B33 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
Identifying whether a financial instrument embodies
an obligation is the starting point in determining the appropriate
classification of that instrument. . . . A financial instrument that
does not embody an obligation cannot be a liability under the current Concepts Statement 6 definition.
ASC 480-10 defines an obligation as a “conditional or unconditional duty or responsibility to transfer assets or to issue equity shares.” This definition is based in part on the definition of a liability in paragraphs 35 and 36 of FASB Concepts Statement 6. Those paragraphs
state, in part:
Liabilities are
probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past
transactions or events. . . . A liability has three essential
characteristics: (a) it embodies a present duty or responsibility to
one or more other entities that entails settlement by probable
future transfer or use of assets at a specified or determinable
date, on occurrence of a specified event, or on demand, (b) the duty
or responsibility obligates a particular entity, leaving it little
or no discretion to avoid the future sacrifice, and (c) the
transaction or other event obligating the entity has already
happened.
Chapter
4 discusses mandatorily redeemable financial instruments,
which (as noted in Chapter
1) are one of the three classes of financial instruments that
must be classified outside of equity under ASC 480-10. ASC 480-10-20 defines
a mandatorily redeemable financial instrument as “[a]ny of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.” The characteristics of such an instrument are consistent with those in the FASB’s definition of a liability in FASB Concepts Statement 6 because they (1) embody an obligation to transfer
assets, (2) leave the issuer no discretion to avoid the future transfer of
assets, and (3) result from a past event (the issuance of the
instrument).
Chapter
5 discusses the second of the three classes: financial instruments, other than outstanding shares, that embody an obligation to repurchase shares (or an obligation that is indexed to such an obligation) in exchange for cash or other assets (e.g., a physically settled forward purchase or written put option on the issuer’s equity shares). These instruments embody obligations that have all the characteristics of a liability as defined in FASB Concepts Statement 6 because they conditionally
or unconditionally require the issuer to transfer assets, they give the
issuer no discretion to avoid the future transfer of assets, and they result
from a past event (i.e., the issuance of the instrument).
Chapter
6 discusses the third of the three classes: certain obligations to deliver a variable number of equity shares. As noted in paragraph B17 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board concluded that some financial instruments
“that embody obligations to issue shares place the holder of the instrument
in a position fundamentally different from the position of a holder of the
issuer’s equity shares, that such obligations do not result in an ownership
relationship, and that an instrument that embodies an obligation that does
not establish an ownership relationship should be a liability.” For example,
the economic payoff profile of an obligation to issue equity shares worth a
fixed monetary amount resemble that of a debt obligation. Even though it is
share settled, such an obligation could adversely affect the economic
interests of current holders of the entity’s equity shares by diluting their
ownership interest.
Under FASB Concepts Statement 6, an obligation to issue
equity shares is not a liability. Nevertheless, an entity should apply ASC
480-10 in evaluating whether a share-settled obligation within the scope of
ASC 480-10 should be classified as a liability since FASB concepts
statements are not an authoritative source of U.S. GAAP (see ASC
105-10-05-3). When the FASB developed the requirements that are now in ASC
480-10, its plan was to amend the definition of a liability in Concepts Statement 6 to include certain share-settled obligations, but the Board has not yet done so. Paragraphs B12 through B14 of the Background Information and Basis for Conclusions of FASB Statement 150 state:
As part of its deliberations on this Statement, the Board discussed the accounting for financial instruments that embody obligations that require (or permit at the issuer’s discretion) settlement by issuance of the issuer’s equity shares. Those obligations do not require a transfer of assets and, thus, do not meet the current definition of liabilities in Concepts Statement 6.
Therefore, those financial instruments have been classified as
equity.
However, not all such obligations establish the type
of relationship that exists between an entity and its owners. For
example, a financial instrument that requires settlement by issuance
of $100,000 worth of equity shares establishes something more akin
to a debtor-creditor relationship than to an ownership relationship,
because it requires that the issuer convey a fixed amount of value
to the holder that does not vary with the issuer’s equity shares. A
share-settled put option on the issuer’s equity shares establishes
the opposite (inverse) of an ownership relationship, because it
requires the issuer to convey value to the holder that
increases as the value of other owners’ interests
decreases.
