Chapter 4 — Mandatorily Redeemable Financial Instruments
Chapter 4 — Mandatorily Redeemable Financial Instruments
4.1 Classification
4.1.1 Overview
ASC
480-10 — Glossary
Mandatorily Redeemable Financial
Instrument
Any of various
financial instruments issued in the form of shares that
embody an unconditional obligation requiring the issuer
to redeem the instrument by transferring its assets at a
specified or determinable date (or dates) or upon an
event that is certain to occur.
ASC
480-10
25-4 A mandatorily redeemable
financial instrument shall be classified as a liability
unless the redemption is required to occur only upon the
liquidation or termination of the reporting
entity.
25-6 In determining if an
instrument is mandatorily redeemable, all terms within a
redeemable instrument shall be considered. The following
items do not affect the classification of a mandatorily
redeemable financial instrument as a liability:
- A term extension option
- A provision that defers redemption until a specified liquidity level is reached
- A similar provision that may delay or accelerate the timing of a mandatory redemption.
25-7 If a financial
instrument will be redeemed only upon the occurrence of
a conditional event, redemption of that instrument is
conditional and, therefore, the instrument does not meet
the definition of mandatorily redeemable financial
instrument in this Subtopic. . . .
55-3
Various financial instruments issued in the form of
shares embody unconditional obligations of the issuer to
redeem the instruments by transferring its assets at a
specified or determinable date or dates or upon an event
that is certain to occur.
55-4 This Section presents two
examples of mandatorily redeemable financial
instruments:
- Certain forms of trust-preferred securities (those that are required to be redeemed at specified or determinable dates)
- Stock that must be redeemed upon the death or termination of the individual who holds it, which is an event that is certain to occur.
55-5 Although some mandatorily
redeemable instruments are issued in the form of shares,
those instruments are classified as liabilities under
this Subtopic because of the embodied obligation on the
part of the issuer to transfer its assets.
To meet ASC 480’s definition of a mandatorily redeemable
financial instrument, the instrument must have all of the following
characteristics:
-
Its legal form must be a share (see Section 4.1.2).
-
It must embody an unconditional obligation of the issuer to redeem the instrument at a specified or determinable date (or dates) or upon an event that is certain to occur (i.e., redemption is certain to occur in the absence of a breach of the instrument’s contractual terms — see Section 4.1.3).
-
The issuer must be required to satisfy the obligation by transferring its assets (see Section 4.1.4).
There are several exceptions in ASC 480 to the requirement to
classify instruments that meet the definition of a mandatorily redeemable
financial instrument as liabilities. See the discussion in Section 4.1.5.
4.1.2 Legal Form of a Share
ASC
480-10 — Glossary
Shares
Shares includes various forms of ownership that may not
take the legal form of securities (for example,
partnership interests), as well as other interests,
including those that are liabilities in substance but
not in form. (Business entities have interest holders
that are commonly known by specialized names, such as
stockholders, partners, and proprietors, and by more
general names, such as investors, but all are
encompassed by the descriptive term owners. Equity of
business entities is, thus, commonly known by several
names, such as owners’ equity, stockholders’ equity,
ownership, equity capital, partners’ capital, and
proprietorship. Some entities [for example, mutual
organizations] do not have stockholders, partners, or
proprietors in the usual sense of those terms but do
have participants whose interests are essentially
ownership interests, residual interests, or
both.)
The term “mandatorily redeemable financial instrument” is
limited to financial instruments “in the form of shares.” In this context,
shares include not just equity securities (including both common and preferred
stock). Rather, the term applies broadly to ownership interests in various
forms, including shares of stock not in the form of securities, partnership
interests (including general partnership interests and limited partnership
interests), membership interests (or units) in limited liability companies or
cooperative entities, and policyholder interests in mutual insurance companies.
However, financial instruments in the legal form of debt are outside the scope
of ASC 480 (see Section
2.2.4).
The following table lists
examples of instruments that, unless a legal analysis of their form suggests
otherwise, would and would not be considered shares under ASC 480:
Share | Not a
Share |
---|---|
|
|
4.1.3 Unconditional Redemption Obligation
To meet the definition of a mandatorily redeemable financial
instrument, the instrument must embody an unconditional redemption obligation.
An obligation involves a duty or responsibility to perform (see Section 2.2.1). A
redemption obligation is unconditional if redemption is certain to occur in the
absence of a violation of the contractual terms. Neither the issuer nor the
holder can have the unilateral discretion to avoid redemption except by both
parties’ consent (i.e., they mutually agree to modify the terms). Accordingly, a
share that is redeemable at the option of either the issuer or the holder, or
whose redemption is contingent upon the occurrence or nonoccurrence of an
uncertain future event, does not meet the definition of a mandatorily redeemable
financial instrument before the option is exercised or the event occurs, because
such an obligation is conditional. Likewise, a share that could be redeemed at
the option of the holder or upon the occurrence of a contingent event that is
outside the control of the issuer or holder does not meet the definition of a
mandatorily redeemable financial instrument.
