Chapter 3 — Contract Analysis

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).

3.3 Unit of Account

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.

In applying ASC 480, an issuer should consider how to appropriately identify units of account (i.e., “[t]he level at which an asset or a liability is aggregated or disaggregated” for accounting purposes). Determining the appropriate units of account is important because the application of ASC 480 and other GAAP depend on how units of account are identified. For example, if an issuer writes a freestanding put option on an equity share, the put option is analyzed as a unit of account that is separate from the share. Under ASC 480, the written put option would be classified as a liability and measured at fair value, with changes in fair value recognized in earnings. If the issuer instead were to embed the same put option in the equity share, however, the put option would not be separately evaluated under ASC 480 because the scope of ASC 480 is limited to freestanding financial instruments (see Sections 2.2.3 and 2.3.2). In this circumstance, the combination of the share and the embedded put option potentially would represent a single unit of account that qualifies for equity classification depending on the application of other GAAP (e.g., ASC 815-15).

3.3.1 Concept of a “Freestanding Financial Instrument”

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.

Because ASC 480 applies only to freestanding financial instruments and not to features embedded in such instruments, the definition of a freestanding financial instrument helps an issuer determine whether an item is within the scope of ASC 480. A single contract often represents a freestanding financial instrument. However, sometimes a single legal agreement consists of more than one component that individually meets the definition of a freestanding financial instrument, such as components that are legally detachable and separately exercisable (e.g., debt with a detachable warrant). Conversely, two separate agreements might, for accounting purposes, have to be combined and treated as a single freestanding financial instrument (e.g., debt issued with a warrant that is not legally detachable and separately exercisable).

ASC 480-10-20 defines a freestanding financial instrument as one that is entered into either “separately and apart from any of the entity’s other financial instruments or equity transactions” or “in conjunction with some other transaction and is legally detachable and separately exercisable.” Therefore, an entity should consider the following questions in identifying freestanding financial instruments:

Was the transaction entered into contemporaneously with and in contemplation of another transaction, or was it entered into separately and apart from other transactions?

The fact that a transaction was entered into separately and apart from any other transaction suggests that it is a freestanding financial instrument that is separate from any other transaction. If the transaction was entered into contemporaneously and in contemplation of another transaction, the entity should assess whether the two transactions represent a single freestanding financial instrument. For example, if warrants are issued in conjunction with a debt issuance of the same issuer, the issuer should consider whether to treat them as being embedded in the debt even if they are subject to a separate contractual agreement.

A transaction’s having been entered into contemporaneously or in conjunction with some other transaction, however, would not necessarily result in a conclusion that the two transactions should be viewed on a combined basis as a single freestanding financial instrument. The entity should also consider whether the transactions are legally detachable and separately exercisable (see below) and whether the combination guidance in ASC 815 applies (see Section 3.3.2).

A one-week period between transactions may be good evidence that the transactions are not contemporaneous if the entity is exposed to market fluctuations during this time. Even when transactions occur at different times, however, entities should consider all available evidence to ensure that no side agreements or other contracts were entered into that suggest the transactions were entered into in contemplation of one another.

Options written by the acquired entity on its stock as of the date of a business combination are often viewed as effectively modifying previously existing shares. Such options are not considered to have been entered into separately and apart from the shares.
Is the item legally detachable?

Neither ASC 480 nor other GAAP provide guidance on the meaning of “legally detachable.” In practice, an item is considered legally detachable from another item if it is (1) separately transferable from that item or (2) otherwise capable of being separated from that item. If an item is separately exercisable but not considered legally detachable, it would not be a separate freestanding financial instrument under item (b) of the definition of a freestanding financial instrument. However, in some cases, the separate exercisability of an item results in a conclusion that an item is legally detachable.

An item is always considered “legally detachable” if it can be transferred separately from another item in a single contractual agreement (or from another item in multiple contracts entered into at the same time) at the holder’s discretion (i.e., without limitations imposed by the counterparty). The fact that an item can be transferred independently from another item indicates that it is a separate unit of account even if the two items were entered into contemporaneously and have the same counterparty. This view is supported by the guidance in ASC 815-10-25-9, which states, in part:

Derivative instruments that are transferable are, by their nature, separate and distinct contracts.