The Board considered and rejected the alternative of resolving the accounting issues raised by those financial instruments by applying the original definitions of liabilities and equity in Concepts Statement 6. The Board decided that it would be
preferable to reconsider the distinction between liabilities and
equity. Otherwise, classification by issuers of financial
instruments that embody obligations would be based solely on whether
the obligation requires settlement by a transfer of assets or by an
issuance of equity instruments. As a result, certain instruments
would be classified as equity even though those instruments do not
establish the type of relationship that exists between an entity and
its owners. Instead, the Board decided that the relevance and
representational faithfulness of the reporting of those obligations
would be improved if classification were based on the type of
relationship established between the issuer and the holder of the
instrument as well as the form of settlement.
An obligation can be either unconditional or conditional. An
obligation is unconditional if no condition needs to be satisfied (other
than the passage of time) to trigger a duty or responsibility for the
obligated party to perform. Examples of unconditional obligations
include:
An obligation is conditional if the obligated party only has
a duty or responsibility to perform if a specified condition is met (e.g.,
the occurrence or nonoccurrence of an uncertain future event or the
counterparty’s election to exercise an option). Examples of conditional
obligations include:
- Physically settled written put options that, if exercised, could require the issuer to purchase equity shares and transfer assets (see Chapter 5).
- Physically settled forward contracts that require the issuer to purchase equity shares upon the occurrence or nonoccurrence of an event that is outside the issuer’s control (see Chapter 5).
- Net-settled forward contracts to purchase equity shares that could require the issuer to transfer cash or a variable number of equity shares to settle the contracts’ fair value if they are in a loss position (see Sections 5.2.3 and 6.2.5).
- Net-settled written options that require the issuer to transfer assets or shares if the counterparty elects to exercise the options (see Sections 5.2.3 and 6.2.6).
ASC 480-10 does not address the accounting for financial
instruments that do not embody any obligation of the issuer. Examples of
such instruments include:
- Outstanding equity shares that do not have any redemption or conversion provisions.
- Purchased call options that permit but do not require the issuer to purchase equity shares for cash (see ASC 480-10-55-35).
- Purchased put options that permit but do not require the issuer to sell equity shares for cash.
An obligation to provide services does not meet the
definition of a financial instrument and is therefore outside the scope of
ASC 480-10 (see Section
2.2.2).
2.2.1.2 Economic Compulsion
An instrument would not necessarily be classified outside of
equity even if its terms have been designed to economically compel the
issuer to redeem it. For example, a perpetual preferred share without any
contractual redemption requirements may have an increasing, discretionary
dividend designed to incentivize the issuer to redeem the instrument by a
certain date. That instrument would not be within the scope of ASC 480-10
because it embodies no obligation.
In developing the guidance in ASC 480-10, the FASB
considered whether an instrument in the form of a share should be viewed to
embody an obligation to redeem the share if the issuer could be economically
compelled to redeem the share but is not legally required to do so. However, the Board decided not to establish any such requirement. Paragraph B24 of the Background Information and Basis for Conclusions of FASB Statement 150
states, in part:
Some types of
preferred stock pay no, or low, dividends during the first few years
they are outstanding and then pay dividends at an increasing rate.
The Board considered whether an issuer of such “increasing-rate
preferred stock” should be deemed to have an obligation to redeem
the shares even though it is not legally obligated to do so. The
Exposure Draft proposed that to the extent the shares are not
mandatorily redeemable and no enforceable obligation to pay
dividends exists, increasing-rate preferred stock does not embody an
obligation on the part of the issuer and, therefore, should not be
classified as a liability. Some commentators proposed that
increasing-rate preferred stock be classified as a liability on the
grounds that the increasing rate made redemption economically
compelling or created an implied mandatory redemption date. The
Board reconsidered that issue during its redeliberations but did not
resolve it. The Board deferred until the next phase of the project a
decision about whether an increasing-rate dividend provision, as
well as other forms of economic compulsion, imposes an obligation on
the issuer that causes the instrument to be a
liability.
While the existence of economic compulsion itself is not
sufficient to cause an instrument to be classified as a liability under ASC
480-10, it may be a factor in the evaluation of whether a feature is
substantive. Further, note that the SEC staff has issued guidance on the
accounting for increasing-rate preferred stock (see ASC 505-10-S99-7).
Example 2-1
Increasing-Rate Preferred Stock
A
perpetual preferred share has the following
terms:
- A fixed par amount ($100).
- A stated dividend rate (5 percent per annum) for an initial period (five years).