As discussed in Section 6.2.6, an outstanding share that
embodies an unconditional obligation should be evaluated as a variable-share
obligation under ASC 480-10-25-14 rather than as a mandatorily redeemable
financial instrument under ASC 480-10-25-4 if the issuer has a choice of
settling the obligation by either transferring assets or delivering a variable
number of nonredeemable shares of equal value.
If an instrument with a mandatory redemption date contains
contractual features that have the effect of making redemption conditional, the
instrument would not meet the definition of a mandatorily redeemable financial
instrument in ASC 480-10-20 because redemption is not certain to occur.
Example 4-1
Mandatorily Redeemable Convertible Shares
An equity share with a fixed redemption date includes an embedded option that
permits the holder to convert the entire instrument into
a fixed number of equity shares before the stated
redemption date. The conversion feature is substantive.
Because the holder may elect to convert the instrument
into equity shares rather than hold it until redemption,
redemption is conditional on the holder’s not
converting.
Accordingly, a fixed-term instrument that is convertible into
the issuer’s shares of stock would not meet the definition of a mandatorily
redeemable financial instrument in ASC 480-10-20 unless (1) the conversion
option has expired, (2) the conversion option is nonsubstantive (see Section 3.2), (3) the
shares that would be delivered upon conversion contain an unconditional
redemption obligation, or (4) the issuer is required to settle all or part of
the instrument in cash or other assets upon conversion (e.g., it must settle the
stated amount, or par, in cash).
In evaluating whether an instrument meets the definition of a
mandatorily redeemable financial instrument, the issuer does not consider
redemption obligations accounted for as freestanding instruments that are
separate from the instrument being evaluated. For example, a perpetual share
that is issued along with a forward contract that requires the issuer to
repurchase a similar share for cash on a specified date would not be viewed as
embodying a redemption obligation as long as the contracts are two separate
freestanding financial instruments (see Section 3.3).
A redemption obligation does not have to be for a fixed amount
to qualify as unconditional. For example, the amount of the redemption
obligation might be for the current fair value of the share or a participating
interest in the issuer’s net assets, or it may vary on the basis of a specified
underlying (e.g., the S&P 500). Further, the timing of redemption does not
have to be fixed if redemption is certain to occur at some point (e.g., upon an
event that is certain to occur at an unknown time).
In determining whether a redemption obligation is unconditional,
an entity does not consider the likelihood of redemption (although the
likelihood that a term will be triggered might affect an evaluation of whether
the term is substantive; see Section 3.2). For example, a high probability that the issuer
will be unable to satisfy a contractually unconditional redemption obligation
(e.g., because of a lack of funds) does not make that obligation conditional.
Conversely, a high probability that an instrument will be redeemed (e.g.,
because of an economic incentive to redeem the instrument) does not make a
conditional redemption obligation unconditional (see Section 2.2.1).
The following table contains
examples of terms and conditions that would be considered unconditional
redemption obligations and those that would not:
Unconditional Redemption Obligations | Not
Unconditional Redemption Obligations |
---|---|
|
|
If the redemption obligation in an outstanding share is
conditional, an issuer that applies SEC guidance should consider whether it must
classify the instrument in temporary equity (see Chapter 9).
4.1.4 Transfer of Cash or Other Assets
As defined, mandatorily redeemable financial instruments are
limited to instruments that the issuer must settle in its assets (e.g., cash or
investments in debt or equity securities issued by third parties). An instrument
that does not involve a future transfer of assets (e.g., a prepaid obligation)
does not meet this definition. Further, an instrument that the issuer must
settle by providing services (e.g., an obligation to repurchase shares in
exchange for services) would not meet the definition and would be outside the
scope of ASC 480 (see Section
2.2.2).
Although the issuer’s equity shares are assets of its
shareholders, they are not the issuer’s assets. Accordingly, an instrument that
the issuer must or may settle in its equity shares would not qualify as a
mandatorily redeemable financial instrument. However, an entity should evaluate
whether ASC 480-20-25-14 requires such an instrument to be classified outside of
equity (see Chapter
6). For example, under that guidance, an issuer would classify as
a liability a share that it must settle in a variable number of its equity
shares worth a fixed monetary amount known at inception (e.g., a preferred share
that is mandatorily convertible in a variable number of common shares worth a
fixed monetary amount). A share that the issuer must “redeem” on a specified
date by delivering a fixed number of the issuer’s equity shares would not meet
the definition of a mandatorily redeemable financial instrument because the
transfer of cash or other assets is not involved. Further, because the delivery
of a variable number of shares is not involved, the issuer would not be required
to classify the share as a liability under ASC 480-10-25-14.
