Chapter 9 — The SEC's Guidance on Temporary Equity
Chapter 9 — The SEC’s Guidance on Temporary Equity
9.1 Overview and Sources of Guidance
Issuers of certain equity-classified instruments that are redeemable for
cash or other assets in circumstances not under their sole control must, in financial
statements filed with the SEC under Regulation S-X, (1) present such instruments in a
caption that is separate from both liabilities and stockholders’ equity on the face of the
balance sheet and (2) apply specific measurement and disclosure guidance to them.
Instruments presented in this manner are described as temporary (or “mezzanine”) equity
instruments.
Under the SEC’s temporary equity guidance, equity instruments that contain
terms that could force the issuer to redeem the instruments for cash or other assets are
presented separately from conventional equity capital, which does not contain such terms.
Temporary equity presentation highlights that the proceeds received from equity instruments
within the scope of the guidance may have to be repaid and thus may not be available to the
issuer as a permanent source of equity financing.
Terms and features that could trigger temporary equity classification are
not limited to those that are explicitly described as cash-settled redemption or put
features. For example, call, conversion, and liquidation features that could force the
issuer to redeem an equity instrument for cash or assets might necessitate such
classification. Accordingly, the SEC staff has advised issuers to “carefully consider all
contractual provisions of a security before determining how it should be classified in the
financial statements.”1
9.1.1 SEC Announcements, Speeches, and Discussions
Although there are many types of SEC guidance on the separate presentation and
disclosure of certain redeemable equity instruments (see Appendix B), the SEC staff announcement in ASC 480-10-S99-3A addresses the
classification and measurement requirements for redeemable equity securities
comprehensively. When applying the SEC’s temporary equity guidance, registrants should
consider these requirements as well as remarks made by the SEC staff in public speeches,
meetings with members of the accounting profession (including the CAQ’s SEC Regulations
Committee and its International Practices Task Force), and informal discussions about how
the staff expects registrants to apply the guidance.
For ease of reference, the FASB has included in the Codification certain portions of the SEC’s rules and guidance (e.g., excerpts from Regulation S-X and SABs). If any discrepancies exist (e.g., because of updates to the SEC’s guidance that the FASB has not yet reflected in the Codification), registrants should apply the text issued by the SEC rather than the version in the Codification. However, note that since the SEC does not separately publish staff announcements or observer comments made at EITF meetings, the Codification is the primary repository for that text.
9.1.2 SEC Rules and Policies
9.1.2.1 Regulation S-X
Regulation S-X, Rule 5-02 (reproduced in ASC 210-10-S99-1), contains
requirements related to what should appear on the face of the balance sheet and be
disclosed in related notes in financial statements filed with the SEC by all entities
except those specifically exempted. Rule 5-02.27 specifies the basic balance sheet
presentation and footnote disclosure requirements related to redeemable preferred stocks
classified as temporary equity. It requires an entity to present redeemable preferred
stocks separately from components of permanent equity on the face of the balance sheet
(see Section 9.8.1).
In presenting redeemable preferred stock separately under Regulation S-X,
registrants should consider the SEC’s additional guidance on this topic, in particular
the SEC staff announcement in ASC 480-10- S99-3A, and the GAAP requirements related to
what should be presented as liabilities or equity. For instance, while Regulation S-X,
ASR 268, CFRP 211, and SAB Topic 3.C focus on redeemable preferred stock, ASC
480-10-S99-3A clarifies that the SEC staff also expects registrants to apply the SEC’s
temporary equity guidance to other types of redeemable equity-classified instruments
(such as common stock and noncontrolling interests; see Section 9.3.1). Further, while Regulation S-X, ASR
268, and CFRP 211 suggest that the temporary equity guidance applies to stocks subject
to mandatory redemption requirements, the FASB has subsequently issued guidance that
requires certain financial instruments to be classified as liabilities even if they are
in the form of outstanding shares of stock (see Chapters 4 and 6). Accordingly, the SEC’s temporary equity guidance
does not apply to outstanding shares that must be classified as liabilities under
GAAP.