- An increasing dividend-rate. As of a specified date in the future, the dividend rate will have increased to an interest rate that is likely to be significantly in excess of market rates (20 percent per annum).
- Discretionary dividends. The issuer has discretion over whether to declare a dividend (i.e., the issuer has no legally enforceable obligation to pay the dividend).
- A call option. The issuer has the right to repurchase the preferred share at its par amount if it also pays all unpaid and accumulated dividends on the preferred share.
- A dividend stopper. The issuer is not permitted to declare and pay any dividends on common shares before it pays all accumulated and unpaid dividends on the preferred share.
In these circumstances,
the issuer may be expected to have a strong economic
incentive to call the preferred stock before the
cumulative undeclared dividends become too large. If
it does not call the instrument, the issuer will
either pay significantly above-market dividends to
the preferred shareholders or be unable to pay
dividends on common stock (potentially resulting in
the loss of much of the value of its common stock).
Nevertheless, the preferred stock is outside the
scope of ASC 480-10 because it does not meet the
definition of a mandatorily redeemable financial
instrument and does not contain an unconditional
obligation to deliver a variable number of shares.
(Note also that the issuer’s incentive to redeem the
instrument would weaken if the market’s required
return on similar instruments approached or exceeded
20 percent per annum, for example, because the
issuer’s financial situation deteriorated
sufficiently or market interest rates
increased.)
2.2.1.3 Issuer Discretion to Avoid a Transfer of Assets or Equity Shares
In a manner consistent with the FASB’s definition of a liability in Concepts Statement 6, an issuer does not have an obligation
under ASC 480-10 if it has complete discretion to avoid the transfer of
assets or equity shares. ASC 480-10 does not address the accounting for a
financial instrument that does not embody any obligation of the issuer.
Therefore, the following are examples of instruments that are outside the
scope of ASC 480-10:
-
An agreement to repurchase an entity's own stock by transferring assets, or to issue equity shares, that permits the issuer to cancel the agreement at any time at its sole discretion without penalty.
-
An agreement that requires the issuer to transfer assets or issue equity shares upon the occurrence of an event that is solely within its control. In this case, the entity has no obligation before the event occurs since the entity could not be forced to transfer assets or issue shares unless it decides to proceed with the event or allows it to occur.
The table in Section 9.4.2 lists examples of events
and circumstances that may be considered solely and not solely within the
issuer’s control when their occurrence triggers a duty or responsibility for
the issuer to transfer assets or issue shares. Note, however, that the
determination of whether a specific event is within the issuer’s control
could differ depending on the specific facts and circumstances. For example,
an event that would ordinarily be considered to be solely within the
issuer’s control may not qualify as such if either (1) the counterparty
controls the issuer’s decision to cause the event to occur through board
representation or other rights or (2) the issuer is firmly committed to
undertake an action that will cause the event to occur.
Example 2-2
Callable and Puttable Warrant
A
warrant:
- Permits Holder H to purchase a fixed number of Entity E’s perpetual common shares for a fixed amount of cash.
- Contains:
- A call option that permits E to repurchase the warrant for a fixed price in cash at any time.
- A put option that permits H to put the warrant to E for a fixed price in cash 30 days after giving notice of its intent to exercise the put. If H gives notice of its intent to exercise the put, E has the right to exercise its call option before the put option becomes exercisable. Accordingly, E can prevent the put option from ever becoming exercised.
In evaluating whether
the warrant embodies one or more obligations that
cause it to fall within the scope of ASC 480-10, E
must consider all of the warrant’s terms and
features.
The warrant
contains two conditional requirements: (1) delivery
of a fixed number of shares for cash if H elects to
exercise the warrant and (2) delivery of a fixed
amount of cash if H elects to put the warrant.
The first conditional
requirement represents an obligation of E, because E
has no discretion to avoid it. To be within the
scope of ASC 480-10, however, an obligation to
deliver shares must be for the delivery of a
variable number of shares (see Chapter
6). Since this conditional obligation
is to deliver a fixed number of equity shares, it
does not cause the instrument to be classified as an
asset or a liability under ASC 480-10.
In assessing the second conditional
requirement, E notes that it is able to prevent the
exercise of the put option by exercising its call
option after the counterparty has notified E of its
intent to exercise the put in 30 days.
