5.1 Classification

ASC 480-10-25-8 requires a financial instrument to be classified as an asset or a liability if all of the following apply:

• It is not an outstanding share (see Section 5.1.2).
• It either (1) “embodies an obligation to repurchase the issuer’s equity shares” or (2) “is indexed to such an obligation” (see Section 5.1.3).
• “It requires or may require the issuer to settle the obligation by transferring assets” (see Section 5.1.4).

For example, a forward purchase contract on an entity’s own equity shares or a written put option on the entity’s own equity shares is classified as a liability if the issuer could be required to physically settle the contract by delivering cash in exchange for the issuer’s equity shares. Similarly, a forward purchase or written put option contract that permits the counterparty to net cash settle the contract would be classified as an asset or a liability. These requirements apply even if the purchase obligation is contingent upon the occurrence or nonoccurrence of an event (unless the event is solely within the entity’s control) or upon the counterparty’s exercise of an option. Further, the requirements apply even if the contract cannot be net settled (e.g., contracts that permit physical settlement only in private-company stock). Thus, contracts that are outside the scope of the derivative accounting guidance because they do not possess the net settlement characteristic in the definition of a derivative in ASC 815 may be within the scope of ASC 480.

 

Connecting the Dots

A freestanding financial instrument that is within the scope of ASC 480-10-25-8 can generally be classified as an asset at the inception of the arrangement only when (1) the instrument is a combination option consisting of a purchased option that has characteristics of an asset and a written option that embodies an obligation under ASC 480-10-25-8 and (2) the initial fair value (premium) of the purchased option component exceeds the initial fair value (premium) of the written option component.

A freestanding financial instrument that is within the scope of ASC 480-10-25-8 can generally be classified as an asset after inception of the arrangement only if one of the following conditions exist:

• The instrument is a combination option consisting of a purchased option that has characteristics of an asset and a written option that embodies an obligation under ASC 480-10-25-8, and the fair value of the purchased option component exceeds the fair value of the written option component.
• The instrument is a forward contract to repurchase equity shares that is subsequently measured at fair value, with changes in fair value reporting in earnings in accordance with ASC 480-10-35-5 (e.g., a net-settled forward contract to purchase equity shares), and the issuer’s share price increases after inception of the contract (i.e., the contract becomes “in-the-money” to the issuing entity).

A freestanding written put option can never be an asset to the issuing entity.

The fact that an obligation to repurchase shares is of short duration does not exempt it from the requirements of ASC 480. Accordingly, the issuer should evaluate treasury stock transactions to determine whether they must be classified as liabilities under ASC 480 in the period between the trade date and the settlement date. For example, the treasury stock repurchase component of a typical accelerated share repurchase transaction would be within the scope of ASC 480 (see Section 3.3.5).

Although a net-cash-settled forward sale or a net-cash-settled written call option on the issuer’s equity shares may require the issuer to transfer assets, such a contract does not require the issuer to repurchase shares and is not indexed to an obligation to repurchase the issuer’s equity shares (unless the underlying equity shares include a redemption obligation). Accordingly, ASC 480-10-25-8 does not apply to such a contract. Nevertheless, ASC 815-40 precludes equity classification for such net-cash-settled contracts on own equity.

 

Connecting the Dots

A call option that is exercisable at the issuer’s discretion could embody an obligation of the issuer. For example, if an entity issues warrants on callable shares and the holder of the warrants controls the entity (i.e., the holder could direct the company to “call” the shares issued upon exercise of the warrants), the call feature is in substance a put feature that embodies an obligation that is subject to ASC 480. Therefore, the warrants would be analyzed as warrants on puttable shares. See Section 5.2.1.1 for further discussion of the requirement to classify warrants on puttable shares as liabilities.

As noted in Section 2.2.4.2, ASC 480-10-20 suggests that the term “equity share” is limited to shares that qualify, and are classified, as equity (including both permanent and temporary equity) in the reporting entity’s financial statements. Nevertheless, ASC 480-10-25-13 and ASC 480-10-55-33 indicate that ASC 480-10-25-8 applies to financial instruments, such as warrants, options, or forwards, that involve the issuance of mandatorily redeemable shares that would be accounted for as liabilities when they are issued. This type of instrument as well as other warrants, options, or forwards that are settled with another instrument that ultimately requires or may require settlement by transfer of assets would be liabilities under ASC 480-10-25-8.

An example of an unconditional obligation to transfer assets is a noncontingent physically settled forward contract to purchase the issuer’s equity shares for cash. Examples of conditional obligations to transfer assets include obligations that are contingent on events or conditions outside the issuer’s control (see Sections 2.2.1 and 9.4.2), such as any of the following:

• The holder’s exercise of an option (e.g., a written put option on the issuer’s equity shares).
• The occurrence or nonoccurrence of an event outside the issuer’s control (e.g., a contingent forward purchase contract).
• The possibility that the fair value of a contract might be in a loss position (e.g., a net-cash-settled forward purchase contract).
• The counterparty’s choice of settlement method (e.g., a written put option that the holder can elect to settle either net in shares or net in cash).

A warrant or call option that permits the holder to purchase equity shares is considered to embody an obligation that may require the transfer of assets if the shares that would be delivered upon exercise of the warrant or option embody such an obligation (e.g., if the shares that would be delivered upon exercise contain a redemption feature that either unconditionally or conditionally requires the issuer to deliver cash).

The issuer’s equity shares are assets of its shareholders, not of the issuer. Accordingly, ASC 480-10-25-8 does not apply to an instrument that the issuer must or may settle in its equity shares (e.g., a net-share-settled written put option on own shares). However, an entity should evaluate whether it must classify such an instrument outside of equity under ASC 480-20-25-14 (see Chapter 6).

In the separate financial statements of a subsidiary, shares issued by its parent are considered assets of the subsidiary in the application of ASC 480-10-25-8. Accordingly, if the subsidiary issues a contract that it must settle in parent shares, that contract requires assets to be transferred in the separate financial statements of the subsidiary. In the consolidated financial statements that include the parent, however, that contract does not require assets to be transferred, because the parent’s equity shares are not the parent’s assets. Accordingly, it is possible that a contract that must be classified as a liability in the subsidiary’s separate financial statements under ASC 480-10-25-8 qualifies as equity in the consolidated financial statements.

An instrument that the issuer must settle by providing services (e.g., an obligation to repurchase shares in exchange for services) does not meet the definition of a financial instrument and therefore is outside the scope of ASC 480 (see Section 2.2.2).

For a contractual term that requires or might require a transfer of assets, classification under ASC 480-10-25-8 as a liability (or as an asset in some circumstances) would not be necessary in any of the following circumstances:

• The event that would cause a transfer of assets is under the sole control of the issuer (see Section 5.2.1.3). Section 9.4.2 discusses the evaluation of whether an event is within the issuer’s control.
• The issuer is or could be required to transfer assets only upon its final liquidation. This is analogous to the exceptions for only-upon-liquidation features in ASC 480-10-25-4 (see Section 4.1.5.2), ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.2), and ASC 815-40-25-9 (see Section 5.2.3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
• The issuer is or could be required to transfer assets only upon the occurrence of an event that would entitle all holders of equity instruments that are equally or more subordinated than the equity instruments underlying the contract to receive the same form of consideration (e.g., cash or shares) upon the occurrence of the event. This is analogous to the limited exception for certain deemed liquidation features in ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.4). See Section 5.2.2 for further discussion.