9.1.2.2 ASR 268
ASR 268 contains the amendments to Regulation S-X that the SEC adopted on July 27, 1979, when it first established separate presentation and disclosure requirements for redeemable preferred stocks. In addition, the supplementary information in ASR 268 discusses the SEC’s decision to require separate presentation and disclosure of redeemable preferred stocks. While the complete, original text of ASR 268 is not reproduced in the Codification, ASC 210-10-S99-1 contains excerpts from Regulation S-X that were amended by ASR 268. Further, ASC 480-10-S99-1 contains selected portions of the supplementary information in ASR 268 that the SEC incorporated into CFRP 211.
9.1.2.3 CFRP 211
The SEC codified selected portions of ASR 268 in CFRP 211 (also known as CFRR 211 or FRR 211). Reproduced in ASC 480-10-S99-1, CFRP 211 provides information about the SEC’s decision to require separate presentation and disclosure of redeemable preferred stocks in accordance with Regulation S-X. CFRP 211 does not contain the actual amendments to Regulation S-X, however, and omits portions of the supplementary information that was originally included in ASR 268, such as a brief discussion of comments the SEC received on the proposed rule that resulted in ASR 268 and the SEC’s observations about the FASB’s standard-setting activity at the time.
9.1.3 SEC Staff Accounting Bulletins
9.1.3.1 SAB Topic 3.C
SAB Topic 3.C (reproduced in ASC 480-10-S99-2) contains the SEC staff’s views on how redeemable preferred stock should be measured and how changes in the carrying amount should be treated in EPS and ratio calculations. The SEC staff announcement in ASC 480-10-S99-3A contains additional detailed guidance on these topics.
9.1.3.2 SAB Topic 14.E
SAB Topic 14.E (reproduced in ASC 718-10-S99-1) contains the SEC’s views on the
application of the temporary equity guidance to share-based payment arrangements with
employees. This Roadmap touches briefly on these topics (see Sections 9.3.9, 9.4.9, and 9.5.12). For a more detailed discussion, see
Deloitte’s Roadmap Share-Based
Payment Awards.
9.1.4 SEC Announcements and Observer Comments Made at EITF Meetings
9.1.4.1 SEC Staff Announcement: Classification and Measurement of Redeemable Securities
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(1) This SEC staff announcement provides the
SEC staff’s views regarding the application of Accounting Series Release No.
268, Presentation in Financial Statements of “Redeemable Preferred
Stocks.” FN1
__________________________________
FN1 ASR 268 (SEC Financial
Reporting Codification, Section No. 211, Redeemable Preferred
Stocks) is incorporated into SEC Regulation S-X, Articles 5-02.27,
7-03.21, and 9-03.19. Hereafter, reference is made only to ASR
268.
The SEC staff announcement in ASC 480-10-S99-3A (originally issued as EITF Topic
D-98) provides a comprehensive overview of the SEC staff’s views on the application of
the redeemable equity requirements in Regulation S-X and related guidance.
9.1.4.2 SEC Observer Comments — Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an ESOP
The SEC staff observer comments in ASC 480-10-S99-4 discuss the application of
the SEC’s temporary equity guidance to equity instruments issued by a sponsor to an ESOP
in situations in which the instruments can be put to the sponsor for cash or other
assets (see Sections 9.3.8
and 9.5.11).
Footnotes
1
From remarks by then SEC Professional Accounting Fellow Dominick J.
Ragone III before the 2000 AICPA Conference on Current SEC Developments.
9.2 Scope — Entities
9.2.1 SEC Registrants
The SEC’s temporary equity guidance applies to SEC registrants’ financial
statements that are prepared in accordance with Regulation S-X (e.g., in annual
reports on Form 10-K and registration statements on Form S-1). Regulation S-X,
Rules 5-02.27 (reproduced in ASC 210-10-S99-1), 7-03.20 (reproduced in ASC
944-210-S99-1(20)), and 9-03.18 (reproduced in ASC 942-210-S99-1(18)), contain
guidance on balance sheet presentation related to redeemable preferred stocks
for SEC registrants that are subject to those rules.
9.2.2 Nonpublic Entities
While the SEC’s temporary equity guidance is not required to be applied to
financial statements that are not filed with the SEC, an entity that is not
filing financial statements with the SEC may elect to apply it anyway (e.g., if
it contemplates becoming an SEC registrant in the future).
