Chapter 4 — Mandatorily Redeemable Financial Instruments

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 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, 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. 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. 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 Cash Conversion Features

If a convertible preferred share meets the definition of a mandatorily redeemable financial instrument in ASC 480 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 account for such share as convertible debt (i.e., in accordance with ASC 470-20). Under ASC 470-20, if the convertible preferred share was issued at a substantial premium, the guidance in ASC 470-20-25-13 and ASC 470-20-25-15 applies to the premium (see Section 7.6.3 of Deloitte’s Roadmap Issuer’s Accounting for Debt). If the convertible preferred share was not issued at a substantial premium and does not contain any embedded derivatives that must be bifurcated under ASC 815-15, the issuer would account for it as a liability in its entirety. The issuer can elect the fair value option and account for the liability at fair value as long as the convertible preferred share was not issued at a substantial premium.

After initial recognition, if the fair value option is not elected, the issuer measures the liability at amortized cost by applying the interest method in ASC 835 and treats as a debt discount or premium any difference between the principal amount to be repaid at maturity or upon conversion and the initial carrying amount of the liability. Any capitalized issuance costs would also be included in the initial carrying amount of the instrument and would affect the effective interest cost under ASC 835. If the initial amount recognized for the liability, including capitalized issuance costs, is less than the principal amount due at maturity or on conversion, the issuer must amortize the net discount over the shortest period to maturity or conversion at the option of the holder.

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, 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, 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.

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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.