Similarly, ASC 815-10-15-5 states, in part:

The notion of an embedded derivative . . . does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.

However, a scenario in which two items cannot be transferred independently of one another suggests that each item is not a freestanding financial instrument under (b) in the definition of a freestanding financial instrument in ASC 480-10-20. For example, if a warrant “travels with” a bond and cannot be transferred separately from the bond, it may be an embedded feature in the bond.

A contract may be entered into in conjunction with some other item. For such a contract to be considered a freestanding instrument, an assessment must be performed of both the form and substance of the transaction, including the substance of the independent transferability of the item. In some circumstances, an item is unconditionally separately transferable by the holder but would have no economic value if the related item were not held, which would suggest that the separate transferability has no substance and the item is embedded in the related item (see further discussion in question 3). Similarly, the holder of shares not readily obtainable in the market may have a separately transferable put option that it can exercise only by delivering the same specific shares. In this case, the shares and the put option may represent a single, combined unit of account on the basis of an assessment of the substance of the transaction.

In other circumstances, an item may be separately transferred only with the consent of the counterparty. If an item may be separated from a related contract without any modification to the contractual terms (e.g., the contract specifically permits the item to be transferred if the issuer gives its consent and such consent cannot be unreasonably withheld), the legally detachable condition is, in substance, generally met since the counterparty has agreed to not withhold its consent. If, however, the counterparty can always prevent the separate transfer of the item at its discretion, the legally detachable condition is, in substance, most likely not met and therefore the item is not a freestanding financial instrument.

The SEC staff has indicated in informal discussions that it is possible for two items that have been entered into contemporaneously with the same counterparty to be considered freestanding financial instruments solely on the basis of the items’ ability to be separately exercised (i.e., even though the contractual terms prevent the items from being transferred separately). This would generally be the case when a reasonable conclusion can be reached that the separate exercisability of one item is sufficient to establish that it is legally detachable from the related item. However, when determining whether an item can be transferred separately, an entity must use significant judgment and consider the transaction’s form and substance. We therefore strongly recommend that an entity consult with its independent accounting advisers when performing this assessment.
Can the item be exercised separately, or does exercise result in the termination, redemption, or automatic exercise of a specifically identified item?

If an item can be freely exercised without terminating the other item (e.g., through redemption, automatic exercise, or expiration), it is considered to be “separately exercisable.” The fact that a warrant remains outstanding if a bond to which it is attached is redeemed, for example, suggests that the warrant is a freestanding financial instrument that is separate from the bond. Similarly, if a bond may remain outstanding after a net-share-settled conversion feature included in the bond is exercised, the conversion feature may be a freestanding financial instrument.

Conversely, if the exercise of an item results in the termination of a specifically identified item, the first item would not be considered separately exercisable from the other item. For example, if a warrant can be exercised only by the tendering of a specific bond in a physical settlement, it may be a feature embedded in the bond rather than a freestanding financial instrument. ASC 470-20-25-3 states, in part:

[I]f stock purchase warrants are not detachable from [a] 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.

Similarly, if a specifically identified share is subject to a redemption requirement, the share and the redemption requirement may represent one single freestanding financial instrument even if they are documented in separate agreements. ASC 480-10-15-7C states, in part:

Some entities have issued shares that are required to be redeemed under related agreements. If the shares are issued with a redemption agreement and the required redemption relates to those specific underlying shares, the shares are mandatorily redeemable.
Does the transaction involve multiple counterparties?

Contracts with different counterparties are treated as separate freestanding financial instruments even if they were issued contemporaneously or are transacted as a package. Thus, ASC 815-10-15-6 suggests that an option added or attached to an existing debt instrument by another party is not an embedded derivative because it does not have the same counterparty. Similarly, ASC 815-15-25-2 indicates that the notion of an embedded derivative in a hybrid instrument does not refer to provisions in separate contracts between separate counterparties.

