Chapter 5 — Obligations to Repurchase Shares by Transferring Assets
Chapter 5 — Obligations to Repurchase Shares by Transferring Assets
5.1 Classification
5.1.1 Overview
ASC 480-10
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
25-9 In this Subtopic,
indexed to is used interchangeably with
based on variations in the fair value of. The
phrase requires or may require encompasses
instruments that either conditionally or unconditionally
obligate the issuer to transfer assets. If the
obligation is conditional, the number of conditions
leading up to the transfer of assets is irrelevant.
25-10 Examples of financial instruments that meet the criteria in paragraph 480-10-25-8 include forward purchase contracts or written put options on the issuer’s equity shares that are to be physically settled or net cash settled.
25-11 All obligations that permit the holder to require the issuer to transfer assets result in liabilities, regardless of whether the settlement alternatives have the potential to differ.
ASC 480-10 — Glossary
Net Cash Settlement
A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain cash equal to the gain.
Physical Settlement
A form of settling a financial instrument under which both of the following conditions are met:
- The party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller.
- The seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
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.
5.1.2 Not an Outstanding Share
ASC 480-10-25-8 applies to instruments other
than those in the legal form of an outstanding share. For example, it applies to
certain contracts that are indexed to, and potentially settled in, the entity’s
own shares (e.g., forward repurchase and written put option contracts on own
shares). For outstanding shares, an entity should instead consider the guidance
on mandatorily redeemable financial instruments (see Chapter 4), certain obligations to deliver
a variable number of shares (see Chapter 6), and temporary equity (see
Chapter 9). The
following are examples of instruments that are not outstanding shares and those
that are:
Not Outstanding Shares (ASC 480-10-25-8 Might Apply) | Outstanding Shares (ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
5.1.3 An Obligation to Repurchase the Issuer’s Equity Shares or One That Is Indexed to Such an Obligation
ASC 480-10-25-8 applies both to contracts that embody obligations to repurchase shares (such as forward purchase and written put option contracts that require gross physical settlement) and to contracts that embody obligations indexed to obligations to repurchase shares (such as warrants on puttable shares). Obligations that are indexed to obligations to repurchase shares have a fair value that is based on variations in the fair value of obligations to repurchase shares, although they may not involve an actual share repurchase (e.g., contracts that the issuer is required or may be required to net cash settle).
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.
The following are examples of contracts that
embody an obligation to repurchase the issuer’s equity shares or are indexed to
such an obligation (“repurchase obligations”) and those that do not (“no
repurchase obligations”):
Repurchase Obligations
(ASC 480-10-25-8 Might Apply) | No Repurchase Obligations
(ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
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.
5.1.4 Requires or May Require the Transfer of Assets
ASC 480-10-25-8 applies to instruments that require or may require the issuer to transfer assets. The phrase “requires or may require” encompasses instruments that either unconditionally or conditionally obligate the issuer to transfer assets. To be classified outside of equity under ASC 480-10-25-8, an obligation to transfer assets does not have to be for a fixed amount. ASC 480-10-25-8 may apply even if the monetary amount of the obligation varies on the basis of a specified underlying (e.g., the S&P 500).
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).
The following are examples of instruments that
require or may require the transfer of assets and those that do not:
Asset Transfer Required (ASC 480-10-25-8 Might Apply) | Asset Transfer Not Required (ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
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.
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.
5.3 Accounting
The initial and subsequent accounting for a financial instrument
classified as an asset or a liability under ASC 480-10-25-8 depends on whether it is
a forward contract that requires physical settlement by repurchase of a fixed number
of equity shares in exchange for cash (including foreign currency).
5.3.1 Forward Contracts That Require Physical Settlement by Repurchase of a Fixed Number of Shares for Cash
5.3.1.1 Scope
Under ASC 480, unconditional forward purchase contracts that
require physical settlement by repurchase of a fixed number of the issuer’s
shares for cash are treated as treasury stock transactions that use borrowed
funds (i.e., debit to equity, credit to payable) rather than as derivatives
(see ASC 815-10-15-74(d)) or executory contracts. In other words, such
transactions are treated as if the repurchase has already occurred and the
payment for the shares has been financed with interest on the financing
arising from the difference between the spot price of the shares repurchased
and the ultimate settlement amount paid on the forward settlement date.
