3.2 Nonsubstantive or Minimal Features

In its evaluation of whether a freestanding financial instrument should be classified outside of equity under ASC 480, an entity is required to disregard any nonsubstantive or minimal features contained in the instrument. For example, if a conversion option in an otherwise mandatorily redeemable preferred equity security is nonsubstantive, the entity ignores that conversion option in determining whether the share should be classified as a liability under ASC 480. Thus, as long as redemption is judged certain to occur because the conversion option is nonsubstantive, a preferred equity security with a stated redemption date might meet the definition of a mandatorily financial instrument in ASC 480-10-20 (see Section 4.1) even if it contains an equity conversion option.

To determine whether a feature is nonsubstantive or minimal, an entity applies judgment and considers “all the terms of [the] instrument and other relevant facts and circumstances.” The examples in ASC 480-10-55’s application guidance imply that it may be relevant for an entity to consider (1) whether the feature is very deeply out-of-the-money and (2) the value of the feature in relation to the other components of the instrument (e.g., whether its fair value is trivial relative to the fair value of the entire instrument):

• ASC 480-10-55-12 states that a conversion option embedded in a mandatorily redeemable preferred equity security would be judged nonsubstantive if the conversion price is “extremely high in relation to the current share price” (i.e., the conversion option is very deeply out-of-the-money; see Section 3.2.2.1). For classification purposes, such a security is analyzed as a mandatorily redeemable equity security without an embedded conversion option. (In the absence of the requirement to disregard nonsubstantive or minimal features, the entity could have circumvented the requirement to classify the preferred equity security as a liability by embedding the nonsubstantive conversion option in the security.)
• In accordance with ASC 480-10-55-41, an outstanding share of preferred stock with a par amount of $100 and paying a small dividend would be judged minimal if the share contains an embedded written option that permits the counterparty to put both (1) the share and (2) 100,000 shares of common stock for an aggregate exercise price of $4.5 million when the current stock market value of those shares is $5 million (see Section 3.2.2.2). For classification purposes, such a financial instrument is analyzed as a freestanding written put option on common stock without a preferred stock host. (In the absence of the requirement to disregard nonsubstantive or minimal features, the entity could have circumvented the requirement to classify the written put as a liability by embedding it in the minimal preferred stock host.)

A feature may be substantive or nonminimal irrespective of whether it is expected or not expected to be exercised or triggered. ASC 480-10-55-40 suggests that a share that contains mirror-image put and call options that permit the issuer to call the instrument and the holder to put the instrument on the same exercise date and at the same strike price is not a mandatorily redeemable financial instrument. Even though there may be a significant likelihood that either the put option or the call option will be exercised, the share is not a mandatorily redeemable financial instrument since there is a reasonable possibility that both options will expire at-the-money. Accordingly, the instrument is analyzed as a share with a conditional redemption requirement rather than as a share that is certain to be redeemed (see Section 4.2.1). However, if the mirror price is set at a level that makes it virtually impossible for one option to expire unexercised (e.g., the exercise price of the put option is set so high that the option is virtually certain to be exercised), the share should be considered mandatorily redeemable.

In the evaluation of whether a feature is nonsubstantive or minimal, it may be relevant to consider whether it was designed to avoid the classification requirements in ASC 480. The FASB’s purpose in developing the requirements related to nonsubstantive or minimal features was to prevent entities from incorporating such features into instruments to circumvent the classification requirements in ASC 480.

If a feature was included in a contract in good faith for substantive business reasons, and the parties believed at the inception of the contract that it was reasonably possible that the feature would become operable, the feature should not be considered nonsubstantive. Conversely, the feature may lack substance if the outcome of a condition in the contract’s terms is predetermined. For instance, an obligation that is conditional in form may, in substance, be unconditional if the condition is certain to be met in the absence of a violation of other legal obligations (e.g., if the holder of an embedded redemption option is legally required to exercise it under the terms of the same contract, a separate agreement, or its articles of incorporation).

The evaluation of whether a feature is nonsubstantive or minimal should be performed only at contract inception and should focus exclusively on those features that, if disregarded, would result in an instrument’s classification as a liability (or as an asset in some circumstances). That is, an issuer does not reassess its conclusion regarding whether a feature is nonsubstantive or minimal even if circumstances change so that the feature becomes substantive, nonsubstantive, minimal, or nonminimal. This view is supported by the guidance in ASC 480-10-55-12, which suggests that an entity does not subsequently reassess its determination that a conversion feature embedded in a preferred share with a stated redemption date is nonsubstantive. In addition, this view is consistent with paragraph B54 of the Background Information and Basis for Conclusions of FASB Statement 150, which implies that the purpose of the guidance is to prevent entities from circumventing the classification provisions of ASC 480 by inserting a nonsubstantive or minimal feature into a contract at its inception. If, however, the contract is modified, a reassessment of whether a feature is nonsubstantive is required.