5.2 Application Issues
5.2.1 Obligation to Issue an Instrument That Embodies an Obligation That Requires or May Require a Transfer of Assets
5.2.1.1 Overview
ASC 480-10
25-13 An instrument that requires the issuer to settle its obligation by issuing another instrument (for example, a note payable in cash) ultimately requires settlement by a transfer of assets, accordingly:
- When applying paragraphs 480-10-25-8 through 25-12, this also would apply for an instrument settled with another instrument that ultimately may require settlement by a transfer of assets (warrants for puttable shares).
- It is clear that a warrant for mandatorily redeemable shares would be a liability under this Subtopic.
ASC 480 applies to contracts that require or could require the issuer to deliver
equity securities (e.g., warrants, written call options, and forward sale
contracts) if the entity could ultimately be forced to redeem those
securities by transferring assets. The guidance applies irrespective of
whether the redeemable equity securities would be classified within equity
(including temporary equity) when issued.
For example, if an entity issues a warrant that permits the holder to purchase
the entity’s equity shares, that warrant is classified as a liability if the
underlying equity shares contain a redemption requirement that is not solely
within the entity’s control (e.g., an investor put option embedded in
preferred stock). Such a warrant must be classified as a liability under ASC
480-10-25-8 because (1) a warrant is a financial instrument other than an
outstanding share and (2) a warrant on a puttable share embodies an
obligation that may require the issuer to ultimately transfer assets. That
is, the issuer is required to transfer assets if the holder exercises the
warrant and subsequently elects to put the shares back to the issuer for
cash or other assets. A forward sale contract on redeemable equity
securities would also be classified as a liability under ASC 480.
If the redemption feature could require the entity to transfer assets, a
contract on redeemable shares is classified outside of equity regardless of
the feature’s timing (e.g., immediately after exercise of the contract or on
some subsequent date in the future) or the redemption price (e.g., fair
value or a fixed price) because such an instrument embodies an obligation
that represents a liability. Therefore, ASC 480-10-25-8 applies to warrants
or forwards to issue shares that are redeemable immediately after exercise
(or settlement) as well as to those that are redeemable on some date in the
future.
In addition, a contract on redeemable shares is classified outside of equity
even if the redemption feature is contingent on the occurrence or
nonoccurrence of a specified event (such as a change in control, reduction
in the issuer’s credit rating, conversion, or failure to obtain by a
designated date the SEC’s declaration that a registration statement is
effective) unless the contingency is (1) solely within the control of the
issuer or (2) an event under which “all of the holders of equally and more
subordinated equity instruments of the entity would always be entitled to
also receive the same form of consideration (for example, cash or shares)
upon the occurrence of the event that gives rise to the redemption (that is,
all subordinate classes would also be entitled to redeem,” as described in
ASC 480-10-S99-3A(3)(f) [see Section 5.2.2]).
5.2.1.2 Warrant for Puttable Shares That May Require Cash Settlement
ASC 480-10
55-32 Entity B issues a warrant for shares that can be put back by Holder immediately after exercise of the warrant. The warrant feature allows Holder to purchase 1 equity share at a strike price of $10 on a specified date. The put feature allows Holder to put the shares obtained by exercising the warrant back to Entity B on that date for $12, and to require physical settlement in cash. If the share price on the settlement date is greater than $12, Holder would be expected to exercise the warrant obligating Entity B to issue a fixed number of shares in exchange for a fixed amount of cash, and retain the shares. That feature alone does not result in a liability under paragraphs 480-10-25-8 through 25-12. However, if the share price is equal to or less than $12, Holder would be expected to put the shares back to Entity B and could choose to obligate Entity B to pay $12 in cash. That feature does result in a liability, because the financial instrument embodies an obligation to repurchase the issuer’s shares and may require a transfer of assets. Therefore, those paragraphs require Entity B to classify the warrant as a liability. A warrant to issue shares that will be mandatorily redeemable is also classified as a liability, and should be analyzed under Topic 815.
55-33 A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets — the obligation is conditioned on the warrant’s being exercised and the shares obtained by the warrant being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable shares also conditionally obligates the issuer to ultimately transfer assets — the obligation is conditioned only on the warrant’s being exercised because the shares will be redeemed. Thus, warrants for both puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under paragraphs 480-10-25-8 through 25-12, even though the number of conditions leading up to the possible transfer of assets differs for those warrants. The warrants are liabilities even if the share repurchase feature is conditional on a defined contingency.
ASC 480-10-55-32 and 55-33 illustrate the application of ASC 480 to a physically
settled freestanding warrant that obligates the issuer to deliver a fixed
number of the issuer’s puttable equity shares in exchange for cash if the
warrant is exercised by the holder. The puttable equity shares include a
redemption feature that permits the holder to tender the share to the issuer
in exchange for cash. In this scenario, the put feature associated with the
shares causes the warrant to be classified as a liability under ASC
480-10-25-8 because that feature represents an obligation to repurchase the
issuer’s shares and may require the issuer to transfer assets. Without the
put feature, the warrant would have been outside the scope of ASC 480.