Example 3-1

Issuance of a Bond With a Warrant

An entity delivers a bond and a warrant on its own equity to an underwriter for cash. The underwriter is a party to the warrant but holds the bond merely as an agent for a third-party investor. The terms and pricing of the bond sold to the third-party investor are not affected by the sale of the warrant to the underwriter. Because they involve different counterparties, the bond and the warrant are two separate freestanding financial instruments.

Under ASC 815-10-25-10, transactions that are entered into with a single party are treated as having the same counterparty even if some of them are structured through an intermediary. In consolidated financial statements, the reporting entity is the consolidated group. Therefore, the parent and its subsidiary would not be considered different parties in the consolidated financial statements. For example, if a parent entity writes a put option on subsidiary shares to the holder of those shares, it is acceptable to view the option as being embedded in the shares in the consolidated financial statements even though the subsidiary technically is not a party to the option.

3.3.2 Combination Guidance

ASC 480-10

25-15 A freestanding financial instrument that is within the scope of this Subtopic shall not be combined with another freestanding financial instrument in applying paragraphs 480-10-25-4 through 25-14 unless combination is required under the provisions of Topic 815. For example, a freestanding written put option that is classified as a liability under this Subtopic shall not be combined with an outstanding equity share.

ASC 480 precludes an entity from treating two or more freestanding financial instruments as a single unit of account unless combination is required under the derivative accounting requirements in ASC 815. Thus, the entity is prevented from circumventing the requirements of ASC 480 by analyzing freestanding instruments on a combined basis as a synthetic instrument. For example, the entity could not combine a written put option on the entity’s shares with an outstanding share and analyze them in combination as a puttable share if the option and the share are separate freestanding financial instruments. If the entity had been permitted to combine the option and the share, it might have been able to avoid the liability classification requirements in ASC 480 for the option since those requirements do not apply to (1) puttable shares that are not certain to be redeemed or (2) embedded put features.

Under a narrow exception in ASC 480, two or more transactions must be combined if their combination would be required in accordance with the derivative accounting guidance in ASC 815. Such combination requirement is intended to prevent entities from circumventing the derivative accounting guidance. Accordingly:

If two or more transactions must be combined under ASC 815, they would be combined under ASC 480 as well.
If two or more transactions do not have to be combined under ASC 815, they would not be combined under ASC 480 either.

ASC 815-10-15-8 states, in part:

In some circumstances, an entity could enter into two or more legally separate transactions that, if combined, would generate a result that is economically similar to entering into a single transaction that would be accounted for as a derivative instrument under [ASC 815-10].

Nevertheless, because it is transaction-based, ASC 815 ordinarily does not permit an entity to treat two or more freestanding financial instruments as a single combined unit of account. ASC 815-10-25-6 states, in part:

[ASC 815-10] generally does not provide for the combination of separate financial instruments to be evaluated as a unit.

However, if two or more freestanding financial instruments have characteristics suggesting that they were structured to circumvent GAAP, they may need to be combined and treated as a single unit of account. Specifically, ASC 815 requires two or more separate transactions to be combined and viewed in combination as a single unit of account for accounting purposes if they were entered into in an attempt to circumvent the derivative accounting requirements in ASC 815 (i.e., measured at fair value, with subsequent changes in fair value recognized in earnings). ASC 815-10-15-9 states that such combination is required if the transactions have all of the following characteristics:

They “were entered into contemporaneously and in contemplation of one another.”
They “were executed with the same counterparty (or structured through an intermediary).”
They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
“There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”

ASC 815-10-25-6 identifies characteristics similar to those listed above from ASC 815-10-15-9 and adds the following commentary:

If separate derivative instruments have all of [these] characteristics, judgment shall be applied to determine whether the separate derivative instruments have been entered into in lieu of a structured transaction in an effort to circumvent GAAP: . . . If such a determination is made, the derivative instruments shall be viewed as a unit.

Note that the SEC staff has indicated that it will challenge the accounting for transactions that have been structured to circumvent GAAP.