The special accounting for physically settled forward
contracts to repurchase shares applies irrespective of whether the amount of
cash the issuer will pay is fixed or variable (e.g., a stated amount of cash
plus interest at a variable interest rate). However, the accounting does not
apply to forward contracts that have settlement alternatives (e.g., the
holder or the issuer has the option to elect net cash settlement or net
share settlement). Further, the guidance does not apply to forward contracts
that require the issuer to transfer noncash assets (e.g., debt securities)
rather than cash to settle the contract. That is, the special accounting and
measurement guidance applies only if the obligation to purchase is
unconditional and requires physical settlement in exchange for cash. A
forward purchase contract that requires the delivery of noncash assets
(e.g., gold) in exchange for the issuer’s equity shares is considered to be
akin to a barter contract as opposed to a contract to repurchase equity
shares with borrowed funds. Therefore, it must be accounted for in the same
manner as conditional obligations to purchase the issuer’s equity shares
(i.e., at fair value, with changes in fair value reported in earnings).
Forward contracts that require physical settlement by
repurchase of a fixed number of the issuer’s shares for cash are outside the
scope of the derivative accounting literature under ASC 815-10-15-74(d) and
cannot be designated as derivative hedging instruments (see Section 2.3.1).
However, the scope exception does not apply to forward contracts that (1) do
not require physical settlement or (2) require physical settlement in
exchange for something other than cash.
5.3.1.2 Initial Measurement
ASC 480-10
30-3 Forward contracts that
require physical settlement by repurchase of a fixed
number of the issuer’s equity shares in exchange for
cash shall be measured initially at the fair value
of the shares at inception, adjusted for any
consideration or unstated rights or
privileges.
30-4 Two ways to obtain the
adjusted fair value include:
- Determining the amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately
- Discounting the settlement amount, at the rate implicit at inception after taking into account any consideration or unstated rights or privileges that may have affected the terms of the transaction.
30-5 Equity shall be reduced
by an amount equal to the fair value of the shares
at inception.
30-6 Cash (as that term is
used in paragraph 480-10-30-3) includes foreign
currency, so physically settled forward purchase
contracts in exchange for foreign currency shall be
measured as provided in paragraphs 480-10-30-3
through 30-5 and 480-10-35-3, then remeasured under
Topic 830.
Although ASC 480-10-30-3 specifies that a forward contract
that requires settlement by repurchase of a fixed number of shares for cash
should initially be measured at the “fair value of the shares at inception,
adjusted for any consideration or unstated rights or privileges,” ASC
480-10-30-4 permits an entity to use the following approaches in determining
that amount:
- The “amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately.” This amount is not discounted. In a manner consistent with the guidance on subsequent measurement in ASC 480-10-35-3(b), this method may be suitable when either the amount to be paid or the settlement date varies.
- The present value of “the settlement amount [discounted] at the rate implicit at inception.” In a manner consistent with the guidance on subsequent measurement in ASC 480-10-35-3(a), this method may be suitable when the amount to be paid and the settlement date are both fixed.
Regardless of the approach used, the entity should consider the need to adjust the accounting for the forward contract to reflect any consideration (e.g., if either party made an up-front cash payment) or unstated (or stated) rights or privileges that may have affected the terms of the transaction (e.g., off-market terms). Unlike ASC 480-10-30-3 and 30-4(b), ASC 480-10-30-4(a) does not specifically mention the need for such an adjustment when the initial measurement is determined on the basis of the amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately. However, in paragraph B61 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board suggests that, in such a scenario, an entity also
should adjust the accounting “for any consideration or unstated rights or
privileges.”
