9.7 Derecognition
9.7.1 Extinguishments
ASC
260-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: The Effect on Calculation of
Earnings per Share for a Period That Includes the
Redemption or Induced Conversion of Preferred
Stock
Scope
This SEC staff announcement applies to redemptions and
induced conversions of equity-classified preferred stock
instruments. For purposes of this announcement:
- Modifications and exchanges of preferred stock instruments that are accounted for as extinguishments, resulting in a new basis of accounting for the modified or exchanged preferred stock instrument, are considered redemptions.
- A preferred stock instrument classified within temporary equity pursuant to the guidance in ASR 268 and paragraph 480-10-S99-3A is considered equity-classified, and redemptions and induced conversions of such securities would be subject to this guidance.
- If an equity-classified security is subsequently required to be reclassified as a liability based on the provisions of other GAAP (for example, because a preferred share becomes mandatorily redeemable pursuant to Subtopic 480-10), the reclassification is considered a redemption of equity by issuance of a debt instrument.
The accounting for
conversions of preferred stock instruments into other
equity-classified securities pursuant to conversion
privileges provided in the terms of the instruments at
issuance is not affected by this announcement.
The Effect on
Income Available to Common Stockholders of a
Redemption or Induced Conversion of Preferred
Stock
If a registrant
redeems its preferred stock, the SEC staff believes that
the difference between (1) the fair value of the
consideration transferred to the holders of the
preferred stock and (2) the carrying amount of the
preferred stock in the registrant’s balance sheet (net
of issuance costs) should be subtracted from (or added
to) net income to arrive at income available to common
stockholders in the calculation of earnings per share.
The SEC staff believes that the difference between the
fair value of the consideration transferred to the
holders of the preferred stock and the carrying amount
of the preferred stock in the registrant’s balance sheet
represents a return to (from) the preferred stockholder
that should be treated in a manner similar to the
treatment of dividends paid on preferred stock. This
calculation guidance applies to redemptions of
convertible preferred stock regardless of whether the
embedded conversion feature is “in-the-money” or
“out-of-the-money” at the time of redemption. The fair
value of the consideration transferred is reduced by the
commitment date intrinsic value of the conversion option
if the redemption includes the reacquisition of a
previously recognized beneficial conversion feature in a
convertible preferred stock instrument. . . .
ASC 260-10-S99-2 provides guidance on the accounting for
extinguishments (redemptions) of equity-classified preferred stock (whether
presented in temporary equity or permanent equity). Under that guidance, an SEC
registrant compares (1) the fair value of the consideration transferred to the
holders of the preferred stock and (2) the carrying amount of the preferred
stock immediately before the modification or exchange (net of issuance costs).
The difference is treated as a return to (or from) the holder of the preferred
stock in a manner similar to dividends paid on preferred stock. For instance,
any excess of fair value of the consideration transferred to the holders of the
preferred stock over the carrying amount of the preferred stock in the issuer’s
balance sheet is treated as a dividend to those holders and charged against
retained earnings or, in the absence of retained earnings, charged against
paid-in-capital (see Section
9.5.5).
Connecting the Dots
Under ASC 260-10-S99-2, it is presumed that the fair value of the
consideration transferred to redeem a preferred stock instrument
reflects the fair value of the preferred stock that is being redeemed.
If the fair value of the consideration transferred to preferred
stockholders does not reflect the fair value of the redeemed shares, the
transaction involves other elements that should be accounted for in
accordance with other GAAP.
The carrying amount that should be used in the calculation is
not necessarily the carrying amount as of the most recent balance sheet date.
The issuer should make one last measurement adjustment immediately before
accounting for the extinguishment if the measurement of the instrument under the
temporary equity guidance has changed since the most recent balance sheet date
(e.g., because of accretion or changes in the redemption value; see Section 9.5.2).
