Chapter 7 — Certain Option Combinations
Chapter 7 — Certain Option Combinations
7.1 Certain Transactions Involving Noncontrolling Interests
ASC 480-10
55-53 A controlling majority owner (parent) holds 80 percent of a subsidiary’s equity shares. The remaining 20 percent (the noncontrolling interest) is owned by an unrelated entity (the noncontrolling interest holder). Simultaneous with the acquisition of the noncontrolling interest, the noncontrolling interest holder and the parent enter into a derivative instrument that is indexed to the subsidiary’s equity shares. The terms of the derivative instrument may be any of the following:
- The parent has a fixed-price forward contract to buy the other 20 percent at a stated future date. (Derivative 1)
- The parent has a call option to buy the other 20 percent at a fixed price at a stated future date, and the noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those same terms, that is, the fixed price of the call is equal to the fixed price of the put option. (Derivative 2)
- The parent and the noncontrolling interest holder enter into a total return swap. The parent will pay to the counterparty (initially the noncontrolling interest holder) an amount computed based on the London Interbank Offered Rate (LIBOR), plus an agreed spread, plus, at the termination date, any net depreciation of the fair value of the 20 percent interest since inception of the swap. The counterparty will pay to the parent an amount equal to dividends paid on the 20 percent interest and, at the termination date, any net appreciation of the fair value of the 20 percent interest since inception of the swap. At the termination date, the net change in the fair value of the 20 percent interest may be determined through an appraisal or the sale of the stock. (Derivative 3)
55-54 If the terms correspond with Derivative 1, the forward purchase contract that requires physical settlement by repurchase of a fixed number of shares (the noncontrolling interest) in exchange for cash is recognized as a liability, initially measured at the present value of the contract amount; the noncontrolling interest is correspondingly reduced. Subsequently, accrual to the contract amount and any amounts paid or to be paid to holders of those contracts are reflected as interest cost. In effect, the parent accounts for the transaction as a financing of the noncontrolling interest and, consequently, consolidates 100 percent of the subsidiary.
55-55 Depending on how
Derivative 2 was issued, one of three different accounting
methods applies. If Derivative 2 was issued as a single
freestanding instrument, under this Subtopic it would be
accounted for in its entirety as a liability (or an asset in
some circumstances), initially and subsequently measured at
fair value. If the written put option and the purchased call
option in Derivative 2 were issued as freestanding
instruments, the written put option would be accounted for
under this Subtopic as a liability measured at fair value,
and the purchased call option would be accounted for under
Subtopic 815-40. Under both of those situations, the
noncontrolling interest is accounted for separately from the
derivative instrument under applicable guidance. However, if
the written put option and purchased call option are
embedded in the shares (noncontrolling interest) and the
shares are not otherwise classified as liabilities under the
guidance in this Subtopic, the instrument shall be accounted
for as discussed in paragraph 480-10-55-59 with the parent
consolidating 100 percent of the subsidiary.
55-56 If the terms correspond with Derivative 3, the total return swap is indexed to an obligation to repurchase the issuer’s shares and may require the issuer to settle the obligation by transferring assets. Therefore it is in the scope of this Subtopic and is required to be accounted for as a liability (or asset in some circumstances), initially, and subsequently measured at fair value. The noncontrolling interest is accounted for separately from the total return swap.
55-57 In applying paragraphs 480-10-25-4 through 25-14 to determine classification, a freestanding financial instrument within this Subtopic’s scope is precluded from being combined with another freestanding financial instrument, unless combination is required under the provisions of Topic 815; therefore, unless under the particular facts and circumstances that Topic provides otherwise, freestanding derivative instruments in the scope of this Subtopic would not be combined with the noncontrolling interest.
55-58 This guidance is limited to circumstances in which the parent owns a majority of the subsidiary’s outstanding common stock and consolidates that subsidiary at inception of the derivative instrument. This guidance is limited to the specific derivative instruments described.
55-59 If the derivative
instrument in Derivative 2 is embedded in the shares
(noncontrolling interest) and the shares are not otherwise
classified as liabilities under the guidance in this
Subtopic, the combination of options should be viewed on a
combined basis with the noncontrolling interest and
accounted for as a financing of the parent’s purchase of the
noncontrolling interest.
55-60 Under that approach, the parent would consolidate 100 percent of the subsidiary and would attribute the stated yield earned under the combined derivative instrument and noncontrolling interest position to interest expense (that is, the financing would be accreted to the strike price of the forward or option over the period until settlement). No gain or loss would be recognized on the sale of the noncontrolling interest by the parent to the noncontrolling interest holder at the inception of the derivative instrument.
