4.3 Accounting
4.3.1 Measurement
4.3.1.1 Initial Measurement
ASC 480-10
30-1 Mandatorily redeemable financial instruments shall be measured initially at fair value.
On initial recognition, mandatorily redeemable financial instruments must be measured at their fair value. An entity applies ASC 820-10 to determine fair value. See Section 4.3.3 for a discussion of the accounting for issuance costs.
4.3.1.2 Subsequent Measurement
ASC 480-10
35-3 Forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares in exchange for cash and mandatorily redeemable financial instruments shall be measured subsequently in either of the following ways:
- If both the amount to be paid and the settlement date are fixed, those instruments shall be measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception.
- If either the amount to be paid or the settlement date varies based on specified conditions, those instruments shall be measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost.
Unless the entity elects to account for the
instrument at fair value, with changes in fair
value recognized in earnings under ASC 825-10, a
mandatorily redeemable financial instrument is
measured subsequently in one of two ways depending
on whether the redemption amount or the redemption
date varies on the basis of specified
conditions:
Redemption Amount
|
Redemption Date
|
Subsequent Measurement
|
---|---|---|
Fixed | Fixed | Present value of the amount to be paid at settlement, discounted by using the implicit rate at inception (i.e., effective interest method) |
Fixed Varies Varies | Varies Fixed Varies | Amount of cash that would be paid under the conditions specified in the contract if settlement occurred as of the reporting date (settlement value) |
4.3.1.2.1 Fixed Date and Fixed Amount
If the redemption date and the redemption amount are both fixed, the instrument is subsequently measured at the present value of the amount to be paid at settlement, discounted by using the implicit rate at inception. The implicit rate is calculated by using the effective interest method (i.e., the implicit rate is the rate that makes the present value of the instrument’s cash flows equal to the initial measurement amount).
If the redemption consists of a stated amount along with accrued and unpaid
dividends, whether or not declared, the present
value as of each measurement date is calculated by
using an effective interest rate that is
determined on the basis of the total redemption
amount (i.e., including both the stated redemption
amount and cumulative dividends, whether or not
declared). For example, if a liquidation
preference is payable at redemption of a
mandatorily redeemable financial instrument, and
the instrument accrues dividends at a per annum
rate of 8 percent (whether or not declared), the
calculation of the effective interest rate would
take into account not just the liquidation
preference but also the dividends at the per annum
rate of 8 percent. Any dividends paid before the
redemption date would reduce the carrying amount
of the instrument.
4.3.1.2.2 Variable Date or Redemption Amount
If the redemption date, the redemption amount, or both vary, the instrument is subsequently measured at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred on the reporting date. Examples of mandatorily redeemable financial instruments with a varying redemption amount include those for which the redemption amount varies on the basis of the instrument’s current fair value or a formula (e.g., one that is dependent on the issuer’s most recent financial year’s EBIT or EBITDA). Examples of instruments for which the redemption date varies include those that are mandatorily redeemable upon an event that is certain to occur but whose timing is uncertain (e.g., the holder’s death).
In estimating the amount of cash that would be paid under the conditions specified in the contract if settlement occurred on the reporting date, an issuer should not incorporate projected changes in the factors that affect a variable redemption price (e.g., forward projections of EBITDA if the redemption price is a function of EBITDA). Instead, the redemption amount is calculated on the basis of the conditions that exist as of the balance sheet date (e.g., the most recent EBITDA measure if the redemption price is a function of EBITDA). This view is consistent with the guidance on redeemable equity securities classified in temporary equity under ASC 480-10-S99-3A (see Chapter 9). In paragraph 14 of ASC 480-10-S99-3A, the SEC staff states that if “the maximum redemption amount is contingent on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure).”
If the redemption amount varies (e.g., as a function of EBITDA), an entity
should not reduce the carrying amount of the
liability below the initially recorded amount. ASC
480-10-45-3 implies that the amount of reported
interest cost cannot be less than zero on a
cumulative basis from the date of initial
recognition (see Section 4.3.2).