Depending on the circumstances, therefore, the entity would make
the following accounting entry if an instrument classified in its entirety in
temporary equity is extinguished at an amount that is less than its net carrying amount:
Temporary equity (at its net carrying amount)
Cash (or other consideration transferred; e.g.,
debt or equity securities, at fair value)
Equity — retained earnings (for the amount of the
difference)
In calculating EPS, the entity would deduct the difference from
(or add it to) net earnings to determine the income available to common
stockholders under ASC 260-10-45-11.
ASC
260-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: The Effect on Calculation of
Earnings per Share for a Period That Includes the
Redemption or Induced Conversion of Preferred
Stock
When a
registrant effects a redemption or induced conversion of
only a portion of the outstanding securities of a class
of preferred stock, the SEC staff believes that, for the
purpose of determining whether the “if-converted” method
is dilutive for the period, the shares redeemed or
converted should be considered separately from the other
shares of the same class that are not redeemed or
converted. The SEC staff does not believe that it is
appropriate to aggregate securities with different
effective dividend yields when determining whether the
“if-converted” method is dilutive, which would be the
result if a single, aggregate computation was made for
the entire series of preferred stock.
For example, assume a registrant has
100 shares of convertible preferred stock outstanding at
the beginning of the period. The convertible preferred
stock was issued at fair value, which was equal to its
par value of $10 per share, and has a stated dividend of
5 percent, and each share of preferred stock is
convertible into 1 share of common stock. During the
period, 20 preferred shares were redeemed by the
registrant for $12 per share.
In
this example, the SEC staff believes that the registrant
should determine whether conversion is dilutive (1) for
80 of the preferred shares by applying the
“if-converted” method from the beginning of the period
to the end of the period using the stated dividend of 5
percent and (2) for 20 of the preferred shares by
applying the “if-converted” method from the beginning of
the period to the date of redemption using both the
stated dividend of 5 percent and the $2 per share
redemption premium.
Accordingly,
assuming that the dividend for the period for the
preferred stock was $0.125 per share, a determination of
whether the 20 redeemed shares are dilutive should be
made by comparing the $2.125 per-share effect of
assuming those shares are not converted to the effect of
assuming those 20 shares were converted into 20 shares
of common stock, weighted for the period for which they
were outstanding. The determination of the
“if-converted” effect of the 80 shares not redeemed
should be made separately, by comparing the EPS effect
of the $0.125 per-share dividend to the effect of
assuming conversion into 80 shares of common
stock.
ASC 260-10-S99-2 contains special guidance on the calculation of
diluted EPS that applies when a portion of an outstanding class of preferred
stock is redeemed or subject to an induced conversion. For additional discussion
of the EPS treatment of redemptions of preferred stock, see Section 3.2.2.6.2.2 of
Deloitte’s Roadmap Earnings
per Share.
9.7.2 Conversions
9.7.2.1 Conversions Under the Original Terms
If an instrument classified as temporary equity (e.g.,
convertible preferred stock) that does not contain a separately recognized
equity component is converted to a permanent equity classified instrument
(e.g., common stock or a different class of preferred stock), the old
instrument is derecognized, and the new instrument typically is recognized
at the current carrying amount of the old instrument on the date of
conversion. Previous adjustments to the carrying amount of the old
instrument under the temporary equity guidance are not reversed (see also
Section
9.7.4). For a discussion of the accounting in situations in
which the old instrument contains a separately recognized equity component,
see Section
3.2.5.2.4 of Deloitte’s Roadmap Earnings per Share.
9.7.2.2 Induced Conversions
ASC 260-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: The Effect on Calculation
of Earnings per Share for a Period That Includes the
Redemption or Induced Conversion of Preferred
Stock
If
convertible preferred stock is converted into other
securities issued by the registrant pursuant to an
inducement offer, the SEC staff believes that the
excess of (1) the fair value of all securities and
other consideration transferred in the transaction
by the registrant to the holders of the convertible
preferred stock over (2) the fair value of
securities issuable pursuant to the original
conversion terms should be subtracted from net
income to arrive at income available to common
stockholders in the calculation of earnings per
share. Registrants should consider the guidance
provided in Subtopic 470-20 to determine whether the
conversion of preferred stock is pursuant to an
inducement offer.