Despite E’s ability to prevent exercise of the put option, E has a conditional
obligation to transfer assets (pay cash) since it
(1) it cannot prevent H from giving notice of its
intent to exercise the put option and (2) is
required to pay cash irrespective of whether it
exercises its call option or allows the put option
to be exercised (i.e., it has no discretion to avoid
the requirement to pay cash). Under ASC 480-10-25-8,
E classifies the warrant as a liability because it
(1) is not an outstanding share, (2) embodies an
obligation that is indexed to an obligation to
repurchase E’s equity shares, and (3) may require E
to settle the obligation by transferring assets;
that is, it contains a conditional obligation to
deliver cash (see Section 5.1). If
the put option was removed, however, ASC 480-10
would not require E to classify the warrant as an
asset or a liability because the conditional
obligation to deliver a fixed number of equity
shares is not within the scope of ASC 480-10 and the
call option does not represent an obligation.
Instead, E would apply other GAAP (e.g., ASC 815-40)
to determine how to account for the warrant.
2.2.1.4 Asset-Classified Instruments Embodying Obligations
ASC 480-10
25-12 Certain financial
instruments that embody obligations that are
liabilities within the scope of this Subtopic also
may contain characteristics of assets but be
reported as single items. Some examples include the
following:
- Net-cash-settled or net-share-settled forward purchase contracts
- Certain combined options to repurchase the issuer’s shares.
Those instruments are
classified as assets or liabilities initially or
subsequently depending on the instrument’s fair
value on the reporting date.
Although ASC 480-10 applies only to instruments that embody
obligations of the issuer, not all instruments within its scope are
liabilities. For example, an issuer may pay a net premium to purchase a
single freestanding financial instrument, such as a collar that includes
both a purchased call option and a written put option on the issuer’s
shares. Because of the written option component, that instrument embodies an
obligation that is within the scope of ASC 480-10. If the fair value of the
purchased option component (a valuable right) exceeds the fair value of the
written option component, however, the collar is an asset rather than a
liability. Similarly, a net-settled forward contract to purchase the
entity’s equity shares embodies a conditional obligation to transfer assets
or equity shares if the stock price is less than the contracted forward
price on the forward settlement date, but it is an asset if the contract is
in a gain position for the issuer on that date.
2.2.1.5 Prepaid Obligations
ASC 480-10 does not apply to a contract that embodies an
obligation to repurchase equity shares (or a contract indexed to such an
obligation) if the issuer prepays its obligation and therefore has no
remaining obligation to transfer assets or issue equity shares. For example,
a prepaid written put option does not meet the criteria to be accounted for
as an asset or a liability under ASC 480-10-25-8 or ASC 480-10-25-14 because
it does not represent an obligation of the issuing entity (i.e., the option
writer) to transfer assets or issue equity shares. (Prepaid written put
option strategies and economically equivalent arrangements have been
marketed under names such as Dragons, Caesars, or ZCalls.)
Although such an instrument is not within the scope of ASC
480-10, the issuing entity (i.e., the option writer) will need to consider
the applicability of other relevant GAAP. For example, the issuing entity
should consider whether the prepaid contract represents a hybrid financial
instrument that includes an embedded derivative that should be bifurcated in
accordance with ASC 815-15-25-1. The issuing entity should also consider the
guidance in ASC 815-40 on contracts related to an entity’s own equity (see
Deloitte’s Roadmap Contracts on an Entity’s
Own Equity) and in ASC 505-10-45-2 on receivables for
the issuance of equity.
In accordance with a 2004 speech by Scott Taub, then deputy chief accountant in
the SEC’s Office of the Chief Accountant, the issuing entity should also
provide transparent disclosures about the transaction and the related
accounting considerations.
Example 2-3
Prepaid Written Put Option
As part of its share repurchase strategy, Entity Y
issues a prepaid written put option on its own
common shares to Bank B. The relevant facts and
circumstances are as follows:
- The notional amount of the option is 100,000 common shares of Y.
- The strike price of the option is $20 per share, which also represents the fair value of Y’s common shares on the option issuance date.
- The option premium is $4 per share.
- On the option issuance date, Y pays B $16 per share (or $1.6 million = $16 per share × 100,000), which represents the prepayment of the option strike price less the amount of the option premium due from B ($16 = $20 – $4).
- The prepaid written put option is a European-style option; it can be exercised (and will also expire) one year after the option issuance date (the exercise date).
