Chapter 4 — Mandatorily Redeemable Financial Instruments

4.2 Application Issues

4.2.1 Share That Is Both Puttable and Callable

ASC 480-10

55-38 An entity issues a share of stock that is not mandatorily redeemable. However, under its terms the stock is both of the following:

Puttable by the holder any time after five years or upon a change in control
Callable by the issuer any time after five years.

55-39 That instrument is outside the scope of this Subtopic. The instrument as a whole is not mandatorily redeemable under paragraphs 480-10-25-4 and 480-10-25-6 because of both of the following conditions:

The redemption is optional (conditional).
A written put option and a purchased call option issued together with the same terms differ from a forward purchase contract under this Subtopic.

55-40 That combination of embedded features does not render the stock mandatorily redeemable because the options could expire at the money, unexercised, and, thus, the redemption is not unconditional. Because the instrument as a whole is an outstanding share, it is not subject to paragraphs 480-10-25-8 through 25-12, nor, because the embedded obligation is conditional, is it subject to paragraph 480-10-25-14. As a financial instrument that is not a derivative instrument in its entirety, it is subject to analysis under Subtopic 815-15 to determine whether the issuer must account for any embedded feature separately as a derivative instrument. Because of the guidance in paragraph 480-10-25-2, paragraphs 480-10-25-4 through 25-14 shall not be applied to any embedded feature for the purposes of that analysis. In applying paragraph 815-15-25-1, the embedded written put option is evaluated under the guidance in Subtopic 815-40 and would generally be classified in equity. If so, the embedded written put option meets the criterion for exclusion in paragraph 815-10-15-74(a) and, therefore, is not separated from its host contract. If the written put option was not embedded in the share, but was issued as a freestanding instrument, it would be a liability under this Subtopic.

ASC 480-10-55-38 through 55-40 illustrate that a share whose terms contain both an embedded issuer call option and an embedded investor put option would not be classified as a liability under ASC 480 even if the options have mirroring terms (e.g., the same strike price). If a redemption option in an outstanding share can be exercised by either party at the same exercise price over a specified period, it may be unlikely that both parties will elect not to exercise the option. Nevertheless, such a redemption option is analyzed as conditional under ASC 480 because redemption is not certain to occur (e.g., it is possible the options could expire at-the-money). (Although not explicitly stated in ASC 480-10-55-38, the discussion in ASC 480-10-55-40 implies that the options have an expiration date. See also Section 3.2.1.) An outstanding share is not classified as a liability under ASC 480 if redemption is conditional.

The accounting analysis for embedded option combinations in ASC 480 differs from that in ASC 815. Under ASC 815-10-25-10, “an embedded (nontransferable) purchased call (put) option and an embedded (nontransferable) written put (call) option [that are combined] in a single hybrid instrument” are “considered as a single forward contract” when they have the same strike price and meet certain other criteria (i.e., such an option combination is treated as an unconditional obligation under ASC 815; see ASC 815-10-25-10 through 25-13). Under ASC 480, the same option combination is analyzed as a conditional obligation.

If an option combination is embedded in the shares issued by a subsidiary, the parent should consider whether it is required to apply the special accounting guidance in ASC 480-10-55-55 and ASC 480-10- 55-59 when preparing its consolidated financial statements. That guidance provides a limited exception to the guidance in ASC 480-10-55-38 through 55-40 by requiring such embedded option combinations and the noncontrolling interest to be accounted for on a combined basis as a financing of the parent’s purchase of the noncontrolling interest (see Section 7.1).

4.2.2 Exchangeable Share

Under ASC 480-10-25-4, an exchangeable share would be classified as a liability if it (1) is mandatorily redeemable for cash on a stated redemption date and (2) contains an option that permits the holder to require the issuer to exchange the share for the shares of a third party. Such an instrument meets the definition of a mandatorily redeemable financial instrument because delivery by the issuer of either cash or assets in the form of third-party shares is certain. Similarly, an exchangeable share would be classified as a liability in the separate financial statements of a subsidiary if it (1) is mandatorily redeemable for cash on a stated redemption date and (2) contains an option for the holder to require the issuer (the subsidiary) to exchange it for nonredeemable shares of its parent. The instrument would meet the definition of a mandatorily redeemable financial instrument in the subsidiary’s separate financial statements because delivery by the subsidiary of either cash or assets is certain. (Note that under ASC 480, shares issued by a parent would be considered assets rather than as equity in the separate financial statements of the subsidiary regardless of how they are classified in the subsidiary’s separate financial statements.)

Example 4-3

Exchangeable Shares

Entity X has issued shares that are exchangeable, at the option of Holder H, into trust units of Parent P. The trust units are traded in an active market. The key terms and rights of the exchangeable shares are as follows:

Initially, each share is exchangeable into one trust unit. The exchangeable shares do not have any voting rights, and H cannot obligate X to pay cash instead of trust units at redemption. As P makes distributions to its unit holders, the exchange ratio increases, thereby increasing the number of trust units to be received when the exchangeable shares are redeemed for trust units.
The shares can be exchanged by H for trust units at any time for 10 years after the date of issuance. However, X must redeem the shares at the end of year 10, in which case X may elect to deliver either trust units or an equivalent amount of cash.
In the event of liquidation, dissolution, or the winding up of X, or any other distribution among X’s shareholders, exchangeable shares are entitled to a preference over X’s common shares with respect to the payment of dividends. The holders of exchangeable shares are entitled to a cumulative preferred-cash dividend.