Regardless of their classification in the subsidiary’s separate
financial statements, shares issued by a parent and held by its subsidiary would
be considered assets in the evaluation of whether ASC 480 applies in the
subsidiary’s separate financial statements.
Example 4-2
Shares Issued by a Subsidiary That Are Mandatorily
Convertible Into Parent Shares
Subsidiary S issues a preferred share that is mandatorily convertible into a
fixed number of common shares issued by its parent on a
specified date. In its separate financial statements, S
would treat any held shares issued by Parent P as assets
when applying ASC 480. Therefore, in S’s separate
financial statements, the mandatorily convertible
preferred shares may meet the definition of a
mandatorily redeemable financial instrument. In P’s
consolidated financial statements, however, common
shares issued by P are not assets but are considered the
issuer’s equity shares. Therefore, in P’s consolidated
financial statements, the mandatorily convertible
preferred share issued by S is outside the scope of ASC
480.
Although the guidance in ASC 480-10-S99-3A on temporary equity
classification contains an exception for certain contracts for which redemption
will be funded by an insurance policy (see Section 9.4.3), there is no similar
exception from the liability classification guidance in ASC 480 for such
contracts. An instrument that must be redeemed for cash or other assets upon the
death of the holder must be classified as a liability even if the issuer has an
insurance contract to cover the cost of redemption (see ASC 480-10-55-64).
The following table contains
examples of obligations to transfer cash or other assets:
Future Transfer of Cash or Other Assets | Not a
Future Transfer of Cash or Other Assets |
---|---|
|
|
4.1.5 Exceptions
4.1.5.1 Overview
There are several exceptions to the liability classification
requirement for instruments that meet the definition of a mandatorily
redeemable financial instrument. Those exceptions apply to:
- Shares that are mandatorily redeemable only upon the liquidation or termination of the reporting entity (see Section 4.1.5.2).
- Mandatorily redeemable noncontrolling interests that are redeemable only upon the liquidation or termination of the subsidiary (see Section 4.1.5.3). (For other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, the classification provisions in ASC 480 apply, but not the measurement provisions.)
- Mandatorily redeemable financial instruments of nonpublic entities that are not SEC registrants unless they are mandatorily redeemable on fixed dates for amounts that are either fixed or are determined by reference to an external index (e.g., an interest rate index or currency index) (see Section 4.1.5.4).
The table below summarizes
the various exceptions to the requirement to apply the guidance in ASC 480
to instruments that meet the definition of a mandatorily redeemable
financial instrument:
Affected Entities
|
Affected Instruments
|
Guidance in ASC 480 That Does Not
Apply
|
Guidance in ASC 480 That Applies
|
---|---|---|---|
All entities | Shares that are mandatorily redeemable only upon
the liquidation or termination of the reporting
entity |
|
|
Parents preparing consolidated
financial statements | Mandatorily redeemable noncontrolling interests
that are redeemable only upon the liquidation or
termination of the subsidiary |
|
|
Other mandatorily redeemable noncontrolling
interests that were issued before November 5,
2003 |
|
| |
Subsidiaries preparing stand-alone financial
statements | Mandatorily redeemable noncontrolling interests
that were issued before November 5, 2003 |
|
|
Nonpublic entities that are not SEC
registrants | Mandatorily redeemable financial instruments other
than those that are mandatorily redeemable on fixed
dates for amounts that are either fixed or
determined by reference to an interest rate index,
currency index, or another external
index |
|
|
If a mandatorily redeemable financial instrument qualifies
for one of the exceptions in ASC 480, the issuer should consider the
applicability of ASC 480-10-S99-3A to that instrument. That guidance
requires SEC registrants to classify certain redeemable securities in
temporary equity (see Chapter 9). In prepared remarks at the 2003 AICPA Conference on
Current SEC Developments, then SEC Professional Accounting Fellow Gregory
Faucette stated the following:
Entities with instruments that qualify for [the
scope exceptions in ASC 480-10-15-7A through 15-15F] should refer to
[ASC 480-10-S99-3A] for guidance related to classification and/or
measurement, as applicable, for those securities that . . . will not
be fully accounted for in accordance with [ASC 480]. In other words,
if both the classification and measurement guidance in [ASC 480 is
inapplicable] for an instrument, look to [ASC 480-10-S99-3A] for
both classification and measurement guidance. If only the
measurement guidance in [ASC 480 is inapplicable] for an instrument,
look to [ASC 480-10-S99-3A] for continued measurement guidance.