3.3.3 Application Issues and Examples

3.3.3.1 Issuance of Warrants and Put Options

Example 3-2

Issuance of Warrants and Put Options

An entity issues stock purchase warrants on its stock to third-party investors. In conjunction with that transaction, the entity enters into a warrant-holder rights agreement with each warrant holder giving it a put right that allows it to require the entity to purchase for cash any or all of the shares issued or issuable to the holders under the warrants. The put right cannot be sold separately from the shares issued or issuable, and those shares cannot be sold separately from the put rights. In other words, the put rights are directly linked to the shares that are issued or issuable under each warrant and accompany the shares if sold or transferred to another party. The put rights cannot be used to put back shares other than those issued or issuable under the warrants.

In this scenario, the warrants and put rights are combined and viewed as one single freestanding financial instrument (unit of account) even though they are documented in two separate legal documents. The combined instrument would be classified as a liability under ASC 480 because it is not an outstanding share, it embodies an obligation of the issuer (see Section 2.2.1), and the entity could be required under the put option to repurchase shares by transferring assets (see Chapter 5). If the warrants are exercised, the put rights would be considered embedded in the shares. As a result, those redeemable shares would be outside the scope of ASC 480 because they do not meet the definition of a mandatorily redeemable financial instrument (see Chapter 4), they represent outstanding shares (see Chapter 5), and they do not embody an unconditional obligation to issue a variable number of shares (see Chapter 6).

3.3.3.2 Put Option on Noncontrolling Interest

Example 3-3

Put Option on Noncontrolling Interest

An entity holds 70 percent of the equity shares of another entity and consolidates that entity (i.e., the entities have a parent-subsidiary relationship). The remaining 30 percent of the shares (the noncontrolling interest) are held by a third party. After the parent acquires its 70 percent of the shares and the third party acquires its 30 percent, the parent entity writes a put option that permits the third party to sell all of its shares to the parent for a fixed price on or before a specified date. Unlike the put option, the shares have no expiration date. Upon exercise, the put option is physically settled. There is no mechanism to net cash or net share settle the option. Given the nature of its terms, the put option cannot be transferred separately from the noncontrolling interest, and the exercise of the put option results in the termination of the noncontrolling interest.

Because it is not legally detachable and separately exercisable, the put option should be considered embedded in the noncontrolling interest rather than a freestanding financial instrument. Because redemption is not certain to occur, the entity would not classify the instrument (the combination of the noncontrolling interest and the put option) as a liability under ASC 480 (see Chapter 4). In the parent’s consolidated financial statements, the put option may be considered embedded in the noncontrolling interest irrespective of whether the option issuer is the parent or the subsidiary.

3.3.3.3 Issuance of Shares and Put Options

Example 3-4

Issuance of Shares and Put Options

An entity issues equity shares along with put options that give the counterparty the right to require the entity to redeem the same number of shares for cash. The options can only be physically settled through the exchange of shares for cash. The put options do not require delivery of any specifically identified shares, and because the shares issued with the put options are publicly traded, they are not the only shares available to settle the put option. Therefore, the put options would not be considered embedded in the shares. Instead, they would be classified as liabilities under ASC 480 (see Chapter 5).

3.3.3.4 Put Right That Expires Upon Share Transfer

Example 3-5

Put Right That Expires Upon Share Transfer

An entity enters into an agreement to sell a share along with a put right to a specific investor. The put right is solely for the benefit of that specific investor with regard to the specific share it has purchased. If the investor transfers the share to a third party, the put right irrevocably terminates upon the transfer. Even if the investor subsequently repurchases the share, it cannot regain its put right.

In these circumstances, the agreement effectively prohibits separation of the put right from the share. Therefore, the put right would not be considered legally detachable from the share and would not be a freestanding financial instrument. Instead, the entity would analyze the share and the put right on a combined basis in determining whether ASC 480 applies. The redeemable shares would be outside the scope of ASC 480 because they do not meet the definition of a mandatorily redeemable financial instrument (see Chapter 4), they represent outstanding shares (see Chapter 5), and they do not embody an unconditional obligation to issue a variable number of shares (see Chapter 6).