- If the fair value of Y’s common shares on the exercise date is equal to or greater than the option strike price, B will pay Y $20 per share (or $2 million = $20 per share × 100,000).
- If the fair value of Y’s common shares on the exercise date is less than the option strike price, B will deliver 100,000 of Y’s common shares to Y.
The effect of Y’s
issuance of the prepaid written put option to B is
as follows:
Possible Outcome | Economic Result |
---|---|
The fair value of Y’s common
shares on the exercise date is greater than the
option strike price. | Entity Y receives a return on the
written option equal to the difference between the
strike price ($2 million = $20 per share × 100,000
shares) and the prepayment amount ($1.6 million =
$16 per share × 100,000 shares), or $400,000: an
annual return of 25 percent. |
The fair value of Y’s common
shares on the exercise date is equal to or less
than the option strike price. | Entity Y reacquires 100,000 of
its common shares for $16 per share (the
prepayment amount) under more favorable terms than
the fair value of the shares on the option
issuance date ($20 per share). |
As an alternative to
the written put option strategy, Y and B could have
entered into an economically equivalent arrangement
(i.e., one that has the same payoff profile)
involving a purchased call option with a strike
price of $0 per share and a written call option with
a strike price of $20 per share. Under this
alternative approach, the prepayment amount of $16
per share represents the premium due on the
in-the-money purchased call option ($20), reduced by
the premium received from the written call option
($4).
Under either approach,
Y would not apply ASC 480-10-25-8 through 25-13 to
the contract. It would, however, consider other
relevant GAAP to determine the appropriate
accounting for its share repurchase
strategy.
2.2.2 Financial Instruments
ASC
480-10 — Glossary
Financial Instrument
Cash, evidence of an ownership interest
in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term
financial instrument in this definition is recursive
(because the term financial instrument is included in
it), though it is not circular. The definition requires
a chain of contractual obligations that ends with the
delivery of cash or an ownership interest in an entity.
Any number of obligations to deliver financial
instruments can be links in a chain that qualifies a
particular contract as a financial instrument.
Contractual rights and contractual
obligations encompass both those that are conditioned on
the occurrence of a specified event and those that are
not. All contractual rights (contractual obligations)
that are financial instruments meet the definition of
asset (liability) set forth in FASB Concepts Statement
No. 6, Elements of Financial Statements, although some
may not be recognized as assets (liabilities) in
financial statements — that is, they may be
off-balance-sheet — because they fail to meet some other
criterion for recognition.
For
some financial instruments, the right is held by or the
obligation is due from (or the obligation is owed to or
by) a group of entities rather than a single entity.
The scope of ASC 480-10 is limited to financial instruments,
which include:
- Ownership interests (e.g., common or preferred shares or interests in a partnership or limited liability company).
- Contracts to deliver cash (e.g., net-cash-settled options or forward contracts).
- Contracts to deliver shares (e.g., share-settled debt or net-share-settled options or forward contracts).
- Contracts to exchange financial instruments (e.g., physically settled written options or forward contracts that involve the exchange of equity shares for cash or another financial asset).
An obligation to provide services does not meet the definition of a financial instrument and is thus outside the scope of ASC 480-10. In paragraph B34 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board notes that the “to provide services” language in the description of a liability in FASB Concepts Statement 6 was omitted from the
definition of an obligation now in ASC 480-10-20:
This Statement [i.e., the guidance that is now in ASC
480-10] omits the Concepts Statement’s phrase to provide
services, because this Statement [i.e., ASC 480-10] applies only to
financial instruments.
However, a financial instrument (e.g., an outstanding share) may
contain embedded features (e.g., an obligation to deliver gold) that would not
have met the definition of a financial instrument on a stand-alone basis. ASC
480-10 applies to such a hybrid financial instrument. ASC 815-15-55-110 and
55-111 contain an example of “mandatorily redeemable preferred stock whose
preferred dividends are payable in cash but that requires redemption at the end
of 1 year for a payment of 312 ounces of gold.” That example implies that ASC
480 applies to the preferred stock and further suggests that the preferred stock
contains an embedded derivative whose underlying is the price of gold, which is
not clearly and closely related to the host preferred stock contract.
2.2.3 Freestanding Financial Instruments
ASC
480-10 — Glossary
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.
ASC
480-10
25-1 The guidance in this
Section shall be applied to a freestanding financial
instrument in its entirety. . . .