4.1.5.2 Only-Upon-Liquidation Exception
ASC 480-10
25-4 A mandatorily redeemable
financial instrument shall be classified as a
liability unless the redemption is required to occur
only upon the liquidation or termination of the
reporting entity.
Certain entities such as partnerships, limited liability
companies, or trusts that are set up for a specific project or purpose may
have a finite life. Their governing documents (e.g., partnership agreement
or articles of organization) may specify a date (e.g., December 31, 2199) on
which they will be terminated and on which their assets will be liquidated,
their liabilities will be settled, and any remaining cash will be
distributed to holders of their equity interests. When such entities issue
equity interests, redemption is certain to occur. Therefore, while those
interests meet the definition in ASC 480-10-20 of a mandatorily redeemable
financial instrument, they do not require classification as liabilities in
accordance with ASC 480-10-25-4.
In consolidated financial statements, a similar exception
applies to instruments that are mandatorily redeemable upon the liquidation
or termination of a subsidiary. In accordance with ASC 480-10-15-7E, such
instruments are not classified as liabilities under ASC 480 even if they
meet the definition of a mandatorily redeemable financial instrument.
If a finite-life entity issues an instrument that is
mandatorily redeemable either upon the scheduled liquidation or termination
of the reporting entity or upon an event that is certain to occur (e.g., the
holder’s death), the only-upon-liquidation exception to liability
classification is available if the event that would trigger redemption is
not certain to occur before the entity’s scheduled liquidation or
termination. In such a scenario, the potential requirement to redeem before
the entity’s liquidation or dissolution represents a conditional obligation
because the event that triggers it is not certain to occur before the
entity’s scheduled liquidation or dissolution. Even though the instrument is
certain to be redeemed, it is possible that redemption will be required only
upon the entity’s liquidation or dissolution, in which case the
only-upon-liquidation exception is available.
4.1.5.3 Noncontrolling Interest Exception
ASC 480-10
15-7E The guidance in this
Subtopic does not apply to mandatorily redeemable
noncontrolling interests (of all entities, public
and nonpublic) as follows:
- The classification and measurement provisions of this Subtopic do not apply to mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities by the subsidiary, under the only upon liquidation exception in paragraphs 480-10-25-4 and 480-10-25-6, but would be classified as liabilities by the parent in consolidated financial statements.
- The measurement provisions of this Subtopic do not apply to other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, both for the parent in consolidated financial statements and for the subsidiary that issued the instruments that result in the mandatorily redeemable noncontrolling interest. For those instruments, the measurement guidance for redeemable shares and noncontrolling interests in other predecessor literature (for example, in paragraph 480-10-S99-3A) continues to apply.
15-7F All public entities as
well as nonpublic entities that are SEC registrants
with mandatorily redeemable noncontrolling interests
subject to the classification and measurement scope
exception in paragraph 480-10-15-7E are required to
follow the disclosure requirements in paragraphs
480-10-50-1 through 50-3 as well as disclosures
required by other applicable guidance.
480-10 — Glossary
Noncontrolling
Interest
The portion of equity (net assets)
in a subsidiary not attributable, directly or
indirectly, to a parent. A noncontrolling interest
is sometimes called a minority interest.
In consolidated financial statements, instruments that are
mandatorily redeemable only upon the liquidation or termination of a
subsidiary (e.g., noncontrolling interests in limited-life subsidiaries) are
not required to be classified as liabilities, even if they meet the
definition of a mandatorily redeemable financial instrument. Further, such
instruments are exempt from the measurement guidance in ASC 480, although
its disclosure requirements apply. In evaluating whether the scope exception
in ASC 480-10-15-7E applies to situations in which the subsidiary does not
meet the definition of a business, an entity should carefully consider the
substance of the arrangement. If the subsidiary is not a substantive entity,
the scope exception does not apply. This conclusion is consistent with
analogous guidance in ASC 815-40-15-5C (see Section 2.6.1 of Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity) as well as ASC 810-10-40-3A. For
example, a subsidiary would not be considered a substantive entity if it was
structured to circumvent the mandatorily redeemable guidance in ASC 480.