ASC 480-10-55-13(b) and ASC 480-10-55-33 state that a freestanding warrant for
mandatorily redeemable shares would be a liability under ASC 480 even though
the obligation to transfer assets is conditional on the exercise of the
warrant. That guidance would apply to a forward to issue puttable or
mandatorily redeemable shares as well (see also Section 2.2.4).
Example 5-1
Warrant on Redeemable Convertible Preferred
Stock
In 20X5, Company C issues a warrant to Company D. The warrant gives D the right to purchase, for a fixed price, C’s Series A convertible preferred stock on December 31, 20X5. The Series A preferred stock that will be delivered upon exercise of the warrant is convertible into Series A common stock or is redeemable for cash at its par amount at the option of the holder on December 31, 20X8.
Because the Series A preferred stock is only conditionally (rather than
mandatorily) redeemable and, upon issuance, will
take the form of an outstanding share, C will
account for the shares (if they are issued) as
equity instruments when they are issued. However, in
its 20X5 financial statements, C is required to
classify the warrant as a liability in accordance
with ASC 480-10-25-8 because the warrant itself (1)
is not an outstanding share and (2) embodies an
obligation to transfer assets (cash) if D elects to
put the Series A convertible preferred stock back to
C.
5.2.1.3 Contracts on Redeemable Equity Shares That Do Not Require a Transfer of Assets
If a freestanding contract on redeemable equity shares cannot require the entity
to transfer assets, the contract is not subject to ASC 480-10-25-8. For
example, the following types of contracts on redeemable equity securities
would not fall within the scope of ASC 480:
-
A purchased put option that permits the issuer, at its option, to sell redeemable equity securities (because the entity has no obligation to issue redeemable equity securities).
-
A purchased call option that permits the issuer, at its option, to repurchase redeemable equity securities (because the entity has no obligation to repurchase the redeemable equity securities).
Further, a contract that requires or might require the issuer to deliver equity shares that contain a cash-settled redemption requirement (e.g., a written warrant or call option or a forward sale contract on redeemable equity securities) would not be subject to ASC 480-10-25-8 if the share redemption requirement is solely within the issuer’s control. Although the shares are redeemable, the issuer cannot be required to transfer assets if it has discretion to avoid a share redemption (see Section 2.2.1).
However, a contract that requires the issuer to deliver equity shares that are
redeemable for cash or other assets upon the occurrence of an event that is
outside the issuer’s control would be subject to ASC 480-10-25-8. For
example, a prepaid forward sale contract that requires the issuing entity to
deliver redeemable equity securities in the future would be a liability
under ASC 480-10-25-8. The accounting for this type of contract is similar
to the accounting for warrants on puttable shares (see Section 5.2.1.2).
5.2.1.4 Prepaid Obligations
5.2.1.4.1 General
The sections below discuss the following types of contracts:
-
Prepaid forward purchase contracts — In a fully prepaid forward contract to purchase equity shares, an issuing entity enters into an agreement that requires the counterparty to sell a fixed or variable number of the issuing entity’s equity shares to the entity in the future. The issuing entity pays the counterparty the total purchase price on the date the parties enter into the contract. On the settlement date(s), the counterparty delivers the shares to the issuing entity.In a partially prepaid forward contract to purchase equity shares, the issuing entity pays some, but not all, of the amount due to the counterparty for the equity shares that will be delivered in the future. Therefore, unlike a fully prepaid forward contract to purchase equity shares, the issuing entity continues to have an obligation to pay the counterparty cash in exchange for the total equity shares it receives.
-
Prepaid written put options — In a fully prepaid written put option on equity shares, an issuing entity enters into an agreement that permits, but does not require, the counterparty to sell a fixed or variable number of the issuing entity’s equity shares to the entity in the future. The issuing entity pays the counterparty an amount equal to the total purchase price of the equity shares (i.e., the total exercise price) less an option premium (i.e., the premium the counterparty would pay to the entity for the put right). If the counterparty exercises the put option, it delivers the equity shares to the entity. If the counterparty does not exercise the put option, it pays the exercise price back to the entity. The issuing entity retains the option premium. See Example 2-3 for an illustration.In a partially prepaid written put option on equity shares, the issuing entity pays some, but not all, of the total exercise price to the counterparty. Therefore, unlike a fully prepaid written put option, the issuing entity continues to have an obligation to pay the counterparty cash if the counterparty exercises the put option.