In some circumstances, the SEC’s temporary equity guidance must be applied to
equity instruments issued by entities that are not SEC registrants:
-
If a private company were a subsidiary of an SEC registrant, the SEC’s guidance would be applied to redeemable equity instruments issued by the subsidiary in the consolidated financial statements of the SEC registrant. However, the private company would not be required to apply the guidance in its stand-alone financial statements if they are not filed with the SEC.
-
A private company or a subsidiary of an SEC registrant may be required to apply SEC guidance in its financial statements that are included, or incorporated by reference, in an SEC registrant’s filing.
A nonpublic entity that becomes an SEC registrant (e.g., an entity that files an
IPO registration statement) is required to comply with the SEC’s guidance.
Often, redeemable convertible preferred stock is fully converted into common
stock upon consummation of an IPO and is no longer outstanding after the IPO.
Nevertheless, an entity must still apply the SEC’s temporary equity guidance, if
applicable, to the redeemable convertible preferred stock in the entity’s
financial statements before the IPO takes effect when the entity files an IPO
registration statement with the SEC.
For a nonpublic entity not previously subject to ASC 480-10-S99-3A, a change to the classification or measurement of an equity instrument as a result of initially adopting ASC 480-10-S99-3A (e.g., in financial statements to be included in a registration statement filed with the SEC) is treated as a change in accounting policy (see ASC 250-10), not as the correction of an error. Accordingly, the nonpublic entity may need to retrospectively revise its prior-period financial statements to meet the SEC’s requirements.
9.3 Scope — Instruments
9.3.1 Equity Instruments
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3) Although ASR 268
specifically describes and discusses preferred
securities, the SEC staff believes that ASR 268 also
provides analogous guidance for other redeemable equity
instruments including, for example, common stock,
derivative instruments, noncontrolling interests,
securities held by an employee stock ownership plan, and
share-based payment arrangements with employees. The SEC
staff’s views regarding the applicability of ASR 268 in
certain situations is described below. [Footnotes and
additional text omitted]
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.
9.3.2 Assets and Liabilities
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3)(a)
Freestanding financial instruments classified as
assets or liabilities. Freestanding financial
instruments that are classified as assets or liabilities
pursuant to Subtopic 480-10 or other applicable GAAP
(including those that contain separated derivative
assets or derivative liabilities) are not subject to ASR
268.FN5 Mandatorily redeemable equity
instruments for which the relevant portions Subtopic
480-10 have been deferred are subject to ASR 268.
__________________________________
FN5 An equity instrument subject to
potential redemption under a freestanding written
put option is not subject to ASR 268 (since the
put option liability is considered a separate unit
of account). However, as discussed in paragraph
3(b), 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 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).
9.3.3 Freestanding Equity-Classified Contracts (Other Than Outstanding Shares)
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3)(b)
Freestanding derivative instruments classified in
stockholders’ equity. Freestanding derivative
instruments that are classified in stockholders’ equity
pursuant to Subtopic 815-40 are not subject to ASR
268.FN6 Equity-classified freestanding
financial instruments that were previously classified
outside of permanent equity under Subtopic 815-40 are
now classified as assets or liabilities pursuant to
Subtopic 480-10. . . .
__________________________________
FN6 A freestanding derivative
instrument would not meet the conditions in
Subtopic 815-40 to be classified as an equity
instrument if it was subject to redemption for
cash or other assets on a specified date or upon
the occurrence of an event that is not within the
control of the issuer.
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.
9.3.4 Hybrid Equity Instruments and Embedded Derivatives
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3)(b) . . . Subtopic
815-40 continues to apply to embedded derivatives
indexed to, and potentially settled in, a company’s own
stock. Accordingly, when a hybrid financial instrument
that is not classified in its entirety as an asset or
liability under Subtopic 480-10 or other applicable GAAP
contains an embedded derivative within the scope of
Subtopic 815-40, the registrant should consider the
applicability of ASR 268 to:
-
The hybrid financial instrument when the embedded derivative is not separated under Subtopic 815-15, or
-
The host contract when the embedded derivative is separated under Subtopic 815-15. . . .