If a noncontrolling interest in an entity that does not have
a limited life qualifies as a mandatorily redeemable financial instrument
under ASC 480, the entity is subject to all of the requirements of ASC 480
unless the nonpublic entity exception applies or the interest is
grandfathered. Under ASC 480-10-15-7E(b), mandatorily redeemable
noncontrolling interests are grandfathered out of ASC 480’s measurement
provisions if the interests were issued before November 5, 2003. This
applies both in the parent’s consolidated financial statements and in the
financial statements of the subsidiary that issued the instrument. The
classification and disclosure provisions of ASC 480 apply to such
instruments.
4.1.5.4 Exception for Certain Instruments of Certain Nonpublic Entities
ASC 480-10
15-7A The classification,
measurement, and disclosure guidance in this
Subtopic does not apply to mandatorily redeemable
financial instruments that meet both of the
following:
- They are issued by nonpublic entities that are not Securities and Exchange Commission (SEC) registrants.
- They are mandatorily redeemable, but not on fixed dates or not for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index.
15-7B Mandatorily redeemable
financial instruments issued by an SEC registrant
are not eligible for the scope exception in
paragraph 480-10-15-7A, even if the entity meets the
definition of a nonpublic entity.
15-7C 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. If an entity with
such shares and redemption agreement is a nonpublic
entity that is not an SEC registrant, those
mandatorily redeemable shares meet the scope
exception in paragraph 480-10-15-7A if they meet the
conditions specified in that paragraph.
15-7D Although the disclosure
requirements of this Subtopic do not apply for those
mandatorily redeemable instruments of certain
nonpublic companies that meet the scope exception in
paragraph 480-10-15-7A, the requirements of Subtopic
505-10 still apply. In particular, paragraph
505-10-50-3 requires information about the pertinent
rights and privileges of the various securities
outstanding, which includes mandatory redemption
requirements. Paragraph 505-10-50-11 also requires
disclosure of the amount of redemption requirements
for all issues of stock that are redeemable at fixed
or determinable prices on fixed or determinable
dates in each of the next five years.
ASC 480-10 — Glossary
Securities and Exchange
Commission Registrant
An entity (or an entity that is controlled by an
entity) that meets any of the following criteria:
- It has issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
- It is required to file financial statements with the Securities and Exchange Commission (SEC).
- It provides financial statements for the purpose of issuing any class of securities in a public market.
ASC Master Glossary
Nonpublic Entity
Any entity other than one that
meets any of the following criteria:
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria.
An entity that has only
debt securities trading in a public market (or that
has made a filing with a regulatory agency in
preparation to trade only debt securities) is a
nonpublic entity.
For nonpublic entities that are not SEC registrants, ASC 480
does not apply to mandatorily redeemable financial instruments other than
those that are mandatorily redeemable on fixed dates for amounts that either
are fixed or are determined by reference to an interest rate index, currency
index, or another external index. For example, if a nonpublic entity has
outstanding shares that are mandatorily redeemable for cash upon the death
of the holder, those shares would not be accounted for as liabilities under
ASC 480, even if they meet the definition of a mandatorily redeemable
financial instrument, because the redemption date is not fixed. Similarly,
if the shares of a nonpublic entity are mandatorily redeemable at the
appraised value or fair value of the holder’s interest in the net assets of
the entity, those shares would not be classified as liabilities under ASC
480, because the redemption amount is neither fixed nor determined on the
basis of an external index.
The following table
illustrates whether ASC 480 does or does not apply to a mandatorily
redeemable financial instrument issued by a nonpublic entity that is not an
SEC registrant:
Redemption Terms | Fixed Date | Variable Date |
---|---|---|
Fixed amount | Yes | No |
Amount determined by reference to an interest rate
index, currency index, or another external
index | Yes | No |
Other variable amounts | No | No |
ASC 480-10-15-7D notes that in accordance with ASC
505-10-50-3 and ASC 505-10-50-11, a nonpublic entity that is not an SEC
registrant that has issued securities to which the exception applies is
required to disclose (1) “information about the pertinent rights and
privileges of the various securities outstanding, which includes mandatory
redemption requirements” and (2) “the amount of redemption requirements for
all issues of stock that are redeemable at fixed or determinable prices on
fixed or determinable dates in each of the next five years.”
To be eligible for the exception in ASC 480-10-15-7A, the
issuer must be a nonpublic entity that is not an SEC registrant. In the
application of ASC 480, a nonpublic entity is an “entity that has only debt
securities trading in a public market (or that has made a filing with a
regulatory agency in preparation to trade only debt securities).” However,
according to ASC 480-10-20, an entity is an SEC registrant if it has debt
securities trading in a public market (or will issue such securities).
Therefore, an entity that has issued either debt or equity securities
trading in a public market, or is in the process of issuing such securities,
is not eligible for the exception.