3.3.3.5 Tranche Preferred Stock Agreement

Example 3-6

Tranche Preferred Stock Agreement

Entity X enters into a preferred stock purchase agreement with unrelated investors to sell two tranches of convertible redeemable preferred stock (the “preferred stock”). The purchase agreement stipulates the following:

On the first closing date, which is the date of the purchase agreement, the investors will acquire 50,000 shares of preferred stock for $50 million.
On the second closing date, the investors will acquire 25,000 additional shares of preferred stock for $25 million subject to a specified condition. The second closing will occur only if (1) a specific milestone related to X’s operations is achieved two years from the first closing date or (2) the specific milestone related to X’s operations is not achieved two years from the first closing date but the holders waive the milestone requirement and elect to purchase the additional shares of preferred stock (the “contingent purchase option”).

The purchase agreement stipulates that the holders of preferred stock issued in the first closing cannot transfer their contingent purchase options separately from the preferred shares acquired in the first closing (or vice versa). However, such holders have the right to convert those preferred shares into common stock before the date that is two years from the first closing date. The purchase agreement does not restrict the holders that convert preferred shares into common stock from selling those common shares. The only restrictions on selling common stock stem from restrictions under U.S. securities laws.

In this example, the contingent purchase option would be considered a freestanding financial instrument because it meets the “legally detachable and separately exercisable” condition. The holders can “detach” the two instruments because they can convert the preferred stock into common stock and sell those shares while retaining the contingent purchase option (i.e., the two instruments are capable of being separated). This would be the case even if the contingent purchase option may not be separately transferred after the conversion into common stock of the preferred shares obtained in the first closing. It would not be appropriate to consider the preferred shares and the contingent purchase option a single combined financial instrument, because the contingent purchase option would not become embedded in the common shares received upon conversion of the preferred stock purchased in the first closing.

Note that the conclusion in this example would not change even if:

The holders could not sell the common shares received upon conversion of the preferred stock purchased in the first closing before satisfaction or expiration of the contingent purchase option. At the inception of the arrangement, the two instruments still meet the legally detachable and separately exercisable condition because the contingent purchase option (1) cannot become embedded in the common shares received upon conversion of the preferred stock purchased in the first closing and (2) does not become freestanding only if the preferred stock purchased in the first closing is converted into common stock (instead, the ability to convert the preferred stock purchased in the first closing is evidence that the contingent purchase option is capable of being separated at the inception of the arrangement).
The preferred stock purchased on the first closing date cannot be transferred or converted before the contingent purchase option is satisfied or expires and the holders have the right to acquire the additional shares related to the contingent purchase option at their option at any time before two years from the closing date. The two instruments still meet the legally detachable and separately exercisable condition because the investor can separate the two components by early exercising the contingent purchase option while retaining the preferred shares acquired on the first closing date.

As this example illustrates, and in a manner consistent with practice, an option or commitment to issue additional preferred shares is almost always a freestanding financial instrument because the separate exercisability of the option or commitment is sufficient to demonstrate that the feature is capable of being separated.

3.3.4 Allocation of Proceeds and Issuance Costs

3.3.4.1 Allocation of Proceeds

The amount of proceeds attributable to a financial instrument affects the determination of its initial carrying amount. 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 3.3.4.2).
A relative fair value method (see Section 3.3.4.3).

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, for example, ASC 470-20-25-24 and ASC 835-30-25-6).

Connecting the Dots

It is appropriate to allocate the proceeds received to multiple freestanding financial instruments issued as part of a single transaction when the proceeds represent the fair value of the package of financial instruments issued. In such a case, an entity should use one of the two methods discussed below. However, if an entity issues multiple freestanding financial instruments and receives proceeds that differ from the fair value of the package of financial instruments issued (i.e., the transaction is not at arm’s length), the entity must appropriately account for the other rights, privileges, or elements included in the transaction. For example, if an entity issues two freestanding financial instruments to a related party and the price paid exceeds the aggregate fair value of the package of instruments issued, the entity may have received a capital contribution from the investor. Alternatively, if an entity issues multiple financial instruments and receives proceeds that are less than the fair value of the package of instruments issued, the entity may have a recognizable asset or may need to record a dividend or expense. The accounting for proceeds that differ from the fair value of the package of financial instruments issued depends on the particular facts and circumstances.