In its separate financial statements, X should classify the exchangeable shares as liabilities. The exchangeable shares meet the definition of a mandatorily redeemable financial instrument since they are mandatorily redeemable on the 10th anniversary of their issuance and will require payment, at X’s option, in either trust units or cash, both of which represent assets of X in the application of ASC 480.

4.2.3 Redemption Requirement That Is Contingent on the Issuer’s Liquidity

A redemption obligation that is unconditional (e.g., it has a mandatory redemption date and no terms that make redemption uncertain) except for a condition that a specified liquidity level must be reached (i.e., the term is extended in case of insufficient liquidity) is treated as an unconditional redemption obligation under ASC 480-10-25-6 and should be classified as a liability.

Similarly, statutory requirements (e.g., corporate state law) may limit an entity’s ability to redeem its own stock in cash or other assets if the entity lacks the wherewithal to pay (i.e., if a lack of sufficient net assets would result in the impairment of the entity’s capital). In these circumstances, the payment of cash or other assets to satisfy a redemption obligation might result in personal liability for directors and potential liability for stockholders. To protect the entity from the risk of breaching the terms of a mandatorily redeemable share, the share may include a provision that defers redemption by the entity if such redemption would be illegal under the applicable state law because of a lack of legally available funds. Such limitation on an entity’s ability to redeem shares should not cause an otherwise unconditionally redeemable instrument to be considered conditionally redeemable. This kind of limitation is similar to a provision that prevents an entity from redeeming an instrument unless a specified liquidity level is reached. However, that guidance should not be applied by analogy to redemption requirements that are contingent upon uncertain future circumstances or events other than the entity’s liquidity (e.g., future revenue).

If an outstanding share must be redeemed only to the extent that the issuer has a sufficient amount of available cash or meets another similar liquidity measure, the issuer should consider whether the redemption requirement represents an unconditional obligation under the above guidance. That is, the issuer should consider whether (1) the lack of sufficient liquidity to redeem the instrument is akin to a default, in which case an unconditional obligation exists, or (2) the issuer controls the ability to determine whether the instrument is redeemed, in which case an unconditional obligation does not exist. A redemption feature that is contingent on a measure of available liquidity that is determined by the entity on the basis of the application of significant judgment or discretion should be viewed as conditional under ASC 480. Only if the entity controls the ability to avoid redemption is the obligation deemed conditional.

Example 4-4

Shares Redeemable With Available Cash

Company A has issued perpetual preferred stock that must be redeemed to the extent that A has available cash. Available cash is defined in the preferred stock terms in a manner that permits subjective adjustments at A’s discretion, as follows:

Available Cash means, as of any date, (1) the amount of cash on hand, less (2) all amounts due and payable as of such date, and less (3) working capital and other amounts, which the Company deems necessary for the Company’s business in its commercially reasonable discretion.

The stock does not meet the definition of a mandatory redeemable financial instrument under ASC 480 because (1) it has no stated redemption date and (2) the determination of whether available cash exists is subject to A’s significant judgment and discretion (i.e., it is within A’s control).

4.2.4 Preferred Stock With Cash Conversion Features

For a convertible preferred share to meet the definition of a mandatorily redeemable financial instrument and be classified as a liability under ASC 480, it must embody an unconditional obligation to transfer assets. A convertible preferred share that the issuer must settle fully or partially in cash irrespective of whether it is converted embodies such an obligation, since a transfer of cash or other assets is certain to occur unless there is a violation of the contractual terms. For example, a fixed-term (i.e., mandatorily redeemable) convertible preferred share meets the definition of a mandatorily redeemable financial instrument and must be classified as a liability under ASC 480 if, upon conversion, it requires the issuer to pay the stated amount (i.e., the liquidation preference, or par amount) in cash and allows the issuer to settle the excess conversion value in cash or shares.

Example 4-5

Cash-Settleable Convertible, Mandatorily Redeemable Preferred Stock

A convertible preferred share has (1) a fixed redemption date on which the issuer will settle its stated par amount in cash and (2) a substantive conversion option that, if exercised by the counterparty, requires the issuer to settle the par amount in cash but permits it to settle the excess of the conversion value over the par amount (the conversion spread) in either cash or shares. The convertible preferred share meets the definition of a mandatorily redeemable financial instrument and is classified as a liability under ASC 480 since the issuer has an unconditional obligation to transfer cash or other assets in exchange for the par amount.

A convertible preferred share that has a stated redemption date and permits the issuer to elect settlement of the entire instrument in either cash or shares or a combination thereof does not contain an unconditional obligation to transfer assets because the issuer has the right to settle the entire conversion value in shares. Accordingly, these types of preferred stock would not meet the definition of a mandatorily redeemable financial instrument in ASC 480.

A requirement to transfer assets that is contingent on the counterparty’s election of a cash settlement or the occurrence (or nonoccurrence) of an uncertain future event represents a conditional, rather than an unconditional, obligation to transfer assets. Thus, convertible preferred stock that has such a requirement is not a mandatorily redeemable financial instrument under ASC 480. For example, a perpetual convertible preferred share that must be settled in cash or other assets upon the counterparty’s election to convert does not meet the definition of a mandatorily redeemable financial instrument in ASC 480 because the obligation to transfer cash or other assets is contingent on such an election.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.