Broker-dealers that are required to file financial
statements with the SEC are not eligible for the exception for nonpublic
entities that are not SEC registrants, even if they do not issue publicly
traded stock or debt. In prepared remarks at the 2003 AICPA Conference on Current SEC
Developments, Mr. Faucette stated the following:
[S]ome broker-dealers have asserted that they
should be eligible for the [exceptions] for mandatorily redeemable
financial instruments of certain nonpublic entities . . . . However,
certain nonpublic entities are defined as entities other than SEC
registrants. The definition of an SEC registrant . . . includes
entities that are required to file financial statements with the
SEC. Thus, the definition of an SEC registrant includes any
broker-dealer that is required to file financial statements with the
SEC, even if they do not issue publicly-traded stock or debt.
Therefore, we believe that any broker-dealer that files statements
with the SEC is not eligible for the additional
[exceptions].
If a nonpublic entity that is not an SEC registrant
subsequently becomes an SEC registrant, the entity applies ASC 480 as if it
were an SEC registrant for all periods presented. In such a scenario, the
exception to some of the requirements in ASC 480 for nonpublic entities is
not available for any period presented. The SEC staff communicated its view
on this matter at the AICPA SEC Regulations Committee meeting on April 8,
2004, which is described in the highlights of that meeting:
An entity is generally no longer eligible for the
nonpublic company treatment alternatives when it is in the process
of becoming a public entity. Such entities must comply with public
company treatment alternatives in the standard as of the date that
all public companies were required to adopt the standard, even if
that requires a company that is in the process of filing an IPO to
restate prior period financial statements.
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.
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.
4.4 Reclassifications
4.4.1 Ongoing Reassessment
ASC 480-10
25-5 A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.
25-7 If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.
55-10 The guidance that follows discusses the requirement in paragraph 480-10-25-7 for reclassification of stock that becomes mandatorily redeemable. For example, an entity may issue equity shares on January 2, 2004, that must be redeemed (not at the option of the holder) six months after a change in control. When issued, the shares are conditionally redeemable and, therefore, do not meet the definition of mandatorily redeemable. On December 30, 2008, there is a change in control, requiring the shares to be redeemed on June 30, 2009. On December 31, 2008, the issuer would treat the shares as mandatorily redeemable and reclassify the shares as liabilities, measured initially at fair value. Additionally, the issuer would reduce equity by the amount of that initial measure, recognizing no gain or loss.
55-11 For another example of a conditionally redeemable instrument, an entity may issue preferred shares with a stated redemption date 30 years hence that also are convertible at the option of the holders into a fixed number of common shares during the first 10 years. Those instruments are not mandatorily redeemable for the first 10 years because the redemption is conditional, contingent upon the holder’s not exercising its option to convert into common shares. However, when the conversion option (the condition) expires, the shares would become mandatorily redeemable and would be reclassified as liabilities, measured initially at fair value.
55-12 If the conversion option were nonsubstantive, for example, because the conversion price is extremely high in relation to the current share price, it would be disregarded as provided in paragraph 480-10-25-1. If that were the case at inception, those preferred shares would be considered mandatorily redeemable and classified as liabilities with no subsequent reassessment of the nonsubstantive feature.
An entity should reassess in each reporting period whether any of its equity-classified shares have become mandatorily redeemable financial instruments. If circumstances change, a share that previously did not meet the definition of a mandatorily redeemable financial instrument may subsequently meet it. For example, a perpetual share that is required to be redeemed in cash upon the occurrence of an event that is not certain to occur (e.g., a deemed liquidation event) would not initially meet the definition of a mandatorily redeemable financial instrument, because redemption is conditional. If the event subsequently becomes certain to occur so that redemption becomes unconditional, the share would begin to meet the definition of a mandatorily redeemable financial instrument and should be reclassified as a liability unless a specific exception from liability classification applies.
Examples include:
- The expiration of a substantive conversion option in a preferred share with a stated redemption date on which the issuer is required to redeem the share for cash (see ASC 480-10-55-11). The share would be reclassified as a liability on the expiration date of the conversion option.
- The holder’s exercise of a physically settled put or redemption option in a perpetual preferred share that makes redemption certain to occur. That share would be reclassified as a liability on the option exercise date and remain a liability until the redemption date. (Redemption would continue to be considered conditional, however, if the issuer has the right to reject the redemption request under the redemption option without penalty.)
- The issuer’s exercise of a physically settled call or redemption option embedded in a perpetual preferred share that makes redemption certain to occur. The share would be reclassified as a liability on the option exercise date.
- The occurrence of an event (e.g., an IPO or change of control) that triggers the mandatory redemption of a perpetual preferred share for cash (see ASC 480-10-55-10 for an example). The share would be reclassified as a liability upon the occurrence of the event.
