9.3 Scope — Instruments

Although Regulation S-X, Rule 5-02.27, as well as ASR 268, CFRP 211, and SAB Topic 3.C focus on redeemable preferred stock, ASC 480-10-S99-3A(3) clarifies that the SEC’s temporary equity guidance applies broadly to equity classified instruments (including separated equity components) that meet the classification criteria for temporary equity (see Section 9.4) irrespective of whether they are in the form of preferred stock. Accordingly, the temporary equity guidance applies to the issuer’s presentation of the following types of instruments if they meet the requirements for temporary equity classification:

• Common stock.
• Preferred stock.
• Equity-classified components of convertible debt.
• Noncontrolling interests.
• Share-based payment arrangements (with employees and nonemployees).
• Equity securities issued by a sponsor to an ESOP.

The temporary equity guidance does not apply to amounts classified as assets or liabilities under GAAP. Accordingly, the following instruments are not within the scope of that guidance even if they are in the form of equity contracts and contain redemption features not solely within the control of the issuer:

• Financial instruments (e.g., mandatorily redeemable financial instruments and written put options on the entity’s own stock) that are classified as assets or liabilities under ASC 480 (see Chapters 4, 5, and 6).
• Contracts on the entity’s own equity (e.g., warrants, options, or forwards that involve the purchase or sale of the issuer’s equity shares) that are accounted for as assets or liabilities under ASC 815-40. (See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a detailed discussion of this guidance.)

However, equity components that have been separated from convertible debt under ASC 470-20 or other GAAP are subject to the temporary equity guidance if they meet the special requirements for temporary equity classification that apply to such equity components (see Section 9.3.5).

An entity is not permitted to elect to present as a liability an instrument that is subject to the temporary equity guidance (and thereby avoid application of the guidance) if the instrument does not qualify as a liability under ASC 480 or other GAAP, except for certain grandfathered instruments that (1) were classified and accounted for as a liability in fiscal quarters beginning before September 15, 2007, and (2) have not been subsequently modified or subject to a remeasurement (new basis) event (see Section 9.8.1).

If a freestanding contract on an entity’s own equity (such as a warrant, option, or forward that involves the purchase or sale of the issuer’s equity instruments) other than an outstanding share includes a redemption requirement that would have resulted in temporary equity classification under ASC 480-10-S99-3A (see Section 9.4), the contract will generally not qualify as equity under GAAP (i.e. ASC 480 or ASC 815-40). However, in very limited circumstances, a freestanding contract on an entity’s own equity that qualifies as equity under ASC 815-40 must be classified in temporary equity. Because the classification of a freestanding instrument (other than an outstanding share) in temporary equity is rare, consultation with an entity’s advisers is encouraged in these situations.

Hybrid equity instruments (i.e., equity instruments that embody both a host contract and an embedded feature, such as preferred stock with an embedded redemption, put, call, or conversion feature) are subject to evaluation under the temporary equity guidance in ASC 480-10-S99-3A.

If the embedded feature is not bifurcated under ASC 815-15 (e.g., a redemption feature embedded in an equity security would not require bifurcation under ASC 815-15 if the net settlement characteristic in the definition of a derivative in ASC 815-10-15-83 is not met), the issuer considers all the terms and features of the entire hybrid instrument in (1) evaluating whether the temporary equity guidance applies to the entire hybrid instrument and (if it does) (2) classifying and measuring the instrument.

If the embedded feature is bifurcated from the host contract as a derivative instrument under ASC 815-15, the issuer should also consider all of the terms and features of the entire hybrid financial instrument in evaluating whether the temporary equity guidance applies to the host contract. As stated in footnote 5 of ASC 480-10-S99-3A(3)(a), “when an embedded written put option has been separated from a hybrid financial instrument with an equity host contract, the host equity instrument is subject to ASR 268.”