55-61 The risks and rewards of owning the noncontrolling interest have been retained by the parent during the period of the derivative instrument, notwithstanding the legal ownership of the noncontrolling interest by the counterparty. Combining the two transactions in this circumstance reflects the substance of the transactions; that the counterparty is financing the noncontrolling interest. Upon such combination, the resulting instrument is not a derivative instrument subject to Subtopic 815-10.
55-62 This accounting applies even if the exercise prices of the put and call options are not equal, as long as those exercise prices are not significantly different.
ASC 480-10 — Glossary
Noncontrolling Interest
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.
7.1.1 Scenarios
ASC 480-10-55-53 through 55-62 contain multiple scenarios illustrating the
accounting for certain transactions that involve noncontrolling interests. Other than in
one scenario, ASC 480-10-55-53 through 55-62 merely illustrate how to apply ASC 480 and
ASC 815-40. However, in the scenario in which an option combination is embedded in the
noncontrolling interest, ASC 480-10-55 contains unique requirements that differ from other
requirements in ASC 480 or ASC 815-40 (see Section 7.1.2).
The following table provides an overview of the scenarios in ASC 480-10-55-53 through 55-62. In each scenario, the parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary, and a third party holds the remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest). However, the parent is exposed to the risks and rewards associated with the noncontrolling interest through a forward, an option combination, or a total return swap on the noncontrolling interest that may require the issuer to pay cash.
Scenario | Parent’s Accounting |
|---|---|
Derivative 1 — The parent has a fixed-price forward contract to buy the other 20 percent on a stated future date (ASC 480-10-55-53(a) and 55-54). |
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Derivative 2 — The parent has a call option to buy the other 20 percent at a fixed price on a stated future date, and the noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those same terms (ASC 480-10-55-53(b) and ASC 480-10-55-55). | The accounting depends on how Derivative 2 was structured. (see Section 7.1.2) |
Derivative 2 is issued as a single freestanding instrument (ASC 480-10-55-53(b) and ASC 480-10-55-55). |
|
The written put option and the purchased call option in Derivative 2 are issued as separate freestanding instruments (ASC 480-10-55-53(b) and ASC 480-10-55-55). |
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The written put option and the purchased call option in Derivative 2 are embedded in the shares, and the shares are not mandatorily redeemable (ASC 480-10- 55-53(b), ASC 480-10-55-55, and ASC 480-10-55-59 through 55-62). |
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Derivative 3 — The parent and the noncontrolling interest holder enter into a total return swap on the other 20 percent (ASC 480-10-55-53(b) and ASC 480-10-55-56). |
|
7.1.2 “Derivative 2”
7.1.2.1 Options Embedded in Noncontrolling Interest
The scenario described in ASC 480-10-55-53(b), ASC 480-10-55-55, and ASC 480-10-55-59 through 55-62 is as follows:
- The parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary.
- The remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest) are held by a third party.
- Simultaneously with the third party’s acquisition of the noncontrolling interest, the parent and the holder of the noncontrolling interest enter into the following option combination, which is labelled “Derivative 2” in ASC 480-10-55-53(b):
- The parent has a call option to purchase the noncontrolling interest at a fixed price on a stated future date.
- The noncontrolling interest holder has a put option to sell the noncontrolling interest to the parent under the same terms. (ASC 480-10-55-62 suggests that the exercise prices do not need to be equal as long as they are not significantly different.)
- The options are embedded in the shares representing the noncontrolling interest (i.e., they are not considered separate freestanding instruments).
- The noncontrolling interest shares do not meet the definition of a mandatorily redeemable financial instrument.
ASC 480-10-55-55 and ASC 480-10-55-59 through 55-62 require the embedded options
and the noncontrolling interest in this scenario to be accounted for on a combined basis
as a financing of the parent’s purchase of the noncontrolling interest. That is, the
transaction is accounted for as a liability in a manner similar to a mandatorily
redeemable financial instrument or a physically settled forward purchase contract on the
issuer’s equity shares under ASC 480 even though redemption of the shares is conditional
on the exercise of one or both of the options. Effectively, therefore, ASC 480-10-55-55
and ASC 480-10-55-59 through 55-62 override ASC 480-10-55-38 through 55-40 under which
shares that embed a written put option and a purchased call option with the same terms
are not considered mandatorily redeemable (see Section 4.2.1).
ASC 480-10-55-55 and ASC 480-10-55-59 through 55-62 apply irrespective of
whether the noncontrolling interest is in the form of common stock or preferred stock.
Further, such guidance applies even if the relative ownership interests of the parent
and the holder of the noncontrolling interest differ from the levels assumed in the
scenario described in ASC 480 (i.e., 80 percent and 20 percent) provided that the parent
owns a majority of the subsidiary’s outstanding common stock and consolidates the
subsidiary at the inception of the arrangement (see ASC 480-10-55-58).