Reclassification is also required if the terms of a share are modified so that it begins to meet or ceases to meet the definition of a mandatorily redeemable financial instrument. However, the modification must be legally binding. An agreement in principle to change the contractual terms of an instrument may not be legally binding (e.g., if it allows either party to walk away without recourse).
A share might have to be reclassified as a liability even if the period until the required redemption date is short. For example, when an entity gives an irrevocable notice to purchase an outstanding redeemable share, it should consider whether the share must be reclassified as a mandatorily redeemable financial instrument.
An instrument for which redemption is not certain to occur does not meet the
definition of a mandatorily redeemable financial instrument.
For instance, a preferred share might contain an option for
the issuer to redeem the preferred share for cash and an
option for the holder to convert the share into common
stock. In such a scenario, even if the issuer notifies the
holder of its intent to exercise the redemption option, the
share would not meet the definition of a mandatorily
redeemable financial instrument if the holder has the
ability to convert the preferred stock into common stock
before the redemption date.
An instrument that previously did not meet the definition of a mandatorily redeemable financial instrument is reclassified as of the date it meets it. Thus, if a conditionally redeemable financial instrument in the form of a share became unconditionally redeemable after the balance sheet date, but before the financial statements were issued or available to be issued, an entity would not classify it as a liability as of the balance sheet date. However, the entity may be required to disclose the subsequent event in accordance with ASC 855-10-50-2 to keep the financial statements from being misleading.
4.4.2 Accounting for Reclassifications
ASC 480-10
30-2 If a conditionally redeemable instrument becomes mandatorily redeemable, upon reclassification the issuer shall measure that liability initially at fair value and reduce equity by the amount of that initial measure, recognizing no gain or loss.
When a conditionally redeemable financial instrument becomes a mandatorily
redeemable financial instrument (see Section
4.1), the issuer reclassifies it from the
equity to liabilities category at its current fair value as
of the date of the reclassification. No gain or loss should
be recognized in the income statement upon reclassification
because the reclassification is considered a distribution to
an owner. However, under the SEC guidance in ASC
260-10-S99-2, the reclassification of an equity-classified
preferred security as a liability (e.g., a preferred share
becomes mandatorily redeemable) is treated as a redemption
of equity by issuance of a debt instrument in the
calculation of EPS. In accordance with ASC 260-10-S99-2,
because the reclassification is accounted for as the
issuance of a new debt instrument to redeem the old equity
instrument (see Section 9.7.1),
previously recognized equity issuance costs would not be
expensed through the income statement but rather recognized
as part of the adjustment to EPS for the redemption of the
preferred stock.
If the instrument was previously classified in temporary equity under ASC 480-10-S99-3A, the issuer may need to adjust its method of measuring the instrument, because ASC 480-10-25-30-2 requires the instrument to be initially measured at fair value as of the reclassification date, and ASC 480-10-S99-3A permits certain accounting policies that are not available under ASC 480-10-35. Unlike paragraph 15 of ASC 480-10-S99-3A, for example, ASC 480-10-35 does not permit an entity to apply an accounting policy of measuring the instrument at the amount of cash that would be paid if settlement occurred as of the reporting date if the redemption date and the redemption amount are both fixed.
Example 4-8
Reclassification of Preferred Stock From Equity to a
Liability
Company D has outstanding preferred stock with the following terms:
- The preferred stock is automatically converted into common stock at a conversion price of $25 per share in the event that D effects a qualified IPO within the next five years.
- If D does not effect a qualified IPO by the end of the fifth year from the issuance date, the preferred stock becomes mandatorily redeemable in five years.
Company D should not classify the preferred stock as a liability under ASC 480 before the fifth year from the
issuance date if it concludes that the conversion upon a qualified IPO is a substantive feature. Furthermore,
while D is required to classify the preferred stock within temporary equity under ASC 480-10-S99-3A, it should
not remeasure the preferred stock to its redemption amount as long as the occurrence of a qualified IPO by
the end of year five is more than remote (see Section 9.5.4.3).
However, if a qualified IPO does not happen by the end of year five, the
preferred stock becomes a mandatorily redeemable
financial instrument for which reclassification as a
liability is required under ASC 480. In this
circumstance, in accordance with ASC 480-10-30-2, D
should reflect the reclassification by measuring the
liability initially at fair value and reducing equity by
the same amount without recognizing a gain or loss. This
reclassification is treated in the same manner as any
other extinguishment of preferred stock under ASC
260-10-S99-2. Therefore, the difference between the
initial fair value amount recognized for the preferred
stock upon reclassification as a liability and the net
carrying amount of the preferred stock (which should be
adjusted under other applicable GAAP, including ASC
480-10-S99-3A if applicable, immediately before such
reclassification) reflects a charge (or credit) to net
income in arriving at income available to common
stockholders.