ASC 470-20 contains guidance on the accounting for induced
conversions of convertible debt. ASC 470-20-40-13 states, in part, that
“conversions of convertible debt to equity securities pursuant to terms that
reflect changes made by the debtor to the conversion privileges provided in
the terms of the debt at issuance (including changes that involve the
payment of consideration) for the purpose of inducing conversion.” In
addition, ASC 470-20-40-16 indicates that if the conversion is an “induced
conversion” as described in ASC 470-20-40-13 through 40-15, the “debtor
shall recognize an expense equal to the fair value of all securities and
other consideration transferred in the transaction in excess of the fair
value of securities issuable pursuant to the original conversion terms.”
Under ASC 470-20-40-13, “[t]hat guidance applies only to conversions that
both:
-
Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time . . . .
-
Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted.”
ASC 470-20 does not address the accounting for induced
conversions of equity-classified preferred stock. If an inducement offer
related to convertible preferred stock would have met the characteristics of
an inducement offer in ASC 470-20, however, the SEC staff requires issuers
to deduct, in their EPS calculation, “the excess of (1) the fair value of
all securities and other consideration transferred in the transaction by the
registrant to the holders of the convertible preferred stock over (2) the
fair value of securities issuable pursuant to the original conversion terms”
in determining income available to common stockholders (see ASC
260-10-S99-2).
Depending on the circumstances, therefore, the issuer would
record the following accounting entry if a preferred share classified in
temporary equity is converted into common stock in accordance with an
induced conversion offer:
Temporary equity (net carrying amount)
Retained earnings (inducement amount)
Equity — common stock
For additional discussion of the EPS treatment of induced
conversions of preferred stock, see Section 3.2.2.6.3 of Deloitte’s
Roadmap Earnings per
Share.
9.7.3 Modifications and Exchanges
ASC 470-50 provides guidance on determining whether a
modification or exchange of debt instruments should be accounted for as a
modification or as an extinguishment; however, there is no specific guidance
under GAAP on whether an amendment to, or exchange of, an equity-classified
preferred stock instrument (whether presented in temporary or permanent equity)
that is not within the scope of ASC 718 should be accounted for as an
extinguishment or a modification.
If the preferred stock is required to be reclassified as a
liability, the reclassification is considered an extinguishment under ASC
260-10-S99-2 (and the fair value of the preferred stock immediately after the
modification or exchange, along with any other consideration, is treated as the
fair value of the consideration transferred; see Section 9.7.1).
In prepared remarks at the 2014 AICPA Conference on
Current SEC and PCAOB Developments, Kirk Crews, then professional accounting
fellow in the SEC’s OCA, noted that registrants may use one of the following
approaches in determining whether an amendment to, or exchange of, an
equity-classified preferred stock constitutes a modification or extinguishment
when the preferred stock is not reclassified as a liability:
-
Qualitative approach — An entity would consider the significance of additions, removals, and changes to existing contractual terms. In addition, the entity would “evaluate the business purpose for the changes and how the changes may influence the economic decisions of the investor.” If the entity determined that the changes were significant, it would treat the amendments or exchange as an extinguishment; otherwise, it would treat the changes as a modification to the preferred stock. (Mr. Crews suggested that the qualitative approach is the “most common approach” observed by the SEC staff.)
-
Fair value approach — An entity would compare the fair value of the preferred stock after the amendment or exchange to the fair value of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. If there is a 10 percent or greater change in the fair value of the preferred stock, the entity would consider the preferred stock to be substantially different and account for the amendment or exchange as an extinguishment. If, however, the change is less than 10 percent, a preferred stock modification has occurred.