It is never appropriate to recognize a financial instrument that represents an obligation or equity of the entity at a negative amount. Furthermore, it is generally not appropriate to recognize no amount for a financial instrument that represents an obligation or equity of the entity. See also the discussion in Section 3.3.4.2.1.

3.3.4.2 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 at fair value on a recurring basis under ASC 480, 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 1” 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 3-7

Debt Issued With a Detachable Warrant

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 and that the total proceeds received are a reasonable approximation of the fair value of the instruments issued.

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, 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, 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 Chapter 5). 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.

3.3.4.2.1 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 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. Ms. Salo provided the following example:

[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.

Her remarks also apply by analogy to debt issued with detachable warrants or other freestanding financial instruments when (1) one or both 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. In addition, her remarks are relevant to an issuer’s determination of the appropriate accounting for a repurchase of an outstanding financial instrument at an amount in excess of its fair value (see Section 6.1.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

Example 3-8

Fair Value of Instruments Exceeds Purchase Price

Entity Y issues debt and detachable warrants on preferred shares that are redeemable by the holder upon a change of control 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 480-10-25-8 (see Chapter 5), Y must account for the warrants as liabilities 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 (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 820-10-35-3, 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, that is, they are not related parties.” Circumstances in which a transaction price may not represent fair value include those in which (1) the transaction was between related parties and 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 FASB Technical Bulletin 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.”

Connecting the Dots

In some situations, an entity may record an expense amount that is more than the amount by which the initial fair value of a financial instrument that is subsequently measured at fair value exceeds the proceeds received. For example, assume that an entity issues 10,000 common shares and warrants to acquire 30,000 common shares for $10 million. Assume also that the common shares are classified in permanent equity and the warrants are classified as a liability and subsequently measured at fair value through earnings. Further assume that the initial fair value of the warrants is $15 million. If the entity only recognized a $5 million expense for the excess of the initial fair value of the warrants over the proceeds, it would initially recognize the common shares at zero. This accounting would not be appropriate if the common shares had a value other than zero since the entity would not be expected to give away its common shares for nothing. Rather, the entity would either recognize an expense larger than $15 million or otherwise account for the other elements of the transaction in accordance with other applicable U.S. GAAP.

3.3.4.3 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 that are 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.

3.3.4.4 Allocation 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. Amounts paid to the investor upon issuance, such as commitment fees, origination fees, and other amounts paid to the investor (e.g., reimbursement of the investor’s expenses) represent a reduction in the proceeds received, not issuance costs.1

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).

SEC Considerations

At the 2023 AICPA & CIMA Conference on Current SEC and PCAOB Developments, SEC Associate Chief Accountant Carlton Tartar highlighted a fact pattern addressed by the SEC staff in which a registrant proposed treating costs related to the initial preparation and auditing of its financial statements as deferred offering costs because the financial statements were prepared for the sole purpose of pursuing an IPO. The staff objected to the registrant’s proposed accounting because although the registrant needed to obtain audited financial statements to pursue an IPO, audited financial statements may be obtained for various other reasons. As a result, the staff did not view these costs as being directly attributable to the planned offering.

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).

However, as indicated in ASC 825-10-25-3, if the fair value option has been elected, “[u]pfront costs and fees [are] recognized in earnings as incurred and not deferred.” 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).

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, a specific allocation method for such costs is prescribed under U.S. GAAP. Otherwise, the allocation method is based on the specific facts and circumstances. In the remaining discussion, it is assumed that an amount of proceeds is allocated to each freestanding financial instrument. If few or no proceeds are allocated to such an instrument issued as part of a group (e.g., a loan commitment entered into with a term loan), an entity may allocate issuance costs on the basis of the relative amount of costs that would have been incurred if each freestanding financial instrument had been entered into separately. Otherwise, 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). 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 generally considered 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.

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).