For further discussion of the EPS impact of a
reclassification, see Sections 3.2.2,
3.2.3.5, and 3.2.4.4 of Deloitte’s Roadmap
Earnings per Share.
4.5 Equity-for-Debt Exchange
Entities sometimes enter into transactions involving the exchange of redeemable
securities classified in equity (or in temporary equity by SEC
registrants, as discussed in ASC 480-10-S99-3A) for mandatorily
redeemable securities classified as liabilities pursuant to ASC
480-10-25-4 (an “equity-for-debt exchange”). For example, an entity
that seeks to defer redemption of outstanding preference shares that
are currently redeemable at their holders’ option for cash may offer
those holders an exchange of existing preference shares for new
preference shares that are mandatorily redeemable at a later
date.
Assuming that the exchange is not akin to a troubled-debt restructuring, the
issuer should account for such an equity-for-debt
exchange as a reacquisition (extinguishment) of
the equity-classified securities and an issuance
of new liability-classified securities. The
redemption of the equity-classified securities
should be accounted for as a treasury stock
transaction under ASC 505, with no gain or loss
recognized in net income. The liability-classified
securities should be initially recognized and
measured at fair value in accordance with ASC
480-10-30-1. To the extent that the initial fair
value of the liability differs from the carrying
amount of the extinguished equity-classified
securities and the extinguished securities
represent preferred shares, the difference should
be deducted from or added to income available to
common stockholders in the calculation of EPS. ASC
260-10-S99-2 provides SEC registrants with
guidance on how redemptions of equity-classified
preferred securities affect the calculation of
EPS.
In some situations, entities analyze modifications or exchanges of
equity-classified redeemable securities by
analogizing to ASC 470-50 or other accounting
literature (see Section 3.2.6 of
Deloitte’s Roadmap Earnings per
Share). However, such analogies are
typically applied when the redeemable securities
both before and after the modification or exchange
are classified in equity (including temporary
equity); they do not apply to equity-for-debt
exchanges.
Example 4-9
Exchange of Preferred Securities
Company R, an SEC registrant, has 1 million outstanding shares of Series A redeemable convertible preferred stock. Company R issued the Series A stock on January 1, 20X1, at its par value of $20 per share, or $20 million in issuance proceeds. The stock is convertible into 5 million shares of R’s common stock (conversion ratio of 5:1 or $4 per share) at the option of each holder at any time and is mandatorily redeemable on June 30, 20X6.
Company R determined that the Series A stock should not be classified as a
liability under ASC 480 because redemption is
contingent on the holders’ not exercising their
conversion option. Because R is an SEC registrant,
it applied the guidance in ASC 480-10-S99-3A and
classified the preferred stock in temporary
equity. Company R also determined that the
conversion feature does not need to be bifurcated
or separately recognized as a derivative
instrument.
In June 20X6, R reached an agreement with holders on December 31, 20X5, to
exchange the 1 million shares of its Series A
stock for 4 million shares of new, Series B
nonconvertible preferred stock in a transaction
that was not akin to a troubled-debt
restructuring. Company R determines that the fair
value of the Series B stock is $21 million. The
Series B stock is not convertible into R’s common
stock but is mandatorily redeemable at par in
February 20X9. The company determines that the new
stock must be classified as a liability under ASC
480.
Company R should account for the exchange of the stock classified as temporary
equity for the stock classified as a liability as
a treasury stock repurchase of the stock
classified as temporary equity and the issuance of
new liability-classified stock measured at the
fair value of the newly issued
liability-classified stock. Below are sample
journal entries.
On January 1, 20X1, R issues the Series A preferred shares for an amount equal to their aggregate par value — $20 million.
Journal Entry — January 1, 20X1
On December 31, 20X5, R issues Series B preferred shares in exchange for the
Series A stock. The aggregate fair value of the
Series B preferred shares is $21 million, so R
recognizes a liability of $21 million. Since the
fair value of the consideration paid to repurchase
the Series A stock (i.e., the Series B preferred
stock) is $1 million more than the Series A
carrying amount, R records a debit to retained
earnings in the amount of $1 million and deducts
$1 million from net earnings in calculating EPS to
arrive at income available to common
stockholders.
Journal Entry — December 31, 20X5
Company R should reflect the $1 million
difference as an adjustment to the numerator in
the calculation of EPS in accordance with ASC
260-10-S99-2.