In the sections below, it is assumed that (1) physical settlement is required
under the contract and (2) the underlying equity shares are classified in
permanent equity. Prepaid forward purchase contracts and prepaid written put
options that require or allow net cash or net share settlement are not
addressed given that such instruments are not common in practice.
5.2.1.4.2 Forward Purchase Contracts
5.2.1.4.2.1 Fully Prepaid Forward Purchase Contracts
In a fully prepaid forward purchase contract, the issuing entity has no
remaining obligation to transfer cash or other assets. Therefore, ASC
480 does not apply because it only addresses freestanding financial
instruments that have characteristics of a liability. ASC 480-10-15-3
states, in part:
The guidance in the Distinguishing Liabilities from
Equity Topic applies to any freestanding financial instrument,
including one that has any of the following attributes: . . .
b. Has characteristics of both a liability and equity and,
in some circumstances, also has characteristics of an asset
(for example, a forward contract to purchase the issuer's
equity shares that is to be net cash settled). Accordingly,
this Topic does not address an instrument that has only
characteristics of an asset.
A fully prepaid forward contract to purchase equity
shares represents a hybrid financial instrument that consists of a loan
to the counterparty (i.e., a receivable of the issuing entity) and an
embedded forward contract on the issuing entity’s equity shares. An
entity cannot recognize the instrument as an asset in its entirety on
the basis of ASC 480 because this type of contract is not within the
scope of ASC 480.1 The entity can only recognize an asset at the inception of a
contract that is within the scope of ASC 480-10-25-8 if the instrument
represents a combination option that includes an asset component that
has an initial fair value (i.e., option premium) that exceeds the
initial fair value (i.e., option premium) of the instrument’s liability
component. See ASC 480-10-25-12(b) and ASC 480-10-55-20.
The accounting for a
fully prepaid forward contract to purchase equity shares is addressed in
the table below. Note that it is assumed in the table that the cash is
paid to the counterparty as opposed to being posted in escrow or as
collateral; these types of arrangements are not discussed in this
section.
|
Number of Shares Being Purchased
|
Accounting
|
|---|---|
|
Fixed
|
Assume that an entity enters into an agreement to
purchase 10,000 shares of common stock that will
be delivered to the entity by the counterparty in
one year for $500 per share (i.e., a total cash
purchase price of $5 million). Further assume that
at inception of the contract, the entity pays the
total purchase price to the counterparty. The
entity should account for the prepaid forward
contract as follows:
Because the number of equity shares being
purchased is fixed, the derivative accounting
scope exception in ASC 815-10-15-74 applies;
therefore, the embedded forward purchase contract
in this hybrid financial instrument does not
require bifurcation under ASC 815-15. As a result,
the contract is accounted for as a single
instrument in its entirety.
The prepayment amount cannot be
classified as an asset on the basis of ASC 480
because that guidance does not apply. Rather, the
prepayment amount must be classified within equity
in accordance with ASC 505-10-45-2, which
indicates that reporting a receivable that is
settled in equity shares is not appropriate.2 Because the prepayment amount is reflected
in equity, the issuing entity is precluded from
electing the fair value option for the contract in
accordance with ASC 825-10-15-5(f).
Although a time-value-of-money element is
inherent in the pricing of the contract as a
result of the prepayment, the entity should not
accrete interest income on the prepaid amount
because it is recognized as an equity transaction.
Note that the treatment described above is
similar to the accounting that applies if,
ignoring interest cost, an entity enters into an
obligation to purchase a fixed number of equity
shares and repays the amount due to the
counterparty immediately after recognizing its
obligation. This accounting would be as
follows:
In both cases, the entity reflects a reduction of
equity for the amount of the forward contract’s
purchase price. On the basis of informal
discussions with the SEC staff, we have confirmed
that the SEC would object to an entity’s
classification of the prepayment as an asset.
|
|
Variable
|
An entity should evaluate a
fully prepaid contract to purchase a variable
number of equity shares as a hybrid financial
instrument with an embedded forward purchase
contract that may require bifurcation under ASC
815-15.3 The accounting is based on the facts and
circumstances and depends on whether the embedded
forward purchase contract requires bifurcation, as
follows:
|
5.2.1.4.2.2 Partially Prepaid Forward Purchase Contracts
In a partially prepaid forward contract to purchase equity shares, the
issuing entity has a remaining obligation to transfer cash or other
assets because the total purchase price was not paid at inception.
Therefore, ASC 480-10-25-8 applies to this remaining obligation although
it does not apply to the amount prepaid. Because this type of contract
may represent a hybrid financial instrument (i.e., a host receivable of
the issuing entity and an embedded forward purchase contract), the
application of other guidance in ASC 480 or U.S. GAAP will depend on the
facts and circumstances.