3.3.5 Accelerated Share Repurchase Programs

ASC 505-30

25-5 An accelerated share repurchase program is a combination of transactions that permits an entity to repurchase a targeted number of shares immediately with the final repurchase price of those shares determined by an average market price over a fixed period of time. An accelerated share repurchase program is intended to combine the immediate share retirement benefits of a tender offer with the market impact and pricing benefits of a disciplined daily open market stock repurchase program.

25-6 An entity shall account for such an accelerated share repurchase program as the following two separate transactions:

As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date
As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock.

Example 1 (see paragraph 505-30-55-1) provides an illustration of an accelerated share repurchase program that is addressed by this guidance.

ASC 505-30 contains unit-of-account guidance that applies to accelerated share repurchase programs. Under ASC 505-30-25-6, an entity accounts for an accelerated share repurchase as two separate units of account: a treasury stock repurchase and a separate forward contract on the entity’s shares. An entity should analyze the treasury stock repurchase and forward contract separately to determine whether ASC 480 applies.

The terms of accelerated share repurchases vary. In a traditional accelerated share repurchase, an entity (1) repurchases a targeted number of its own shares at the current stock price up front for cash and (2) simultaneously enters into a net-settled forward sale of the same number of shares. Economically, the forward serves as a true-up mechanism to adjust the price ultimately paid for the shares purchased. The purpose is to reduce the number of outstanding shares immediately at a repurchase price that reflects the average stock market price over an extended period (e.g., the volume-weighted average price (VWAP) on each trading day during the contract period). On a combined basis, the initial share repurchase and the forward sale put the issuer in an economic position similar to that of having conducted a series of open market purchases of its own stock over a specified period.

In practice, the settlement of the treasury stock repurchase often takes place one or a few days after the execution of the accelerated share repurchase (e.g., the initial share delivery date may be three business days after the transaction date), at which time the issuer pays cash and receives an initial number of shares. If so, the obligation to repurchase shares in exchange for cash is classified as a liability under ASC 480-10-25-8 during the period between the accelerated share repurchase transaction date and the settlement date of the treasury stock repurchase (sometimes described as the “initial share delivery date” or the “prepayment date”). Note that in some accelerated share repurchase transactions, the payment of cash in the treasury stock repurchase occurs before the receipt of the initial shares, in which case ASC 480 may cease to apply once the obligation to pay cash has been settled.

In evaluating whether the forward component of an accelerated share repurchase is within the scope of ASC 480, the issuer should consider whether it embodies an obligation to transfer assets or a variable number of shares that meet the criteria in ASC 480-10-25-8 or ASC 480-10-25-14 (see Chapters 5 and 6, respectively). Usually, an issuer is not required to classify as a liability under ASC 480 the forward contract component in a traditional accelerated share repurchase because it does not embody an obligation to repurchase shares for assets and does not involve an obligation to deliver a variable number of shares with a monetary value that moves inversely with — or is based on something other than — the price of the issuer’s stock. However, an issuer cannot assume that the forward contract component of an accelerated share repurchase is outside the scope of ASC 480 without analyzing its specific terms and features.

In some accelerated share repurchase transactions, a portion of the prepayment amount on the initial share delivery date represents a premium paid by the issuer to increase the forward sale price that the issuer will receive in the forward component of the transaction (relative to an at-market forward) rather than a payment for the shares to be received in the initial treasury stock repurchase. For example, the issuer may apply 20 percent of the prepayment amount to the forward component to reduce the likelihood that the forward component will ever dilute EPS. In this case, the issuer may be required to account for the forward component as an asset or liability under ASC 480-10-25-8 in the period between the transaction date and the prepayment date (which may be the initial share delivery date) if the forward component permits net share settlement, because the forward component embodies an obligation to pay cash (on the initial share delivery date) to repurchase shares (the issuer will receive shares at the forward settlement date if the stock price is less than the forward price).

If the forward component is outside the scope of ASC 480, the issuer should evaluate it under other literature (e.g., ASC 815-40) to determine whether it must be accounted for as an asset or a liability (see Section 3.2.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

ASC 505-30

Example 1: Accelerated Share Repurchase Program

55-1 This Example illustrates the guidance in paragraph 505-30-25-5 by identifying the two separate transactions, namely a treasury stock purchase and a forward contract, that are present in what is sometimes described as an accelerated share repurchase program.