This is consistent with the view that an entity
cannot recognize interest income on a liability as
well as with the guidance on redeemable securities
classified in temporary equity under ASC
480-10-S99-3A (see Section 9.5). In
paragraph 16(e) of ASC 480-10-S99-3A, the SEC
staff states that “the amount presented in
temporary equity should be no less than the
initial amount reported in temporary equity for
the instrument. That is, reductions in the
carrying amount of a redeemable equity instrument
. . . are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument.” If the instrument is redeemed for an
amount less than the net carrying amount, the
issuer recognizes the difference as an
extinguishment gain.
4.3.1.3 Embedded Features
If a feature must be separated as an embedded derivative under ASC 815-15, an
entity should analyze the host contract separately from the embedded
derivative in determining the appropriate measurement under ASC 480-10-35-3
(e.g., in estimating the redemption amount). This is consistent with ASC
815-15-25-54, which requires an entity to account for a host contract that
remains after separation of an embedded derivative on the basis of GAAP
applicable to instruments of that type that do not contain embedded
derivatives.
Example 4-6
Mandatorily Redeemable Preferred Stock
Indexed to the Price of Gold
A mandatorily redeemable preferred share has a fixed redemption date and a
redemption price that is indexed to the price of
gold (i.e., $100,000 plus the cumulative change in
the price of 100 ounces of gold, if positive).
Entity X determines that (1) the initial fair
value of the entire instrument is $100,000, (2)
the indexation to gold should be separated as an
embedded derivative under ASC 815-15, (3) the
derivative has an initial fair value of $5,000,
and (4) the host contract that remains after
separation of the embedded derivative has a fixed
redemption amount of $100,000.
Entity X measures the host contract as a mandatorily redeemable financial instrument with an initial carrying amount of $95,000 (determined by using a with-and-without method in accordance with ASC 815-15-30-2), a fixed redemption amount of $100,000, and a fixed redemption date. It would subsequently measure the host contract at the present value of the assumed fixed redemption amount of $100,000 discounted by using the implicit rate at inception (i.e., a rate determined on the basis of an initial carrying amount of $95,000) in accordance with ASC 480-10-35-3(a).
Example 4-7
Mandatorily Redeemable Financial Instrument
With a Put Option
A mandatorily redeemable financial instrument contains a feature that could accelerate an otherwise fixed redemption date if uncertain future events occur (e.g., a put option contingent on a change in control). If the acceleration feature is separated as an embedded derivative, the host contract is analyzed as a mandatorily redeemable financial instrument with a fixed settlement date.
A mandatorily redeemable financial instrument with a fixed redemption amount at
maturity may contain a put or call feature that
permits the holder or the issuer to settle the
instrument early at an amount other than the fixed
redemption amount. For example, the issuer may
have an option to call the instrument before the
stated redemption date at a premium to its fixed
redemption amount, or the holder may have an
option to put the instrument early at a discount
to its fixed redemption amount. Although such an
instrument could be viewed as having a variable
redemption amount and a variable redemption date,
it is generally appropriate for an entity to treat
the instrument as having a fixed redemption amount
at maturity under ASC 480-10-35-3 and to analyze
the put or call feature separately in determining
whether the feature must be bifurcated as an
embedded derivative under ASC 815-15. In the
application of the interest method (see Section
4.3.1.2), any discount from the amount
payable on the first noncontingent put date would
be amortized to that date.
4.3.1.4 Preferred Stock With CCF (Before the Adoption of ASU 2020-06)
Before the adoption of ASU 2020-06, if a convertible preferred share meets the
definition of a mandatorily redeemable financial instrument in ASC 480-10
because (1) it specifies the date on which it will be redeemed for cash (or
other assets) and (2) the issuer is required to settle it either fully or
partially in cash (or other assets) upon conversion (see Sections 2.5 and
4.2.4), the
issuer should consider whether the instrument is subject to the guidance on
convertible debt with CCFs in ASC 470-20.