ASC 480-10 applies only to financial instruments that are
freestanding in accordance with the definition of a freestanding financial
instrument in ASC 480-10-20. Accordingly, an entity does not apply ASC 480-10
separately to a feature that is embedded in a financial instrument (see
Section
2.3.2).
For example, if an outstanding share that is not mandatorily
redeemable contains an embedded put option feature that permits the holder to
require the issuer to repurchase the share for a fixed amount of cash, that
option would not be analyzed separately from the share under ASC 480-10 unless
the share is minimal (see Section 3.2). ASC 480-10 does not require classification of that
outstanding share as a liability even though the share contains a component
(i.e., the embedded written put) for which liability classification would have
been required if the component had been issued as a freestanding financial
instrument that was separate from the share (see Chapters 4 and 6).
The definition of a freestanding financial instrument helps not
only in the identification of whether an item is within the scope of ASC 480-10
but also in the determination of the appropriate units of account; that is,
whether an item should be aggregated or disaggregated for accounting purposes
(see Section 3.3).
2.2.4 Legal Form of Share or Involves Equity Shares
ASC
480-10
05-6 For purposes of this
Subtopic, three related terms — shares, equity shares,
and issuer’s equity shares — are used in the particular
ways defined in the glossary.
The instruments in each of the three classes of freestanding
financial instruments that must be classified outside of equity under ASC 480-10
either (1) have the legal form of a share (see Section 2.2.4.1) or could result in the
receipt or delivery of the issuer’s equity shares (see Sections 2.2.4.2 and
2.2.4.3) or (2)
are indexed to an obligation to repurchase its equity shares:
- Mandatorily redeemable financial instruments (the first class; see Chapter 4) applies only to “instruments issued in the form of shares” (emphasis added).
- The second class (see Chapter 5) applies only to financial instruments that embody “an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation” (emphasis added).
- The third class (see Chapter 6) applies only to obligations that “the issuer must or may settle by issuing a variable number of its equity shares” (emphasis added).
If a contract is not in the legal form of a share and does not
involve the potential receipt or delivery of the issuer’s equity shares or is
not indexed to an obligation to repurchase the issuer’s equity shares, it would
be outside the scope of ASC 480-10. Accordingly, financial instruments that are
in the legal form of debt are outside the scope of ASC 480-10. For example, a
note in the legal form of debt that has a stated maturity, stated coupon rate,
and creditor rights is outside the scope of ASC 480-10 even if it is mandatorily
exchangeable into a specified number of common shares on a future date (e.g.,
certain premium income-exchangeable securities). The issuer should present such
a security as a liability on the basis of its legal form.
An instrument that represents a legal-form debt obligation
should be classified as a liability even if it has certain economic
characteristics that are similar to an equity instrument. For example, an
instrument that represents a legal-form debt obligation in the jurisdiction in
which it is issued and carries creditor rights (e.g., an ability to seek
recourse in a bankruptcy court) should be classified as a liability even if the
issuer only has a de minimis amount of common equity capital and the instrument
is described as an “equity certificate,” has a long maturity (e.g., 40 years),
is subordinated to all other creditors, contains conversion rights into common
equity, and provides dividend rights that are similar to those of a holder of
common equity (e.g., payable only if declared). If it is not readily apparent
whether a claim on the entity legally represents debt or equity, an entity may
need to seek an opinion from legal counsel.
In this Roadmap, the term “share-settled debt” is used to
describe a share-settled obligation that is not in the legal form of debt but
has the same economic payoff profile as debt (see Chapter 6).
2.2.4.1 Shares
ASC 480-10 — Glossary
Shares
Shares includes various forms of
ownership that may not take the legal form of
securities (for example, partnership interests), as
well as other interests, including those that are
liabilities in substance but not in form. (Business
entities have interest holders that are commonly
known by specialized names, such as stockholders,
partners, and proprietors, and by more general
names, such as investors, but all are encompassed by
the descriptive term owners. Equity of business
entities is, thus, commonly known by several names,
such as owners’ equity, stockholders’ equity,
ownership, equity capital, partners’ capital, and
proprietorship. Some entities [for example, mutual
organizations] do not have stockholders, partners,
or proprietors in the usual sense of those terms but
do have participants whose interests are essentially
ownership interests, residual interests, or
both.)