If the contract requires settlement by the issuing entity’s delivery of
the remaining amount of cash due in exchange for a fixed number of
equity shares, the contract will not be a derivative instrument in its
entirety nor will it represent a hybrid financial instrument that
contains an embedded forward purchase contract that must be bifurcated
because of the exception in ASC 815-10-15-74(d) (i.e., the partial
prepayment does not negate the application of this scope exception). The
entity should therefore account for the remaining cash obligation in
accordance with ASC 480-10-25-8.
For example, assume that
an entity enters into an agreement to purchase 10,000 shares of common
stock that will be delivered to the entity by the counterparty in one
year for $500 per share (i.e., a total cash purchase price of $5
million). Further assume that the entity pays the counterparty $2
million at inception of the contract and is obligated to pay the
counterparty $3 million in one year in conjunction with the settlement
of the contract. If the present value of the issuing entity’s remaining
obligation to pay $3 million to the counterparty is $2.8 million, the
entity would recognize the following entry at inception of the contract:
The entity would then recognize interest expense on the obligation in
accordance with the interest method. (Note that the total purchase price
of $5 million in this example would not be expected to equal the total
purchase price of $5 million when the contract is fully prepaid because
of the time value of money. However, for simplicity, the assumptions in
this example are the same as those above in which the total purchase
price is fully paid at inception of the contract.)
If the contract requires settlement by the issuing
entity’s delivery of the remaining amount of cash due in exchange for
the acquisition of a variable number of equity shares, the accounting
may be more complex and will depend on the facts and circumstances. The
issuing entity should first evaluate whether the contract represents a
single unit or multiple units of account. This is important because each
individual unit of account must be evaluated under ASC 480 and ASC 815,
as applicable. The entity should then evaluate whether each unit of
account is within the scope of ASC 480 or ASC 815. This will involve an
evaluation of whether the contract (or unit of account) meets the
definition of a derivative in its entirety, which may depend on whether
the initial net investment characteristic in ASC 815-10-15-83(b) is met.
If the contract (or unit of account) is not a derivative in its
entirety, the entity will need to determine whether it contains an
embedded derivative for the forward purchase element that must be
bifurcated under ASC 815-15. This will require the entity to evaluate
whether the embedded forward purchase contract meets the characteristics
of a derivative instrument in ASC 815-10-15-83 and, if so, whether the
scope exception in ASC 815-10-15-74 (i.e., ASC 815-40) is applicable.
While ASC 480-10-25-8 applies to a partially prepaid
forward contract to purchase a variable number of equity shares (because
it obligates the issuing entity to pay cash to the counterparty for its
remaining payment obligation), an entity should not recognize the
prepayment amount as an asset on the basis of the guidance in ASC 480;
however, it should recognize an obligation for the remaining cash amount
due as a liability under ASC 480-10-25-8. Although recognition of the
prepayment amount as an asset may seem appropriate if the contract
represents a single unit of account that must be treated as a derivative
under ASC 815, we understand that the SEC staff may challenge the
accounting for a prepayment on an entity’s own equity as an asset. An
entity should therefore consult with its accounting advisers before
recognizing any amount of the prepayment as an asset.
5.2.1.4.3 Written Put Options
5.2.1.4.3.1 Fully Prepaid Written Put Options
In a fully prepaid written put option, the issuing
entity has no remaining obligation to transfer cash or other assets.4 Therefore, ASC 480 does not apply because it only addresses
freestanding financial instruments that have characteristics of a
liability (see Section
5.2.1.4.2.1).
A fully prepaid written put option represents a hybrid financial
instrument that consists of a loan to the counterparty (i.e., a
receivable of the issuing entity) and an embedded written put option on
the issuing entity’s equity shares. The contract can never be a
derivative instrument in its entirety because the initial net investment
characteristic in ASC 815-10-15-83(b) is not met. An entity cannot
recognize the instrument as an asset in its entirety on the basis of ASC
480 because the contract is not within the scope of ASC 480. An entity
can only recognize an asset at the inception of a contract that is
within the scope of ASC 480-10-25-8 if the instrument represents a
combination option that includes an asset component that has an initial
fair value (i.e., option premium) that exceeds the initial fair value
(i.e., option premium) of the instrument’s liability component. See ASC
480-10-25-12(b) and ASC 480-10-55-20.
The issuing entity will need to evaluate whether the embedded written put
option must be bifurcated under ASC 815-15. This will depend upon
whether that embedded feature, on a stand-alone basis, meets the
definition of a derivative and, if so, whether the scope exception in
ASC 815-10-15-74(a) (i.e., ASC 815-40) applies.
If bifurcation of the embedded written put option is not required under
ASC 815-15, the issuing entity should recognize the prepayment amount
within equity (contra equity) in accordance with ASC 505-10-45-2. The
issuing entity cannot recognize the contract as an asset unless it is
settled for cash before the financial statements are issued or available
to be issued.