-
Cash flow approach — An entity would compare the contractual cash flows of the preferred stock after the amendment or exchange with the contractual cash flows of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. As it would under the fair value approach, the entity would consider a change of 10 percent or greater to be substantially different and would account for the amendment or exchange as an extinguishment. A change of less than 10 percent would be considered a modification.
In addition, Mr. Crews noted that some registrants may be using
the legal form approach to determine whether an amendment to, or exchange of, an
equity-classified preferred stock constitutes a modification or an
extinguishment. Under the legal form approach, an exchange that results in the
issuance of new preferred stock would be accounted for as an extinguishment of
the exchanged preferred stock. Mr. Crews cautioned registrants that the legal
form is merely one factor in the evaluation of whether an amendment or exchange
should be accounted for as a modification or an extinguishment and emphasized
that the form of the change in and of itself should not be determinative of the
accounting outcome.
If a modification or exchange represents an extinguishment for
accounting purposes, it is accounted for as a redemption of the existing equity
instrument and the issuance of a new instrument (see Section 9.7.1).
At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, Mr. Crews suggested that if a registrant determines that an
amendment to, or exchange of, equity-classified preferred stock is a
modification, it would be appropriate for the entity to analogize to the
guidance in ASC 718-20-35-3 on modifications to equity-classified share-based
payment awards. If the fair value of the instrument after the modification
exceeds its fair value before the modification, the entity should recognize the
incremental fair value to reflect the modification. Mr. Crews indicated that the
staff would not object to an entity’s recognition of the additional fair value
in retained earnings as a deemed dividend from the entity to the preferred
stockholders. (This implies that in calculating EPS, entities would deduct the
incremental fair value from net earnings in determining income available to
common stockholders under ASC 260-10-45-11.) Mr. Crews suggested that in certain
unique circumstances, it may be appropriate to recognize the additional fair
value as an expense (e.g., if facts and circumstances indicate that it is
reflective of compensation for agreeing to restructure the preferred stock). He
noted that while the SEC staff has accepted both methods, the appropriate method
for recognizing the additional fair value would depend on “the underlying
purpose for and circumstances surrounding the modification.”
For additional discussion of the evaluation of modification and
exchanges of preferred or common stock and the related EPS impact, see Section 3.2.6 of
Deloitte’s Roadmap Earnings
per Share.
9.7.4 Reclassifications
After an equity instrument’s issuance, it may begin or cease to
meet the criteria for temporary equity classification. Its classification should
therefore be reassessed under the guidance on temporary equity classification
whenever circumstances change. Examples of events or changes in circumstances
that could trigger reclassification include:
-
The expiration of redemption features that triggered temporary equity classification (e.g., an investor put option or contingent redemption feature embedded in a preferred stock instrument).
-
The modification of terms of the equity instrument to remove all redemption features (see also Section 9.7.3).
-
A change in the holder’s ability to control whether the issuer will trigger or exercise a redemption feature or permit a holder redemption option to become exercisable (e.g., because the holder gains or loses control over the board; see Section 9.4.4). For instance, a call option embedded in an equity instrument would be assessed differently depending on whether the holder can direct the entity to exercise the call option through board representation or voting rights.
-
A change in the issuer’s ability to settle a share-settled redemption feature in its equity shares in accordance with the equity classification conditions in ASC 815-40-25 (e.g., a change in the number of authorized, but unissued shares available to settle the instrument; see Section 9.4.6).
-
It becomes certain that an outstanding share with redemption provisions will be redeemed and subject to the liability classification guidance in ASC 480 (see Section 4.4). For example, redemption might become certain if a substantive equity conversion option embedded in a mandatorily redeemable preferred share expires or a contingency that triggers the automatic redemption of a share is met.
-
An instrument ceases to be subject to ASC 718 (see Section 9.3.9).