The issuer of an instrument within the scope of the cash conversion guidance in ASC 470-20 is required to separate the instrument into its liability and equity components by allocating the issuance proceeds and any direct transaction costs between the two components. Under the cash conversion guidance, the issuer determines the measurement of the liability and equity components by using a “liability-first” allocation approach as follows:
- The issuer first determines the carrying amount of the liability component before considering any allocation of transaction costs. It determines the carrying amount on the basis of a hypothetical nonconvertible debt instrument that includes any or all features embedded in the convertible debt except for the conversion feature and any feature that is nonsubstantive at inception. The measurement attribute for the liability component at initial recognition is its fair value.
- Then, the issuer determines the carrying amount of the equity component before considering any allocation of transaction costs. The issuer measures the equity component by using a residual approach under which the amount of issuance proceeds that remains after allocation to the liability component is allocated to the equity component.
- Finally, the issuer allocates qualifying transaction costs between the liability and equity components in proportion to the allocation of proceeds between each component in the first two steps.
After initial recognition, the issuer measures the liability component at amortized cost by applying the interest method in ASC 835 and treats as a debt discount the excess of the principal amount to be repaid at the end of the expected life of similar hypothetical nonconvertible debt over the initial carrying amount of the liability component. The debt discount and any transaction costs allocated to the liability component (i.e., the debt issuance costs) are amortized over the expected life of similar nonconvertible debt by using the interest method.
In accordance with ASC 825-10-15-5(f), the issuer is not permitted to elect the fair value option in ASC 825-10 for an instrument within the scope of the cash conversion guidance in ASC 470-20 since such an instrument contains a separated equity component.
Changing Lanes
ASU
2020-06 removes the separation model in ASC
470-20 for certain convertible instruments with a CCF. Therefore,
the guidance discussed above on the CCF accounting model does not
apply to entities that have adopted ASU 2020-06. However, the ASU
does not affect the above discussion of when convertible preferred
shares are within the scope of ASC 480-10-15-4. See Chapter 1 for
additional details about ASU 2020-06.
4.3.2 Interest Cost
ASC 480-10
45-2B Depending on the settlement terms, this Subtopic requires that mandatorily redeemable shares that are not subject to the deferral in paragraphs 480-10-15-7A through 15-7F be measured at either the present value of the amount to be paid at settlement or the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount as interest cost (change in redemption amount).
45-3 Any amounts paid or to be paid to holders of the contracts discussed in paragraph 480-10-35-3 in excess of the initial measurement amount shall be reflected in interest cost.
For a mandatorily redeemable financial instrument, the following items are reported as interest cost:
- Changes in its carrying amount, including the amortization of any discount if the contract is measured at the present value of the amount to be paid at settlement.
- Any amounts paid or to be paid to the holder in excess of the initial measurement amount, including the payment or declaration of dividends and the accrual of cumulative dividends.
Accrued cumulative dividends are recognized as interest cost, even if not
declared, if the holder is entitled to such
dividends during the life of the contract or at
settlement. Conversely, undeclared noncumulative
dividends are not recognized as interest cost if
the holder is not entitled to them before they are
declared (i.e., the undeclared dividends are not
paid at settlement).
4.3.3 Issuance Costs
Unless the issuer elects to account for the mandatorily redeemable financial
instrument at fair value with changes in fair value recognized in earnings under
ASC 825-10, an entity should treat any issuance costs as a direct deduction from
the amount reported for the liability on the face of the balance sheet in a
manner similar to its treatment of debt issuance costs under ASC 835-30-45-1A.
Subsequently, the entity reports the amortization of the issuance costs as
interest cost in a manner similar to its amortization of a debt discount. If the
entity elects to measure the instrument at fair value with changes in fair value
recognized in earnings under ASC 825-10, any up-front costs and fees are
expensed at inception under ASC 825-10-25-3. For a discussion of what qualifies
as an issuance cost, see Section 3.3.4.4.