If the embedded written
put option must be bifurcated under ASC 815-15, the issuing entity
should recognize a derivative liability for the written put option and
classify the host contract (i.e., a loan receivable) within equity
(contra equity) in accordance with ASC 505-10-45-2. For example, assume
that an entity writes an option that allows the counterparty to sell
10,000 common shares to the entity in one year for a total purchase
price of $5 million. Further assume that the written option’s premium is
$1 million. As a result, the issuing entity pays the counterparty $4
million at inception of the contract. The entity would recognize the
following entry at inception:
5.2.1.4.3.2 Partially Prepaid Written Put Options
In a partially prepaid written put option, since the
total purchase price is not paid at inception, the issuing entity has a
remaining obligation to transfer cash or other assets if the
counterparty exercises the option. Because the contract still contains
an obligation to transfer assets, ASC 480-10-25-8 applies. In addition,
the issuing entity must determine whether the contract represents a
hybrid financial instrument (i.e., a host receivable and an embedded
written put option) or meets the definition of a derivative in its
entirety. Therefore, the treatment of a partially prepaid written put
option depends on the facts and circumstances, including whether the
instrument contains one or multiple units of account.
If the contract is not a derivative in its entirety because the initial
net investment characteristic is not met under ASC 815-10-15-83(b), it
may be appropriate to account for the instrument in a manner similar to
a fully prepaid written put option (see Section 5.2.1.4.3.1).
If, however, the contract meets the initial net investment
characteristic under ASC 815-10-15-83(b), it may be appropriate for the
issuing entity to account for the instrument as an asset that is
initially and subsequently measured at fair value, with changes in fair
value reported in earnings. This accounting may be appropriate since the
instrument could become a liability if the fair value of the shares were
to decline to such a level that the remaining payment obligation
exceeded the total value of the equity shares to be received on
settlement. However, we understand that the SEC staff may challenge the
treatment of a prepayment on an entity’s own equity as an asset. An
entity should therefore consult with its accounting advisers before
reporting an asset for any partially prepaid written put option.
5.2.2 Deemed Liquidation Events
ASC 815-40
55-2 An event that causes a change in control of an entity is not within the entity’s control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.
55-3 However, if a change-in-control provision requires that the counterparty receive, or permits the counterparty to deliver upon settlement, the same form of consideration (for example, cash, debt, or other assets) as holders of the shares underlying the contract, permanent equity classification would not be precluded as a result of the change-in-control provision. In that circumstance, if the holders of the shares underlying the contract were to receive cash in the transaction causing the change in control, the counterparty to the contract could also receive cash based on the value of its position under the contract.
55-4 If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt).
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(f)
Certain redemptions upon liquidation events.
Ordinary liquidation events, which involve the
redemption and liquidation of all of an entity’s equity
instruments for cash or other assets of the entity, do
not result in an equity instrument being subject to ASR
268. In other words, if the payment of cash or other
assets is required only from the distribution of net
assets upon the final liquidation or termination of an
entity (which may be a less-than-wholly-owned
consolidated subsidiary), then that potential event need
not be considered when applying ASR 268. Other
transactions are considered deemed liquidation events.
For example, the contractual provisions of an equity
instrument may require its redemption by the issuer upon
the occurrence of a change-in-control that does not
result in the liquidation or termination of the issuing
entity, a delisting of the issuer’s securities from an
exchange, or the violation of a debt covenant. Deemed
liquidation events that require (or permit at the
holder’s option) the redemption of only one or more
particular class of equity instrument for cash or other
assets cause those instruments to be subject to ASR 268.
However, as a limited exception, a deemed liquidation
event does not cause a particular class of equity
instrument to be classified outside of permanent equity
if all of the holders of equally and more subordinated
equity instruments of the entity would always be
entitled to also receive the same form of consideration
(for example, cash or shares) upon the occurrence of the
event that gives rise to the redemption (that is, all
subordinate classes would also be entitled to
redeem).
Under ASC 480-10-25-8, an entity must classify as liabilities those contracts,
other than outstanding shares, that require or could require the issuer to
repurchase its equity shares by transferring assets. Therefore, a freestanding
financial instrument that embodies an obligation (e.g., a warrant, written call
option, or forward) to issue the issuer’s equity shares (either preferred or
common stock) typically would be classified as an asset or liability under ASC
480-10-25-8 if those shares are puttable by the holder for cash (or other
assets) upon the occurrence of a deemed liquidation event (e.g., a change in
control) even if the underlying shares will be classified by the issuer as
equity upon issuance.