The temporary equity guidance does not apply to hybrid instruments that are accounted for in their entirety as liabilities. It also does not apply to an outstanding equity share if it is determined that any and all redemption features associated with the share are freestanding financial instruments that are separate from the share.

Under GAAP, an issuer is required to separate certain convertible debt instruments into liability and equity components provided that the equity conversion feature is not required to be bifurcated as an embedded derivative under ASC 815-15. The equity-classified component of a convertible debt instrument that has been separated into liability and equity components should be evaluated under the temporary equity guidance (see Sections 9.4.8 and 9.5.7 for a discussion of specific considerations related to applying the temporary equity guidance to such equity components).

Separation of equity components is required under GAAP for the following types of convertible debt unless the equity conversion feature must be bifurcated as an embedded derivative under ASC 815-15:

• Convertible debt issued at a substantial premium (see ASC 470-20-25-13).
• Convertible debt instruments that are modified or exchanged in a transaction that does not qualify as an extinguishment for accounting purposes and involves an increase in the fair value of the embedded conversion option (see ASC 470-50-40-15).
• Convertible debt with an embedded conversion option that no longer meets the bifurcation criteria in ASC 815-15-25-1.

Similarly, convertible preferred stock that is classified as a liability under ASC 480 (see Chapters 4 and 6) may contain an equity component that must be separated. An issuer should evaluate whether any separated equity component in liability-classified shares of preferred stock should be accounted for under the SEC’s temporary equity guidance.

In connection with issuances of equity shares, convertible instruments, and equity-linked contracts, issuers may agree to pay amounts in the event they are unable to deliver registered shares or maintain an effective registration (see Section 2.7). The SEC’s temporary equity guidance does not apply to registration payment arrangements within the scope of ASC 825-20. Such arrangements are accounted for separately from any related financial instrument (such as a share or contract on own equity) even if they are included in the contractual terms of that instrument (see ASC 825-20-25-1 as well as ASC 825-20-30-1 and 30-2). Accordingly, an issuer does not consider such arrangements in evaluating whether the related instrument should be classified in temporary equity under ASC 480-10-S99-3A even if the registration payment arrangement is included in the contractual terms of the share or contract on own equity itself. Instead, the issuer would account for those provisions separately as a registration payment arrangement in accordance with ASC 825-20 provided that the arrangement meets the ASC master glossary definition thereof. In other words, the mere fact that the issuer might be required to pay a cash penalty under a registration payment arrangement related to an outstanding equity share does not trigger temporary equity classification for that equity share, because the registration payment arrangement is treated as a separate unit of account.

Under ASC 825-20-15-4, an arrangement would not qualify for the scope exception for registration payment arrangements if any of the following applies:

• The form of consideration transferred is a contingently adjustable conversion ratio in a convertible instrument.
• The payment is adjusted by reference to either an observable market other than the issuer’s stock (e.g., a commodity price) or an observable index.
• The payment is made when the contract subject to the arrangement is settled (i.e., a registration payment arrangement is not treated as a separate unit of account if the issuer is required to repurchase the related share upon a failed registration).

Accordingly, such provisions would be considered in the analysis of the financial instrument that contains them unless they represent separate units of account. The SEC staff believes that it would be inappropriate to analogize to ASC 815-10-25-16 or ASC 825-20 in the evaluation of whether an arrangement outside the scope of ASC 825-20 is a separate unit of account (see ASC 480-10- S99-3A(3)(c)).

In accordance with ASC 810-10-45-15, the ownership interests in a subsidiary that are held by owners other than the parent are a noncontrolling interest (for further discussion of this guidance, see Deloitte’s Roadmap Noncontrolling Interests). An entity should evaluate the noncontrolling interest in a subsidiary (i.e., the portion of equity or net assets not attributable to the parent) to determine whether to account for it as temporary equity. ASC 480-10-S99-3A contains special measurement and EPS guidance that applies to noncontrolling interests that must be classified as temporary equity (see Sections 9.5.10 and 9.6.3). However, an entity that applies ASC 480-10-S99-3A is not relieved of its requirements under the accounting and disclosure guidance in ASC 810-10.