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.
9.3.5 Convertible Debt Instruments Separated Into Liability and Equity Components
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3)(e)
Convertible debt instruments that contain a
separately classified equity component. Other
applicable GAAP may require a convertible debt
instrument to be separated into a liability component
and an equity component.FN8 . . .
__________________________________
FN8 See Subtopics 470-20 and 470-50;
and Paragraph 815-15-35-4.
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.
9.3.6 Equity Instruments Subject to Registration Payment Arrangements
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable
Securities
S99-3A(3)(c)
Equity instruments subject to registration payment
arrangements. The determination of whether an
equity instrument subject to a registration payment
arrangement (as defined in [the ASC master glossary]) is
subject to ASR 268 should be made without regard to the
existence of the registration payment arrangement (that
is, the registration payment arrangement is a separate
unit of account). However, in determining the
applicability of ASR 268 to an equity instrument with
any other related arrangement, a conclusion that the
related arrangement is a separate unit of account should
not be based on an analogy to Paragraph 815-10-25-16.
ASC
815-10
25-16 Paragraphs 825-20-25-2
and 825-20-30-2 require that a financial instrument
subject to a registration payment arrangement be
recognized and measured in accordance with other
applicable GAAP (for example, this Subtopic) without
regard to the contingent obligation to transfer
consideration pursuant to the registration payment
arrangement. That is, those paragraphs require that an
entity recognize and measure a registration payment
arrangement as a separate unit of account from the
financial instrument(s) subject to that
arrangement.
ASC
Master Glossary
Registration Payment
Arrangement
An
arrangement with both of the following
characteristics:
- It specifies that the issuer will endeavor to do either of the following:
- File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
- Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
- It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).
ASC
825-20
15-4 The guidance in this
Subtopic does not apply to any of the following:
-
Arrangements that require registration or listing of convertible debt instruments or convertible preferred stock if the form of consideration that would be transferred to the counterparty is an adjustment to the conversion ratio. See Subtopic 470-20 on debt with conversion and other options or Subtopic 505-10 on equity for related guidance.
-
Arrangements in which the amount of consideration transferred is determined by reference to either of the following:
- An observable market other than the market for the issuer’s stock
- An observable index.
For example, if the consideration to be transferred if the issuer is unable to obtain an effective registration statement is determined by reference to the price of a commodity. See Subtopic 815-15 for related guidance. - Arrangements in which the financial instrument or instruments subject to the arrangement are settled when the consideration is transferred (for example, a warrant that is contingently puttable if an effective registration statement for the resale of the equity shares that are issuable upon exercise of the warrant is not declared effective by the SEC within a specified grace period).
25-1 An entity shall recognize
a registration payment arrangement as a separate unit of
account from the financial instrument(s) subject to that
arrangement.
25-2 The financial
instrument(s) subject to the registration payment
arrangement shall be recognized in accordance with other
applicable generally accepted accounting principles
(GAAP) (for example, Subtopics 815-10; 815-40; and
835-30) without regard to the contingent obligation to
transfer consideration pursuant to the registration
payment arrangement.
30-1 An entity shall measure a
registration payment arrangement as a separate unit of
account from the financial instrument(s) subject to that
arrangement.
30-2 The financial
instrument(s) subject to the registration payment
arrangement shall be measured in accordance with other
applicable generally accepted accounting principles
(GAAP) (for example, Subtopics 815-10; 815-40; and
835-30) without regard to the contingent obligation to
transfer consideration pursuant to the registration
payment arrangement.
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)).
9.3.7 Noncontrolling Interests
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.
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3) Although ASR 268
specifically describes and discusses preferred
securities, the SEC staff believes that ASR 268 also
provides analogous guidance for other redeemable equity
instruments including, for example, . . . noncontrolling
interestsFN2 . . . .
__________________________________
FN2 The Master Glossary defines
noncontrolling interest as “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.” ASR 268 applies to redeemable
noncontrolling interests (provided the redemption
feature is not considered a freestanding option
within the scope of Subtopic 480-10). Where
relevant, specific classification and measurement
guidance pertaining to redeemable noncontrolling
interests has been included in this SEC staff
announcement.