55-2 The treasury stock purchase is as follows.

55-3 Investment Banker, an unrelated third party, borrows 1,000,000 shares of Company A common stock from investors, becomes the owner of record of those shares, and sells the shares short to Company A on July 1, 1999, at the fair value of $50 per share. Company A pays $50,000,000 in cash to Investment Banker on July 1, 1999, to settle the purchase transaction. The shares are held in treasury. Company A has legal title to the shares, and no other party has the right to vote those shares.

55-4 The forward contract is as follows.

55-5 Company A simultaneously enters into a forward contract with Investment Banker on 1,000,000 shares of its own common stock. On the October 1, 1999, settlement date, if the volume-weighted average daily market price of Company A’s common stock during the contract period (July 1, 1999, to October 1, 1999) exceeds the $50 initial purchase price (net of a commission fee to Investment Banker), Company A will deliver to Investment Banker cash or shares of common stock (at Company A’s option) equal to the price difference multiplied by 1,000,000. If the volume-weighted average daily market price of Company A’s common stock during the contract period is less than the $50 initial purchase price (net of a commission fee to Investment Banker), Investment Banker will deliver to Company A cash equal to the price difference multiplied by 1,000,000.

55-6 Under the guidance in paragraph 505-30-25-5, an entity would account for this accelerated share repurchase program as two separate transactions:

As shares of common stock acquired in a treasury stock transaction recorded on the July 1, 1999, acquisition date
As a forward contract indexed to its own common stock.

ASC 505-30-55-1 through 55-6 illustrate how accelerated share repurchase transactions are analyzed as two separate units of account (i.e., a treasury stock repurchase and a forward contract). The issuer would need to evaluate whether ASC 480 applies to the treasury stock repurchase, the forward contract, or both.

Example 3-9

Accelerated Share Repurchase Transaction

An issuer enters into an accelerated share repurchase transaction on December 30 under which it is obligated to transfer a fixed amount of cash (a prepayment amount of $500 million) in exchange for a fixed number of its common shares (10 million initial shares) on the initial share delivery date (January 2). On the transaction’s final settlement date (March 31), the issuer will either deliver or receive shares. If the VWAP of the issuer’s common shares exceeds $50, the issuer will deliver shares; if the VWAP is less than $50, the issuer will receive shares. The number of shares that will be received or delivered is calculated as the prepayment amount ($500 million) divided by the VWAP over the contract period less the initial shares (10 million) already delivered.

In these circumstances, the treasury stock repurchase is required to be accounted for as a liability under ASC 480-10-25-8. In accordance with ASC 480-10-30-3, the issuer recognizes the liability on the accelerated share repurchase transaction date initially measured “at the fair value of the shares at inception, adjusted for any consideration or unstated rights or privileges.” Simultaneously, in accordance with ASC 480-10-30-5, equity is “reduced by an amount equal to the fair value of the shares at inception.” Because under ASC 480-10-35-3(a) both the amount to be paid — $500 million — and the settlement date — January 2 — are fixed, the liability is measured at the present value of the amount to be paid at settlement — $500 million — with interest cost accruing at the rate implicit at inception during the period from the transaction date to the initial share delivery date. (Further, if any part of the prepayment amount represents a premium payment for the forward component of the accelerated share repurchase transaction, that portion would be accounted for separately as a liability measured at fair value under ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5, between the transaction date and the initial share delivery date, as discussed above.)

On the initial share delivery date, the liability for the treasury stock repurchase is extinguished by delivery of the prepayment amount. After the initial share delivery date, the transaction is outside the scope of ASC 480 and is therefore evaluated under other GAAP (e.g., ASC 815-40; see Section 3.2.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

Footnotes

Depending on the relationship between the issuer and the investor, amounts paid to the investor could represent a dividend or other distribution. An entity should use judgment and consider the particular facts and circumstances when determining what these amounts represent.