The requirement in ASC 480-10-30 to adjust the initial
measurement to reflect any consideration or unstated rights or privileges is
analogous to the requirement in ASC 835-30-25-6 to separately recognize any
unstated (or stated) rights or privileges upon the issuance of a note (e.g.,
when an entity lends cash at no interest in exchange for a contract to
purchase products at a below-market price, the difference between the amount
of cash lent and the present value of the receivable may represent an
addition to the cost of the products purchased).
The issuer recognizes the forward by crediting liabilities
and debiting equity for the amount of the initial measurement. (If the
forward is over the shares of a consolidated subsidiary, the noncontrolling
interest would be debited.) In effect, the forward is accounted for as if
two transactions had occurred: (1) a spot repurchase of the shares that will
be repurchased under the contract and (2) the issuance of debt for the
obligation to pay the share repurchase price on the forward settlement
date.
Connecting the Dots
The Inflation Reduction Act of 2022, which was signed into law on
August 16, 2022, imposes a 1 percent excise tax on stock repurchases
that occur after December 31, 2022, by publicly traded companies.
Specifically, a covered corporation would be subject to a tax equal
to 1 percent of (1) the fair market value of any of its stock that
it (or certain affiliates) repurchased during any taxable year, with
limited exceptions, minus (2) the fair market value of any of its
stock that it (or certain affiliates) issued during the taxable year
(including compensatory stock issuances). The 1 percent excise tax
would also be imposed on acquisitions of stock in certain mergers or
acquisitions involving covered corporations.
Because the excise tax is not based on a measure of
income, it is not an income tax and thus is outside the scope of ASC
740. While the accounting for taxes paid in connection with the
repurchase of stock is not specifically addressed in U.S. GAAP,
entities may consider the guidance in AICPA Technical Q&As
Section 4110.09, which indicates that direct and incremental legal
and accounting costs associated with the acquisition of treasury
stock may be added to the cost of the treasury stock. Therefore, it
is acceptable for an entity to account for an excise tax obligation
that results from the repurchase of common stock classified within
permanent equity as a cost of the treasury stock transaction.
Any reductions in such excise tax obligation arising from share
issuances would also be recognized as part of the original treasury
stock transaction regardless of the nature of the share issuances.
Additional considerations are necessary when redemptions of
preferred stock result in an excise tax obligation, which would be
recognized as a cost of redeeming the preferred stock. The
accounting for redemptions of preferred stock differs depending on
the classification of the preferred stock as permanent equity,
temporary equity, or a liability. An entity that has repurchased
both common stock and preferred stock during a taxable period would
need to use a systematic and rational allocation approach to account
for the effect of share issuances on the excise tax obligation.
For more information about the stock repurchase tax under the
Inflation Reduction Act of 2022, see Deloitte’s April 27, 2023,
Heads Up.
5.3.1.3 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.
35-4 Cash (as that term is
used in the preceding paragraph) includes foreign
currency, so physically settled forward purchase
contracts in exchange for foreign currency shall be
measured as provided in the preceding paragraph then
remeasured under Topic 830.
The subsequent measurement
guidance that applies to forward contracts that require physical settlement
by repurchase of a fixed number of the issuer’s equity shares in exchange
for cash is similar to the guidance applicable to mandatorily redeemable
financial instruments (see Section 4.3). Thus, the “debt” component of such a forward
contract is measured subsequently in one of two ways depending on whether
the repurchase amount or the repurchase date varies on the basis of
specified conditions:
Repurchase Amount
|
Repurchase 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) |
5.3.1.3.1 Fixed Date and Fixed Amount
If the repurchase date and the repurchase 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 rate that makes the present value
of the instrument’s cash flows equal to the initial measurement
amount).
5.3.1.3.2 Variable Date or Redemption Amount
If either the repurchase date or the repurchase 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 as of the reporting date. Under this method, the
amount to be paid is not discounted. Examples of instruments with a
varying redemption amount include those for which the repurchase amount
is based on the issuer’s stock price or a formula (e.g., one that
depends on the issuer’s most recent financial year’s EBIT or EBITDA). An
example of an instrument for which the redemption date varies includes
one that will be settled upon the occurrence of an event that is certain
to occur but whose timing is uncertain.