However, the warrants should be classified as equity by analogy to ASC
815-40-55-2 through 55-4 (see Section 5.2.3.3 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity) and ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.4) in the
narrow and limited circumstances in which (1) the equity shares into which the
instrument is convertible becomes puttable only upon the occurrence of an event
that is not within the entity’s control and (2) in accordance with ASC
480-10-S99-3A(3)(f), “all of the holders of equally and more subordinated equity
instruments of the entity would always be entitled to also receive the same form
of consideration (for example, cash or shares) upon the occurrence of the
[deemed liquidation] event . . . (that is, all subordinate classes would also be
entitled to redeem” their shares). We have discussed this view with the FASB
staff as part of a formal technical inquiry. (Note that in practice, however,
this limited exception rarely applies to warrants on preferred stock.)
Example 5-2
Warrants on Redeemable Common Shares
In 20X1, Company Y issues a warrant to Company Z that gives Z the right to
purchase, for a fixed price, Y’s common stock on
December 31, 20X3. Under Y’s articles of incorporation,
Y is obligated to redeem all of its outstanding shares
of common stock upon the occurrence of a
change-in-control transaction that does not result in
the final liquidation or termination of Y (a “deemed
liquidation event”). That is, all common shareholders of
Y immediately before the deemed liquidation event will
be entitled to redeem their shares upon the occurrence
of the deemed liquidation event. The common stock is not
otherwise redeemable.
Each holder of Y’s common stock would always be entitled to receive the same
form of consideration (cash or other assets or both)
upon redemption at the same amount per share.
Because the common stock is only conditionally redeemable and, upon issuance,
will take the form of an outstanding share, Y will
account for the common shares issued (if the warrant is
exercised) as equity instruments (i.e., they do not
represent mandatorily redeemable financial instruments
under ASC 480-10-25-4).
In its 20X1 financial statements, Y would not classify the warrants as
liabilities under ASC 480-10-25-8 because (1) the common
stock into which the warrant is convertible becomes
redeemable only upon the occurrence of a deemed
liquidation event and (2) upon the occurrence of the
deemed liquidation event, all investors in “equally and
more subordinated equity instruments of the entity would
always be entitled to also receive the same form of
consideration (for example, cash or shares).” If the
warrant meets the conditions for equity classification
in ASC 815-40, Y would classify it as an equity
instrument.
5.2.3 Obligations With Settlement Alternatives
Some obligations give one of the parties the choice of whether the obligation
will be settled by the issuer’s transfer of assets or by its issuance of shares
(e.g., option or forward contracts on own shares that permit either net cash or
net share settlement). In these circumstances, the issuer should determine
whether ASC 480-10-25-8 or ASC 480-10-25-14 takes precedence in the assessment
of whether the contract must be accounted for outside of equity under ASC
480.
5.2.3.1 Issuer Choice
Certain financial instruments embody obligations that permit the issuer to elect
the settlement method (i.e., cash or equity shares). Such obligations should
be treated as obligations that must be settled in equity shares. Therefore,
when the issuer has the discretion to avoid a transfer of assets upon
settlement (e.g., by electing net share settlement of the contract),
liability classification is required only if (1) the conditions in ASC
480-10-25-14 (see Chapter 6) related to changes in monetary value are met or
(2) the shares that would be delivered require or may require the transfer
of assets (e.g., puttable shares; see Section 5.2.1).
Certain financial instruments embody obligations
that permit the issuer to determine whether it will settle
the obligation by transferring assets or by issuing equity shares.
Because those obligations provide the issuer with discretion to
avoid a transfer of assets, the Board concluded that those
obligations should be treated like obligations that require
settlement by issuance of equity shares. That is, the Board
concluded that this Statement should require liability
classification of obligations that provide the issuer with the
discretion to determine how the obligations will be settled if, and
only if, the conditions in [ASC 480-10-25-14] related to changes in
monetary value are met.
5.2.3.2 Counterparty Choice
If the counterparty can elect the settlement method and can require the issuer
to transfer assets (e.g., by electing physical settlement or net cash
settlement of the contract), the obligation to transfer those assets must be
evaluated under ASC 480-10-25-8. In such a scenario, ASC 480-10-25-14 does
not apply because all obligations that give the holder the option to require
the issuer to transfer assets represent liabilities even if the monetary
values of the settlement alternatives (shares or assets) could differ (see
ASC 480-10-25-11). This is because these obligations give no discretion to
the issuer to avoid transferring assets.