The liability accounting required by ASC 480-10-55-59 through 55-62 applies only to the combination of a call option and a put option on a noncontrolling interest when the options (1) are exercisable on the same future date and (2) have either the same fixed price or, as discussed in ASC 480-10-55-62, exercise prices that are not significantly different. Entities may be required to use significant judgment to determine whether the call and put options have the same fixed price. For example, if the call and put options each have an exercise price with the same fixed amount and the same adjustment for an interest component such as LIBOR, the call and put options would be considered to have the same fixed price.
However, the liability classification guidance in ASC 480-10-55-59 through 55-62
does not apply if (1) the option exercise prices are based on a formula (e.g., EBITDA)
that is not simply an indexation to interest rates or (2) the options are contingent on
the satisfaction of certain conditions.
For options that have an exercise price based on EBITDA, the substance of the
transaction does not represent the parent’s financing of the purchase of the
noncontrolling interest because the purchase price continues to vary on the basis of the
subsidiary’s operating performance. Options that are contingent on the satisfaction of
certain conditions also do not represent the parent’s financing of the purchase of the
noncontrolling interest because such purchase will not occur if the specified conditions
are not met.
If the liability classification in ASC 480-10-55-59 through 55-62 does not apply
solely because the option exercise prices are based on a formula that is not simply an
indexation to interest rates, the noncontrolling interest is not considered a
mandatorily redeemable financial instrument under ASC 480-10-25-4 (see Chapter 4) and is not subject to
liability classification under the other provisions of ASC 480. Accordingly, the parent
would classify the noncontrolling interest as an equity instrument. However, if the
parent is an SEC registrant, the noncontrolling interest would be subject to
classification and measurement in temporary equity in accordance with ASC 480-10-S99-3A
(see Chapter 9).
7.1.2.2 Freestanding Options
If a parent and the holder of a noncontrolling interest
enter into put and call options on the noncontrolling interest, and either
the option combination or each option is considered to be a freestanding
financial instrument (see Section 3.3) that is separate from the noncontrolling
interest, the noncontrolling interest and the options would not be accounted
for on a combined basis as a financing of the parent’s purchase of the
noncontrolling interest. Instead, the accounting for the options depends on
whether they represent a single freestanding financial instrument (in which
case the option combination is accounted for as an asset or a liability
under ASC 480-10-25-8) or two separate freestanding financial instruments
(in which case the put option is accounted for as a liability under ASC
480-10-25-8, and the call option is evaluated under ASC 815-40). Either way,
the accounting differs from that on noncontrolling interests with embedded
options in ASC 480-10-55-59 through 55-62 because the noncontrolling
interest would be reflected in equity by the parent.
7.2 Illustrations of the Application of ASC 480 to Certain Option Combinations
The application of the scope provisions and the accounting requirements in ASC
480 depends on how an issuer’s contractual rights and obligations are aggregated or
disaggregated into units of account (see Section 3.3). ASC 480-10-55-19 and 55-20 and
in ASC 480-10-55-34 through 55-37 illustrate the application of ASC 480 to sets of
options that involve the same counterparty and are executed contemporaneously. Each
freestanding financial instrument is assessed separately under ASC 480, whereas a
freestanding financial instrument that includes multiple components is analyzed in
its entirety.
ASC 480-10
Combination of Written Put Option and Purchased Call Option Issued as a Freestanding Instrument
55-18 If a freestanding financial instrument consists solely of a written put option to repurchase the issuer’s equity shares and another option, that freestanding financial instrument in its entirety is subjected to paragraphs 480-10-25-4 through 25-14 to determine if it meets the requirements to be classified as a liability.
55-19 For example, an entity may enter into a contract that requires it to purchase 100 shares of its own stock on a specified date for $20 if the stock price falls below $20 and entitles the entity to purchase 100 shares on that date for $21 if the stock price is greater than $21. That contract shall be analyzed as the combination of a written put option and a purchased call option and not as a forward contract. The written put option on 100 shares has a strike price of $20, and the purchased call option on 100 shares has a strike price of $21. If at issuance the fair value of the written put option exceeds the fair value of the purchased call option, the issuer receives cash and the contract is a net written option — a liability. If required to be physically settled, that contract is a liability under the provisions in paragraphs 480-10-25-8 through 25-12 because it embodies an obligation that may require repurchase of the issuer’s equity shares and settlement by a transfer of assets. If the issuer must or can net cash settle the contract, the contract is a liability under the provisions of those paragraphs because it embodies an obligation that is indexed to an obligation to repurchase the issuer’s equity shares and may require settlement by a transfer of assets. If the issuer must or can net share settle the contract, that contract is a liability under the provisions in paragraph 480-10-25-14(c), because the monetary value of the obligation varies inversely in relation to changes in the fair value of the issuer’s equity shares.