In estimating the amount of cash that would be paid
under the conditions specified in the contract if settlement occurred as
of the reporting date, an issuer should not incorporate projected
changes in the factors that affect a variable repurchase price (e.g.,
forward projections of EBITDA if the repurchase price is a function of
EBITDA). Instead, the issuer should calculate the repurchase amount on
the basis of the conditions that exist as of the balance sheet date
(e.g., the most recent EBITDA measure if the repurchase price is a
function of EBITDA). This view is consistent with the guidance that
applies to redeemable equity securities classified in temporary equity
under ASC 480-10-S99-3A (see Section 9.5.2). Paragraph 14 of
ASC 480-10-S99-3A states, in part:
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 repurchase 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, because 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. This is
consistent with the view that an entity cannot recognize interest income
on a liability as well as with the guidance that applies to redeemable
securities classified in temporary equity under ASC 480-10-S99-3A (see
Section
9.5.2). Paragraph 16(e) of ASC 480-10-S99-3A states, in
part:
[T]he 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
its net carrying amount, the issuer recognizes the difference as an
extinguishment gain.
5.3.1.3.3 Interest Cost
ASC 480-10
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.
After the execution of a forward contract that requires
physical settlement by repurchase of a fixed number of the issuer’s
equity shares in exchange for cash, changes in the contract’s carrying
amount and any amounts paid to the holder in excess of the initial
measurement amount must be presented as interest cost.
5.3.1.4 Example
ASC 480-10
55-14 For example, an entity
may enter into a forward contract to repurchase 1
million shares of its common stock from another
party 2 years later. At inception, the forward
contract price per share is $30, and the current
price of the underlying shares is $25. The
contract’s terms require that the entity pay cash to
repurchase the shares (the entity is obligated to
transfer $30 million in 2 years). Because the
instrument embodies an unconditional obligation to
transfer assets, it is a liability under paragraphs
480-10-25-8 through 25-12. The entity would
recognize a liability and reduce equity by $25
million (which is the present value, at the 9.54
percent rate implicit in the contract, of the $30
million contract amount, and also, in this example,
the fair value of the underlying shares at
inception). Interest would be accrued over the
2-year period to the forward contract amount of $30
million, using the 9.54 percent rate implicit in the
contract. If the underlying shares are expected to
pay dividends before the repurchase date and that
fact is reflected in the rate implicit in the
contract, the present value of the liability and
subsequent accrual to the contract amount would
reflect that implicit rate. Amounts accrued are
recognized as interest cost.
55-15 In this example, no
consideration or other rights or privileges changed
hands at inception. If the same contract price of
$30 per share had been agreed to even though the
current price of the issuer’s shares was $30,
because the issuer had simultaneously sold the
counterparty a product at a $5 million discount,
that right or privilege unstated in the forward
purchase contract would be taken into consideration
in arriving at the appropriate implied discount rate
— 9.54 percent rather than 0 percent — for that
contract. That entity would recognize a liability
for $25 million, reduce equity by $30 million, and
increase its revenue for the sale of the product by
$5 million. Alternatively, if the same contract
price of $30 per share had been agreed to even
though the current price of the issuer’s shares was
only $20, because the issuer received a $5 million
payment at inception of the contract, the issuer
would recognize a liability for $25 million and
reduce equity by $20 million. In both examples,
interest would be accrued over the 2-year period
using the 9.54 percent implicit rate, increasing the
liability to the $30 million contract
price.
55-16 If a variable-rate
forward contract requires physical settlement, a
different measurement method is required
subsequently, as set forth in paragraph
480-10-35-3.
The three related examples in ASC 480-10-55-14 and 55-15
illustrate the accounting for physically settled forward purchase contracts
that require the repurchase of a fixed number of equity shares for cash. In
each of the examples, the issuer is obligated to repurchase equity shares in
exchange for cash of $30 million in two years. Further, the initial amount
of the liability recognized is the same in the examples ($25 million).