5.2.3.3 Summary
The following table summarizes the analysis
under ASC 480 of financial instruments other than outstanding shares
embodying obligations to repurchase shares that give the issuer or the
holder a choice of settlement either in assets or nonredeemable equity
shares:
Settlement Alternatives | Issuer Choice | Counterparty Choice |
|---|---|---|
Transfer of assets (physical settlement or net cash) or a variable number of nonredeemable equity shares (net shares) | Evaluate as variable-share obligation under ASC 480-10-25-14 | Evaluate as an obligation to repurchase shares by transferring assets under ASC 480-10-25-8 |
Transfer of assets (physical settlement or net cash) or a fixed number of nonredeemable equity shares | Outside scope of ASC 480 | Evaluate as an obligation to repurchase shares by transferring assets under ASC 480-10-25-8 |
5.2.4 Financial Instruments That Embody Multiple Obligations
ASC 480-10
55-29 The implementation guidance that follows addresses financial instruments involving multiple components that embody (or are indexed to) an obligation to repurchase the issuer’s shares and that may require settlement by transferring assets. Some freestanding financial instruments composed of more than one option or forward contract embodying obligations require or may require settlement by transfer of assets. Paragraphs 480-10-15-3 through 15-4 state that the provisions of this Subtopic apply to freestanding financial instruments, including those that comprise more than one option or forward contract, and paragraphs 480-10- 25-4 through 25-14 shall be applied to a freestanding financial instrument in its entirety. Under paragraphs 480-10-25-8 through 25-12, if a freestanding instrument is composed of a written call option and a written put option, the existence of the written call option does not affect the classification. Unlike the application of paragraph 480-10-25-14, applying paragraphs 480-10-25-8 through 25-12 does not involve making any judgments about predominance among obligations or contingencies.
Some financial instruments contain more than one option or forward component
(e.g., a puttable warrant that contains both a written put option and a written
call option). Unless the financial instrument is an outstanding share, the
instrument is classified as an asset or a liability under ASC 480-10-25-8 if it
embodies any obligation to repurchase the issuer’s equity shares (or is indexed
to such an obligation) and requires or may require the issuer to transfer
assets. Unlike ASC 480-10-25-14, under which an entity evaluates the
predominance of the monetary value on settlement of variable-share obligations
(see Section
6.2.4), ASC 480-10-25-8 does allow an entity to determine whether the
obligation to transfer assets is predominant.
5.2.5 Put Warrants
ASC 815-40
55-16 Put warrants are frequently issued concurrently with debt securities of the entity, are detachable from the debt, and may be exercisable only under specified conditions. The put feature of the instrument may expire under varying circumstances, for example, with the passage of time or if the entity has a public stock offering. Under Subtopic 470-20, a portion of the proceeds from the issuance of debt with detachable warrants must be allocated to those warrants.
55-17 Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to do any of the following:
- Exercise the warrant feature to acquire the common stock of the entity at a specified price
- Exercise the put option feature to put the instrument back to the entity for a cash payment
- Exercise both the warrant feature to acquire the common stock and the put option feature to put that stock back to the entity for a cash payment.
55-18 Because the contract gives the counterparty the choice of cash settlement or settlement in shares,
entities should report the proceeds from the issuance of put warrants as liabilities and subsequently measure
the put warrants at fair value with changes in fair value reported in earnings as required by Topic 480. That is,
a put warrant that embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an
obligation, and that requires or may require a transfer of assets is within the scope of that Topic and therefore
is to be recognized as a liability.
A put warrant is an example of a contract that must be classified as a liability
under ASC 480. Even though the warrant gives the counterparty an option to
purchase the entity’s stock, the contract is classified as a liability in its
entirety under ASC 480-10-25-8 if the entity could be forced to repurchase the
warrant for cash or other assets because it represents an obligation that is
indexed to an obligation to repurchase the entity’s equity shares, and the
entity may be required to transfer cash or other assets. Alternatively, the
counterparty may have the right to put back to the entity for cash the stock it
received upon exercise of the warrant. In that case, the contract embodies an
obligation to repurchase equity shares for cash and is classified as a liability
in its entirety under ASC 480-10-25-8 (see Section 5.2.1). The accounting analysis
for put warrants is different from that for net-cash-settled written call
options on an entity’s equity shares. Although a net-cash-settled written call
option on an entity’s equity shares embodies an obligation to transfer cash or
other assets, it is (1) evaluated under ASC 815-40 instead of ASC 480 since it
does not represent an obligation to repurchase the issuer’s equity shares and is
not indexed to such an obligation and (2) classified as a liability in its
entirety under ASC 815-40.
ASC 480-10
55-30 Consider, for example, a puttable warrant that allows the holder to purchase a fixed number of the issuer’s shares at a fixed price that also is puttable by the holder at a specified date for a fixed monetary amount that the holder could require the issuer to pay in cash. The warrant is not an outstanding share and therefore does not meet the exception for outstanding shares in paragraphs 480-10-25-8 through 25-12. As a result, the example puttable warrant is a liability under those paragraphs, because it embodies an obligation indexed to an obligation to repurchase the issuer’s shares and may require a transfer of assets. It is a liability even if the repurchase feature is conditional on a defined contingency in addition to the level of the issuer’s share price.