55-20 If, in this example, the fair value of the purchased call option at issuance exceeds the fair value of the written put option, the issuer pays out cash and the contract is a net purchased option, to be initially classified as an asset under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c). If the fair values of the two options are equal and opposite at issuance, the financial instrument has an initial fair value of zero, and is commonly called a zero-cost collar. Thereafter, if the fair value of the instrument changes, the instrument is classified as an asset or a liability and measured subsequently at fair value.
Three Freestanding Instruments
55-34 An issuer has the following three freestanding instruments with the same counterparty, entered into contemporaneously:
- A written put option on its equity shares
- A purchased call option on its equity shares
- Outstanding shares of stock.
55-35 Under this Subtopic those three contracts would be separately evaluated. The written put option is reported as a liability under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c) (depending on the form of settlement) and is measured at fair value. The purchased call option does not embody an obligation and, therefore, is not within the scope of this Subtopic. The outstanding shares of stock also are not within the scope of this Subtopic, because the shares do not embody an obligation for the issuer. Under paragraph 480-10-25-15, neither the purchased call option nor the shares of stock are to be combined with the written put option in applying paragraphs 480-10-25-4 through 25-14 unless otherwise required by Topic 815. If that Topic required the freestanding written put option and purchased call option to be combined and viewed as a unit, the unit would be accounted for as a combination of options, following the guidance in paragraphs 480-10-55-18 through 55-20.
Two Freestanding Instruments
55-36 An issuer has the following two freestanding instruments with the same counterparty entered into contemporaneously:
- A contract that combines a written put option at one strike price and a purchased call option at another strike price on its equity shares
- Outstanding shares of stock.
55-37 As required by paragraph 480-10-25-1, paragraphs 480-10-25-4 through 25-14 are applied to the entire freestanding instrument that comprises both a put option and a call option. Because the put option element of the contract embodies an obligation to repurchase the issuer’s equity shares, the freestanding instrument that comprises a put option and a call option is reported as a liability (or asset) under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c) (depending on the form of settlement) and is measured at fair value. Under paragraphs 480-10-15-3 through 15-4 and 480-10-25-1, that freestanding financial instrument is within the scope of this Subtopic regardless of whether at current prices it is a net written, net purchased, or zero-cost collar option and regardless of the form of settlement. The outstanding shares of stock are not within the scope of this Subtopic and, under paragraph 480-10-25-15, are not combined with the freestanding written put and purchased call option. (Some outstanding shares of stock are within the scope of this Subtopic, for example, mandatorily redeemable shares or shares subject to a physically settled forward purchase contract in exchange for cash.)
ASC 480-10-55-19 and 55-20, and ASC 480-10-55-35 and 55-36 contain two similar
examples of a freestanding financial instrument that consists of a combination of a
written put option and a purchased call option on own stock. The accounting analysis
of this option combination under ASC 480 depends on whether the issuer could be
required to settle its obligation under the written put option component by
transferring assets or may settle it by transferring a variable number of equity
shares. If the issuer could be required to settle the obligation by transferring
assets (either in a physical settlement or net in cash), the instrument is
classified as a liability (or as an asset in some circumstances) under ASC
480-10-25-8 because it is not an outstanding share and it embodies an obligation to
repurchase the issuer’s equity shares or is indexed to such an obligation (see
Chapter 5). If the
issuer must or can elect to settle the obligation by delivering a variable number of
shares, the instrument is classified as a liability (or as an asset in some
circumstances) under ASC 480-10-25-14(c) because (1) it is a financial instrument
other than an outstanding share that embodies a conditional obligation that the
issuer must or may settle by issuing a variable number of shares and (2) its
monetary value is inversely related to the issuer’s stock price (see Chapter 6). In either case,
the instrument is classified outside of equity because of the written put option
component. The purchased call option does not affect the analysis of the appropriate
classification of the instrument because the call option does not represent an
obligation of the issuer.
Although the classification analysis in these two examples focuses on the
written put option component, the option combination is accounted for in its
entirety since it represents a single freestanding financial instrument. For
example, in the fair value measurement of the instrument, both the written put
option and the purchased call option components are considered. Note, however, that
the purchased call option component of the combination would have been outside the
scope of ASC 480 had it been issued as a freestanding instrument that is separate
from the written put option, as illustrated in ASC 480-10-55-34 and 55-35, since it
(1) would have represented a unit of account that is separate from the written put
option and (2) embodies no obligation of the issuer. Similarly, outstanding shares
of stock that are freestanding financial instruments and separate from the put and
call options are analyzed independently of the options, as illustrated in ASC
480-10-55-34 through 55-37.