3.1 Identifying and Evaluating Contractual Terms

In determining the appropriate accounting for a contract or transaction under ASC 480, an entity is well advised to devote adequate time to reading the underlying legal documents. Terms that are significant to the accounting analysis may be buried deep within the fine print of the contract. All of the contractual terms as well as the legal and regulatory framework and surrounding facts and circumstances need to be carefully evaluated in light of the applicable accounting requirements.

In forming a view on the appropriate accounting, an entity cannot necessarily rely on the name given to a transaction (e.g., mandatorily redeemable equity security, convertible preferred equity certificate, hybrid equity unit, warrant, or equity option) or how it is described in summary term sheets, slideshow presentations, and marketing materials. Products with similar economics and legal characteristics 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 accounting analysis for a warrant on an entity’s own stock might depend on whether it includes redemption requirements, and for a convertible preferred equity certificate, such analysis might depend on whether the certificate is in the legal form of debt or equity). Furthermore, the names given to contractual provisions in legal documents (e.g., conversion features or share settlement provisions) do not necessarily reflect how they would be identified and analyzed for accounting purposes. Minor variations in how contractual terms are defined can have major accounting implications.

For example, a share described contractually as “redeemable” or “mandatorily redeemable” does not necessarily meet the definition of a mandatorily redeemable financial instrument under ASC 480. If a share with a mandatory redemption date contains, for instance, a substantive conversion feature that permits the investor to convert the share into a fixed number of common shares before the mandatory redemption date, the share would not be considered mandatorily redeemable under ASC 480 (see Section 4.1).

An individual contract may consist of multiple legal documents (e.g., a trade confirmation that refers to a master agreement or a contract that is modified by a side letter). The issuer should consider all such documents in identifying the terms of the contract. To determine the appropriate accounting for a contract that involves the receipt or delivery of equity shares, the issuer should also consider whether the terms of the underlying shares could affect the accounting analysis of the contract. For example, an entity may write a call option or warrant on its equity shares under which the shares that would be delivered upon the option’s exercise are redeemable by the shareholder in accordance with the issuer’s articles of incorporation, a certificate of designation applicable to the shares, a separate agreement, or another arrangement. Such a redemption provision may affect the classification of the warrant even if the warrant contract does not mention any redemption requirement (see Section 5.2.1.1).