55-31 Entity A issues a puttable warrant to Holder. The warrant feature allows Holder to purchase 1 equity share at a strike price of $10 on a specified date. The put feature allows Holder instead to put the warrant back to Entity A on that date for $2, and to require settlement in cash. If the share price on the settlement date is greater than $12, Holder would be expected to exercise the warrant, obligating Entity A to issue a fixed number of shares in exchange for a fixed amount of cash. That feature does not result in a liability under paragraphs 480-10-25-8 through 25-12. However, if the share price is equal to or less than $12, Holder would be expected to put the warrant back to Entity A and could choose to obligate Entity A to pay $2 in cash. That feature does result in a liability, because the financial instrument embodies an obligation that is indexed to an obligation to repurchase the issuer’s shares (as the share price decreases toward $12, the fair value of the issuer’s obligation to stand ready to pay $2 begins to increase) and may require a transfer of assets. Therefore, paragraphs 480-10-25-8 through 25-12 require Entity A to classify the instrument as a liability.
ASC 480-10-55-30 and 55-31 illustrate the application of ASC 480 to a physically
settled warrant that (1) obligates the issuer to deliver a fixed number of
nonredeemable equity shares in exchange for cash if the holder elects to
exercise it and (2) contains a put feature that permits the holder to require
the issuer to redeem the warrant for cash. In such a scenario, the put feature
causes the entire warrant to be classified as a liability under ASC 480-10-25-8
because that feature is indexed to an obligation to repurchase the issuer’s
shares and may require the issuer to transfer assets. The fact that the warrant
has a potential settlement outcome for which asset or liability classification
is not required under ASC 480 is irrelevant to the accounting analysis if at
least one of the warrant’s settlement outcomes is subject to ASC 480-10-25-8. If
the warrant instead had been issued without the put feature, it would have been
outside the scope of ASC 480 because that guidance does not apply to a written
warrant that requires the issuer to deliver a fixed number of nonredeemable
equity shares upon exercise.
In the example in ASC 480-10-55-31, the put feature is exercisable on the same date as the option to require delivery of a fixed number of shares. If the facts in ASC 480-10-55-31 were changed so that the put feature was not exercisable until a later date (e.g., the put was embedded in the shares delivered upon exercise) or was conditional upon the occurrence or nonoccurrence of an uncertain future event (e.g., a change in control), the classification of the warrant as a liability under ASC 480-10-25-8 would not change, because the possibility that the instrument will require the issuer to settle the obligation by transferring assets is sufficient for liability classification. Further, the warrant would be classified as a liability even if the put feature is not expected to be exercised.
5.2.6 Simple Agreement for Future Equity
A simple agreement for future equity (SAFE) is a contract that gives the holder a
right to obtain the issuer’s shares in the future in exchange for an up-front
payment. For example, the terms of a SAFE might specify that (1) the issuer will
deliver to the holder a variable number of its shares if the issuer raises equity
capital (i.e., an equity financing) and (2) the investor has a right to elect to
receive either a cash payment equal to the purchase amount or a variable number of
shares if there is a change of control or an IPO (i.e., a liquidity event).
Typically, a SAFE is not in the legal form of an outstanding share. If the SAFE is
in the legal form of debt, ASC 480 does not apply and the SAFE is classified as a
liability (see Section 2.2.4). If the SAFE is
not in the legal form of an outstanding share or debt, the issuer should evaluate
whether the SAFE must be classified as a liability under ASC 480-10-25-8 or, if not,
under ASC 480-10-25-14. If the SAFE gives the holder an option to redeem the
instrument for cash upon a change of control, the issuer would classify the SAFE as
a liability under ASC 480-10-25-8 because a change of control is an event that is
considered not under the sole control of the issuer (see Section 9.4.2).
Footnotes
1
This is consistent with remarks made by SEC
Associate Chief Accountant Carlton Tartar at the 2023 AICPA
& CIMA Conference on Current SEC and PCAOB Developments. Mr.
Tartar discussed a prepaid share repurchase arrangement entered
into in conjunction with a SPAC merger and indicated that the
SEC staff objected to the recognition of the prepayment as an
asset under ASC 480.
2
ASC 505-10-45-2 allows an
entity to record an asset if it collects cash
before the financial statements are issued or
available to be issued. However, in a prepaid
forward contract to purchase equity shares, the
issuing entity will never receive cash from the
counterparty.
3
The embedded forward contract
would require bifurcation under ASC 815-15 if it
meets the characteristics of a derivative
instrument on a freestanding basis and does not
qualify for the scope exception in ASC
815-10-15-74(a) (i.e., ASC 815-40).
4
In a manner similar to the discussion above, it
is assumed that the entity has delivered the cash to the
counterparty as opposed to posting cash as collateral or to an
escrow account that is not available to be used by the
counterparty.