If a subsidiary issues shares to a third party, and those shares meet the definition of a mandatorily redeemable financial instrument in ASC 480, those shares are classified as liabilities rather than as temporary equity unless the shares are exempt from some or all of the guidance in ASC 480 (see Section 4.1.5) as follows:

• If the shares are exempt from the classification and measurement requirements in ASC 480, the temporary equity guidance (including classification and measurement) in ASC 480-10-S99-3A applies to the shares.
• If the shares are exempt from ASC 480’s requirements for measurement but not classification, ASC 480-10-S99-3A’s requirements for measurement but not classification apply to the shares. Accordingly, even though the shares are classified as liabilities under ASC 480, an entity applies ASC 480-10-S99-3A’s measurement provisions to adjust their carrying amount. (This accounting applies to certain mandatorily redeemable noncontrolling interests issued before November 5, 2003, in accordance with ASC 480-10-15-7E(b).)

In prepared remarks at the 2003 AICPA Conference on Current SEC Developments, then Professional Accounting Fellow Gregory Faucette stated the following:

The temporary equity guidance does not apply to a noncontrolling interest that is subject to a redemption feature in a freestanding financial instrument that is separate from the noncontrolling interest, such as a freestanding written put option. In practice, entities consider the FASB’s definition of a freestanding financial instrument and other related guidance (see Section 3.3) in evaluating whether a redemption feature for accounting purposes should be considered freestanding or part of the same unit of account as the noncontrolling interest.

Under U.S. federal income tax regulations, employer securities (such as convertible preferred stock) that are held by participants in a qualifying ESOP and are not readily tradable on an established market must contain an option that permits the participant to put the security to the employer. The temporary equity guidance applies in the sponsor’s financial statements to equity instruments that are held by an ESOP and can be put to the sponsor for cash or other assets. ASC 480-10-S99-3A and S99-4 contain special guidance on the sponsor’s accounting for equity securities held by ESOPs (see Sections 9.4.10 and 9.5.11).

As discussed in more detail in Deloitte’s Roadmap Share-Based Payment Awards, equity-classified share-based payment arrangements (e.g., employee stock options and stock awards with redemption features) that are accounted for in accordance with ASC 718 should be evaluated under the SEC’s temporary equity guidance. In prepared remarks before the 2005 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Shan Benedict (Nemeth) stated the following:

Further, in his prepared remarks before the 2006 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Joseph Ucuzoglu stated:

ASC 480-10-S99-3A specifies how the SEC’s temporary equity guidance applies to share-based payment arrangements (see Sections 9.4.9 and 9.5.12). If an instrument ceases to be within the scope of ASC 718, the issuer should reassess whether the temporary equity guidance applies. The issuer would conclude that the temporary equity guidance:

• No longer applies if a share-based payment arrangement that was classified as temporary equity must be reclassified as a liability under ASC 480 because it is no longer within the scope of ASC 718 (see Section 2.4).
• Begins to apply when ASC 718 ceases to apply if a share-based payment arrangement that was previously within the scope of ASC 718 would have been classified as temporary equity had it not met one of the specific classification exceptions applicable to share-based payment arrangements within the scope of ASC 718 (see Section 9.4.9).

In these circumstances, the subsidiary would conclude that for its separate financial statement purposes, the equity instrument does not have any stated redemption features (see also Section 9.4.4). This is the case even though the equity instrument would be considered a redeemable noncontrolling interest in the parent’s consolidated financial statements.

Temporary equity classification would, however, be required if (1) there was a separate agreement in place between the parent and the subsidiary that could require the subsidiary to pay the parent the redemption price or (2) the subsidiary was secondarily liable on the obligation under the redemption feature (i.e., the holder of the equity security has recourse to the subsidiary if the parent does not honor its obligation under the redemption terms).