However, the fair value of the shares at inception differs and, in two of
the examples, consideration or other rights or privileges are exchanged.
In the example in ASC
480-10-55-14, no consideration or other rights or privileges are exchanged
at the inception of the contract, and the fair value of the shares at
inception is $25 million. Under ASC 480-10-30-3, the liability is initially
recognized at an amount equal to fair value of the shares at inception ($25
million). In accordance with ASC 480-10-30-5, the offsetting entry is to
equity. Accordingly, the accounting entries at inception are (in
millions):
In the two examples in ASC 480-10-55-15, consideration or
other unstated rights or privileges are exchanged at inception:
- In the first example in ASC 480-10-55-15, the fair value of the shares at inception is $30 million. The repurchase price in two years is also $30 million, which is favorable to the issuer. To compensate the counterparty, the issuer provides a sales discount of $5 million to the counterparty at the same time as the issuance of the forward contract. In accordance with ASC 480-10-30-3, the liability is initially recognized at $25 million, which is the fair value of the shares at inception ($30 million) adjusted for the value of the sales discount ($5 million). Under ASC 480-10-30-5, the offsetting entry reduces equity. The value of the sales discount represents consideration paid for the off-market element of the contract to repurchase equity shares and reduces equity by another $5 million, with an offsetting entry to sales revenue. Thus, the accounting entries at inception are (in millions):
- In the second example in ASC 480-10-55-15, the fair value of the shares at inception is $20 million. The repurchase price in two years is $30 million, which is unfavorable to the issuer. To compensate the issuer, the counterparty pays $5 million at the inception of the forward contract. In accordance with ASC 480-10-30-3, the liability is initially recognized at an amount equal to the fair value of the shares at inception ($20 million), adjusted for the cash payment received ($5 million). The initial measurement of the liability is therefore $25 million. Under ASC 480-10-30-5, the offsetting entry is to equity. The up-front cash payment of $5 million is consideration received from the counterparty for the off-market element of the contract to repurchase equity shares and increases cash and equity by $5 million. Therefore, the accounting entries at inception are as follows (in millions):While not discussed in ASC 480-10-55-14 and 55-15, the implicit rate used to calculate interest cost over the life of the instrument in each of the three examples is determined by solving for the interest rate that equates the present value of $30 million in two years to the initial measurement amount of $25 million. If annual compounding is used, this rate is approximately 9.545 percent. In year one, the issuer records interest cost of $2.386 million by increasing the carrying amount of the liability to $27.386 million. In year two, the issuer records interest cost of $2.614 million by increasing the carrying amount to $30 million, which equals the settlement amount to be paid in cash at that time.
5.3.2 Other Contracts
ASC
480-10
30-7 All other financial
instruments recognized under the guidance in Section
480-10-25 shall be measured initially at fair
value.
35-1 Financial instruments
within the scope of Topic 815 shall be measured
subsequently as required by the provisions of that
Topic.
35-4A Contingent consideration
issued in a business combination that is classified as a
liability in accordance with the requirements of this
Topic shall be subsequently measured at fair value in
accordance with 805-30-35-1.
35-5 All other financial
instruments recognized under the guidance in Section
480-10-25 shall be measured subsequently at fair value
with changes in fair value recognized in earnings,
unless either this Subtopic or another Subtopic
specifies another measurement attribute.
55-17 In contrast to forward
purchase contracts that require physical settlement in
exchange for cash, forward purchase contracts that
require or permit net cash settlement, require or permit
net share settlement, or require physical settlement in
exchange for specified quantities of assets other than
cash are measured initially and subsequently at fair
value, as provided in paragraphs 480-10-30-2,
480-10-30-7, 480-10-35-1, and 480-10- 35-5 (as
applicable), and classified as assets or liabilities
depending on the fair value of the contracts on the
reporting date.
Except for forward contracts that require the issuer to
repurchase a fixed number of shares for cash, contracts that are classified as
assets or liabilities under ASC 480-10-25-8 are measured initially and
subsequently at their fair value (i.e., they are accounted for in a manner
similar to derivatives under ASC 815). For example, this measurement applies
to:
-
Net-cash-settled forward purchase contracts on own stock.