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:
Entities with instruments that qualify for the [exception in ASC 480-10-15-7A
through 15-7F] should refer to [ASC 480-10-S99-3A] for guidance related
to classification and/or measurement, as applicable, for those
securities that . . . will not be fully accounted for in accordance with
[ASC 480]. In other words, if both the classification and measurement
guidance in [ASC 480] has been deferred for an instrument, look to [ASC
480-10-S99-3A] for both classification and measurement guidance. If only
the measurement guidance in [ASC 480] has been deferred for an
instrument, look to [ASC 480-10-S99-3A] for continued measurement
guidance.
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.
9.3.8 Securities Held by an ESOP
ASC 480-10 — Glossary
Employee Stock Ownership
Plan
An employee stock
ownership plan is an employee benefit plan that is
described by the Employee Retirement Income Security Act
of 1974 and the Internal Revenue Code of 1986 as a stock
bonus plan, or combination stock bonus and money
purchase pension plan, designed to invest primarily in
employer stock. Also called an employee share ownership
plan.
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3) Although ASR 268
specifically describes and discusses preferred
securities, the SEC staff believes that ASR 268 also
provides analogous guidance for other redeemable equity
instruments including, for example, . . . securities
held by an employee stock ownership planFN3 .
. . .
__________________________________
FN3 ASR 268 applies to equity
securities held by an employee stock ownership
plan (whether or not allocated) that, by their
terms, can be put to the registrant (sponsor) for
cash or other assets. Where relevant, specific
classification and measurement guidance pertaining
to employee stock ownership plans has been
included in this SEC staff announcement.
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).
9.3.9 Share-Based Payment Arrangements
ASC
480-10 — SEC Materials — SEC Staff Guidance
SEC
Staff Announcement: Classification and Measurement of
Redeemable Securities
S99-3A(3) Although ASR 268
specifically describes and discusses preferred
securities, the SEC staff believes that ASR 268 also
provides analogous guidance for other redeemable equity
instruments including, for example, . . . share-based
payment arrangements with employeesFN4 . . .
.
__________________________________
FN4 As indicated in Section
718-10-S99, ASR 268 applies to redeemable
equity-classified instruments granted in
conjunction with share-based payment arrangements
with employees. Where relevant, specific
classification and measurement guidance pertaining
to share-based payment arrangements with employees
has been included in this SEC staff announcement.
SEC Staff Accounting Bulletins
SAB Topic 14.E, FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain
Redeemable Financial Instruments [Reproduced in ASC
718-10-S99-1]
Question 1: While the instruments
are subject to FASB ASC Topic 718, is ASR 268 and
related guidance applicable to instruments issued under
share-based payment arrangements that are classified as
equity instruments under FASB ASC Topic 718?
Interpretive Response: Yes. The
staff believes that registrants must evaluate whether
the terms of instruments granted in conjunction with
share-based payment arrangements that are not classified
as liabilities under FASB ASC Topic 718 result in the
need to present certain amounts outside of permanent
equity (also referred to as being presented in
“temporary equity”) in accordance with ASR 268 and
related guidance. [Footnote omitted]
When an instrument ceases to be subject
to FASB ASC Topic 718 and becomes subject to the
recognition and measurement requirements of other
applicable GAAP, the staff believes that the company
should reassess the classification of the instrument as
a liability or equity at that time and consequently may
need to reconsider the applicability of ASR 268.
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:
Based on the guidance regarding classification provided
in [ASC 718], most awards with redemption features that are outside of
the control of the issuer are required to be classified as liabilities.
However for those that are not, Section E of SAB 107 [i.e., SAB Topic
14.E] clarifies that registrants should evaluate whether the terms of
the award result in the need to classify an amount outside of permanent
equity in accordance with ASR 268. This classification and measurement
guidance is applicable to an award whether it is vested or unvested.
Further, in his prepared remarks before the 2006 AICPA Conference on Current SEC and
PCAOB Developments, then SEC Professional Accounting Fellow Joseph Ucuzoglu
stated:
The staff has observed the
increasing use by both public companies and pre-IPO companies of special
classes of stock that are granted only to employees. Public companies
often create special classes of stock to more closely align the
compensation of an employee with the operating performance of a portion
of the business with which he or she has oversight responsibility. . . .