9.7.4.1 Reclassifications From Temporary Equity to Permanent Equity
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and
Measurement of Redeemable Securities
S99-3A(18) If classification
of an equity instrument as temporary equity is no
longer required (if, for example, a redemption
feature lapses, or there is a modification of the
terms of the instrument), the existing carrying
amount of the equity instrument should be
reclassified to permanent equity at the date of the
event that caused the reclassification. Prior
financial statements are not adjusted. Additionally,
the SEC staff believes that it would be
inappropriate to reverse any adjustments previously
recorded to the carrying amount of the equity
instrument (pursuant to paragraphs 14–16) in
conjunction with such reclassifications.
If an equity instrument no longer meets any of the criteria
for temporary equity classification (and is not a liability under ASC 480),
the instrument is remeasured up to the date of the reclassification (with a
corresponding impact on EPS) and reclassified from temporary equity to
permanent equity at its current carrying amount as of the date of the event
that caused the reclassification. An issuer is precluded from
retrospectively adjusting its balance sheet as if the temporary equity
guidance had never applied (i.e., as if the securities were not redeemable
in prior financial reporting periods). In recording the reclassification to
permanent equity, an entity cannot reverse prior redemption-amount
adjustments that affected the EPS calculation. For example, in the period of
reclassification, there should not be an EPS benefit equal to any cumulative
charges to retained earnings that reduced EPS in prior periods. An EPS
adjustment might be required, however, for a modification of terms (see
Section
9.7.3).
The SEC’s guidance does not address which specific permanent
equity accounts (e.g., retained earnings and APIC) should be affected by the
reclassification. However, if previous measurement adjustments were
reflected in the calculation of EPS, it would not be appropriate to adjust
retained earnings (or accumulated deficit) to remove the effect of those
adjustments (since a reclassification should not affect EPS). Further, if
the holder agrees to forfeit its right to previously accrued and undeclared
dividends, the corresponding amount should be recorded against paid-in
capital (rather than retained earnings) because such amount represents a
capital contribution. If a common stock instrument was redeemable at its
fair value and had no EPS impact in previous periods (see Section 9.6.2), it
would be appropriate to adjust permanent equity accounts (e.g., retained
earnings or APIC) by the same amounts as the redemption-amount adjustments
that had previously been recorded to those respective accounts. The prior
redemption-amount adjustments would have no effect on EPS in this scenario
(i.e., a preferential distribution has not occurred), and a permanent
reduction to retained earnings is therefore unnecessary.
Example 9-22
Reclassification From Temporary Equity to
Permanent Equity
On January 1, 20X1, Entity E, an SEC registrant, issues redeemable common stock
for proceeds of $100 million, which equals the
stock’s par amount and its fair value as of its
issuance date. The terms of the stock specify that
(1) the holder has a right to require E to redeem
the stock at a price equal to the current fair value
of the stock on the redemption date and (2) the
holder’s redemption right is exercisable at any time
and expires if E consummates an IPO. Because E could
be forced to redeem the stock, it classifies the
stock in temporary equity. Entity E makes the
following entry (in millions):
On
December 31, 20X1, the fair value of the stock has
increased to $300 million. Thus, E is required to
record a redemption-amount adjustment of $200
million to increase the carrying amount of the
redeemable stock to $300 million. Assume that E has
a retained earnings balance of $100 million and an
APIC balance of $50 million (related to a previous
issuance of nonredeemable common shares). Entity E
first records a charge against retained earnings of
$100 million to reduce retained earnings to zero.