In ASC 480-10, the term “share” is not limited to a
financial instrument in the form of equity securities but broadly applies to
any financial instrument that takes the form of an ownership interest. For
example, shares include common and preferred shares, partnership interests
(e.g., participating securities in the form of preferred limited partnership
interests issued by investment funds licensed as SBICs), membership
interests in limited liability companies or cooperative entities, and
policyholder interests in mutual insurance companies.
The following table lists
examples of instruments that, unless a legal analysis of their form suggests
otherwise, would and would not be considered shares under ASC 480-10:
Share | Not a Share |
---|---|
|
|
Under U.S. GAAP, instruments that are in the legal form of
shares (i.e., instruments that evidence a claim to the net assets of the
issuer and do not provide the holder with creditor rights) generally are
classified in the stockholders’ equity section of the balance sheet (either
permanent or temporary equity) unless they meet the criteria for liability
classification in ASC 480-10. Thus, a preferred stock instrument that is not
classified as a liability under ASC 480-10 generally would be presented in
equity even if it has a stated liquidation preference, a stated dividend,
redemption features, and a claim to net assets that is senior to that of
common stockholders.
2.2.4.2 Equity Shares
ASC 480-10 — Glossary
Equity Shares
Equity shares refers only to shares
that are accounted for as equity.
ASC 480-10-20 suggests that the term “equity share” is
limited to shares that qualify, and are classified, as equity (including
both permanent and temporary equity) in the reporting entity’s financial
statements. The term does not apply to shares that are classified as
liabilities. Nevertheless, ASC 480-10-25-8 applies to financial instruments,
such as warrants, options, or forwards, that involve the issuance of
mandatorily redeemable shares that would be accounted for as liabilities
when they are issued; see ASC 480-10-25-13(b) and ASC 480-10-55-33 and
Sections
5.1.3 and 5.2.1.
Surplus notes, which are defined in ASC 944-470-20 as
“financial instruments issued by insurance entities that are includable in
surplus for statutory accounting purposes as prescribed or permitted by
state laws and regulations,” do not qualify as equity shares under ASC
944-470-25-1 but are reported as debt instruments. ASC 944-470-05-1
indicates that such notes are also known as “certificates of contribution,
surplus debentures, or capital notes.”
2.2.4.3 Issuer’s Equity Shares
ASC 480-10 — Glossary
Issuer’s Equity
Shares
The equity shares
of any entity whose financial statements are
included in the consolidated financial statements.
Noncontrolling Interest
The portion of equity (net assets)
in a subsidiary not attributable, directly or
indirectly, to a parent. A noncontrolling interest
is sometimes called a minority interest.
ASC 480-10
15-6 Paragraphs 480-10-55-53
through 55-58 apply to the specific circumstances
described by those paragraphs in which a majority
owner enters into a transaction in the shares of a
consolidated subsidiary and a derivative instrument
indexed to the noncontrolling interest in that
subsidiary.
References in ASC 480-10 to the “issuer’s equity shares”
include equity shares issued by any consolidated subsidiary. For example, if
a parent writes a freestanding put option on a noncontrolling interest in a
subsidiary, the put option might fall within the scope of ASC 480-10 in the
parent’s consolidated financial statements even if it is not recognized in
the subsidiary’s financial statements. Similarly, an entity should evaluate
a put option written by a subsidiary on its own or its parent’s equity
shares to determine whether the option falls within the scope of ASC 480-10
in the consolidated financial statements. ASC 480-10-55-53 through 55-58
contain special accounting guidance on transactions involving noncontrolling
interests (see Section
7.1).
Conversely, shares issued by entities that are not
consolidated in the reporting entity’s financial statements are not the
issuer’s equity shares. For example, if a subsidiary enters into a contract
to purchase the parent’s equity shares for cash, that contract would be
within the scope of ASC 480-10 in the parent’s consolidated financial
statements but not in the subsidiary’s separate financial statements.1 Further, shares issued by an equity method investee or a third party
are not considered the issuer’s equity shares and are therefore outside the
scope of ASC 480-10. Accordingly, an entity that enters into a contract to
purchase or deliver shares of an equity method investee or a third party
would apply other GAAP in accounting for the contract (e.g., ASC 815-10, ASC
321, or ASC 323).
Footnotes
1
See Section 4.2.2 of Deloitte’s
Roadmap Noncontrolling Interests for further
discussion of the accounting for a subsidiary that owns shares of
its parent.