-
Forward purchase contracts on own stock that permit the counterparty to elect either net cash settlement or net share settlement.
-
Forward contracts that require or may require the repurchase of a variable number of equity shares for cash.
-
Forward contracts that require or may require the repurchase of equity shares for noncash assets.
-
Written put options on own equity shares that require or may require the repurchase of equity shares by the transfer of assets.
-
Written warrants or call options on own equity shares that require or may require the repurchase of the warrants or options by the transfer of assets.
-
Written warrants or call options on equity shares that require or may require the repurchase of the equity shares that would be delivered upon the exercise of the warrant or option by the transfer of assets.
5.4 Reassessment
Under ASC 480-10-25-8, an issuer assesses at inception whether a financial
instrument, other than an outstanding share, embodies an obligation to repurchase
the issuer’s equity shares (or is indexed to such an obligation) and therefore
requires or may require the issuer to settle the obligation by transferring assets.
If an outstanding instrument ceases to embody such an obligation after inception
(e.g., because the contract specifies that the obligation expires on a specific date
or upon the occurrence of a specified event, such as an IPO), an issuer may elect to
apply either of the following two views as an accounting policy choice under ASC
480-10-25-8:
-
View A: No reassessment — An issuer does not subsequently reassess whether an instrument should be classified as an asset or a liability under ASC 480-10-25-8 unless the instrument is treated as a new instrument for accounting purposes (e.g., as a result of a modification or exchange that is accounted for as an extinguishment of the existing instrument; see ASC 470-50). That is, the issuer applies literally the requirement in ASC 480-10-25-8 to perform the evaluation “at inception.”
-
View B: Reassessment — An issuer reassesses whether an instrument that was classified as an asset or a liability under ASC 480-10-25-8 should continue to be classified as an asset or a liability under ASC 480, ASC 815-40, and any other applicable GAAP if the obligation that caused the instrument to be classified as an asset or a liability under ASC 480-10-25-8 no longer exists. That is, the classification of an instrument reflects its operative terms as of the assessment date but does not take into account any expired terms. (As discussed in Section 3.2.1, however, the issuer does not reassess whether any feature is nonsubstantive or minimal after inception.) If reclassification is appropriate, it is performed as of the date the obligation ceases to exist. This view is consistent with the reassessment guidance in ASC 480-10-25-4 (see Section 4.4.1) and ASC 815-40 that applies to instruments within the scope of that guidance (see Section 5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
Example 5-3
Reassessment of the Classification of Warrants on
Redeemable Shares
Company A issues physically settled warrants on its convertible preferred stock. The convertible preferred stock includes a provision that requires A to redeem the stock for cash upon a deemed liquidation event (e.g., a change of control). Further, the convertible preferred stock includes a mandatory conversion feature that requires the stock to be converted into nonredeemable common stock upon an IPO. If an IPO were to occur, therefore, the warrants would no longer be settleable in convertible preferred stock but in nonredeemable common stock. At inception, A classifies the warrants as liabilities under ASC 480-10-25-8 because the deemed liquidation provision represents an obligation to repurchase shares of A’s convertible preferred stock that may require the issuer to transfer assets under ASC 480-10-25-8 (see Section 5.2.2).
After inception, A undergoes an IPO. On the IPO date, all of A’s outstanding series of convertible preferred stock are converted into shares of nonredeemable common stock in accordance with the mandatory conversion terms of the convertible preferred stock. Further, the warrants are no longer settleable in convertible preferred stock. Therefore, the warrants no longer embody an obligation that requires or may require the issuer to transfer assets under ASC 480-10-25-8.
Depending on its accounting policy for reassessment under ASC 480-10-25-8, A
could elect either to continue to classify the warrants as
liabilities under ASC 480-10-25-8 or to reclassify them to
equity provided that they meet all the conditions for equity
classification in ASC 815-40 and any other applicable
GAAP.