Then it records a charge of $50 million to reduce
APIC to zero. Given that both retained earnings and
APIC have been reduced to zero, E finally records a
$50 million charge to create an accumulated deficit
of $50 million. Hence, E makes the following entry
to recognize the change in the redemption value
during 20X1 (in millions):
On
December 31, 20X2, the redemption value of the
common stock has increased to $400 million. During
20X2, E incurred a net loss of $75 million, and
there was no other activity that affected its equity
accounts. The additional $100 million adjustment for
the redemption amount of the common stock increases
the accumulated deficit to $225 million (= $50
million + $75 million + $100 million). Entity E
makes the following entry to reflect the change in
the redemption value during 20X2 (in
millions):
In the next period ended December 31, 20X3, E had no net earnings or net losses
and, as a result of consummating an IPO, its common
stock was no longer redeemable. On the date
immediately before the IPO, the stock was redeemable
for $400 million. Because the common stock was
redeemable at its fair value and there was no EPS
impact in previous periods, E adjusted its permanent
equity accounts to remove the effect of the
application of the temporary equity guidance to the
common stock. Accordingly, E recorded the
reclassification of the common stock from temporary
equity to permanent equity by recognizing a $100
million credit to paid-in capital for common stock,
a $225 million credit to accumulated deficit, a $25
credit to retained earnings, and a $50 million
credit to APIC (in millions):
The adjusted retained earnings balance equals $25 million, which reflects the
initial retained earnings balance of $100 million
less the cumulative net loss of $75 million. The
adjusted APIC balance equals $50 million. These
balances are the same as those that would have been
reported had the temporary equity guidance never
been applied.
9.7.4.2 Reclassifications From Permanent Equity to Temporary Equity
The SEC’s temporary equity guidance does not address
reclassifications from permanent equity to temporary equity. Because that
guidance requires an entity to initially measure an instrument classified as
temporary equity at fair value (unless an exception applies), by analogy to
the reclassification guidance in ASC 815-40, it would be appropriate (unless
an exception applies) for an entity to reclassify the instrument out of
permanent equity at its current fair value as of the date of the event that
caused the reclassification. The entity would account for any adjustment to
the carrying amount as an adjustment to equity (APIC).
9.7.4.3 Reclassifications From Temporary Equity to a Liability
ASC 260-10 — SEC Materials — SEC Staff
Guidance
SEC Staff Announcement: The Effect on Calculation
of Earnings per Share for a Period That Includes the
Redemption or Induced Conversion of Preferred
Stock
S99-2 . . .
3. If an equity-classified security is
subsequently required to be reclassified as a
liability based on the provisions of other GAAP
(for example, because a preferred share becomes
mandatorily redeemable pursuant to Subtopic
480-10), the reclassification is considered a
redemption of equity by issuance of a debt
instrument.
If an instrument is reclassified from temporary equity to a
liability, the reclassification is treated as an extinguishment of the
original instrument (see Section 9.7.1). The difference between the carrying amount
and the fair value of the instrument is recorded against equity.
9.7.5 Deconsolidation of a Subsidiary
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(19) Section 810-10-40
provides guidance on the measurement of the gain or loss
that is recognized in net income when a parent
deconsolidates a subsidiary. As indicated in Paragraph
810-10-40-5, that gain or loss calculation is impacted
by the carrying amount of any noncontrolling interest in
the former subsidiary. Since adjustments to the carrying
amount of a noncontrolling interest from the application
of paragraphs 14–16 do not initially enter into the
determination of net income, the SEC staff believes that
the carrying amount of the noncontrolling interest that
is referred to in Paragraph 810-10-40-5 should similarly
not include any adjustments made to that noncontrolling
interest from the application of paragraphs 14–16.
Rather, previously recorded adjustments to the carrying
amount of a noncontrolling interest from the application
of paragraphs 14–16 should be eliminated in the same
manner in which they were initially recorded (that is,
by recording a credit to equity of the parent).
When a subsidiary with a redeemable noncontrolling interest is
deconsolidated, the issuer reverses any previous adjustments to the carrying
amount of the noncontrolling interest that it has made in accordance with the
temporary equity guidance. Any gain or loss on deconsolidation under ASC 810 is
calculated on the basis of the carrying amount of the noncontrolling interest
after previous temporary equity adjustments have been eliminated against equity.
An entity is required to disclose the amount credited to equity of the parent
upon the deconsolidation of the subsidiary (see Section 9.8.2).