Similarly, pre-IPO companies often create special classes of stock to
provide employees with an opportunity to participate in any appreciation
realized through a future initial public offering or sale of the
company, with limited opportunity for gain if no liquidity event occurs.
[It] is important to note that even when such instruments are considered
a substantive class of equity for accounting purposes, the terms of
these instruments often result in a requirement to classify the
instruments outside of permanent equity in the balance sheet pursuant to
[ASC 480-10-S99-3A].
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).
9.3.10 Separate Financial Statements of a Subsidiary
The SEC’s temporary equity guidance applies in the separate financial statements
of a subsidiary that (1) is an SEC registrant or (2) elects to apply the SEC’s
guidance on classification and measurement of redeemable equity securities (see
Section 9.2.2). However, a subsidiary
entity that applies such guidance would not classify a redeemable equity
instrument within temporary equity in its separate financial statements if all
of the following conditions are met:
- The only redemption feature pertaining to the equity instrument was issued by the subsidiary’s parent.
- The subsidiary is not responsible for making any payment if the redemption feature is settled.
- The equity instrument subject to the redemption terms will be legally owned by the parent upon settlement.
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).
9.4 Classification
9.4.1 Characteristics That Trigger Temporary Equity Classification
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(2) ASR 268 requires
preferred securities that are redeemable for cash or
other assets to be classified outside of permanent
equity if they are redeemable (1) at a fixed or
determinable price on a fixed or determinable date, (2)
at the option of the holder, or (3) upon the occurrence
of an event that is not solely within the control of the
issuer. As noted in ASR 268, the Commission reasoned
that “[t]here is a significant difference between a
security with mandatory redemption requirements or whose
redemption is outside the control of the issuer and
conventional equity capital. The Commission believes
that it is necessary to highlight the future cash
obligations attached to this type of security so as to
distinguish it from permanent capital.”
S99-3A(4) ASR 268 requires
equity instruments with redemption features that are not
solely within the control of the issuer to be classified
outside of permanent equity (often referred to as
classification in “temporary equity”). . . .
S99-3A(5) Determining whether
an equity instrument is redeemable at the option of the
holder or upon the occurrence of an event that is solely
within the control of the issuer can be complex. The SEC
staff believes that all of the individual facts and
circumstances surrounding events that could trigger
redemption should be evaluated separately and that the
possibility that any triggering event that is not
solely within the control of the issuer could
occur — without regard to probability — would require
the instrument to be classified in temporary equity.
Paragraphs 6–11 provide examples of the application of
ASR 268.
Unless an exception applies, an equity-classified instrument must be presented as temporary equity if the issuer could be required to redeem it for cash or other assets in any circumstance not under the issuer’s sole control. Informally, the SEC staff has indicated that this guidance should be “strictly and rigidly applied.”
Example 9-1
Preferred Stock With Embedded Put Option
Company U, an SEC registrant, issued, for $33 million, a 6.5 percent convertible
preferred stock with an embedded put option. If
exercised, the put option requires U to repurchase the
shares for $33 million. Because U’s repurchase of the
shares is conditioned upon exercise of the put option,
the shares do not meet the definition of a mandatorily
redeemable financial instrument in ASC 480 (see
Chapter 4). Further, the issuer has
determined that the put option is not required to be
bifurcated as a derivative instrument under ASC 815-15.
Because the redemption of the shares of preferred stock
is outside the issuer’s control, these shares must be
classified as temporary rather than permanent equity.
Note that classification of the convertible preferred
stock in temporary equity would also have been required
even if the put option had been separated as an embedded
derivative under ASC 815-15.
According to ASC 480-10-S99-3A(2), which contains interpretations of the requirements of Regulation S-X, Rule 5-02.27(a) (as amended by ASR 268), an equity-classified instrument is presented as temporary equity if it is redeemable for cash or other assets in any of the following circumstances:
- “[A]t a fixed or determinable price on a fixed or determinable date” (e.g., convertible preferred shares that are mandatorily redeemable for cash on a specified date in the future if not previously converted by the holder).
- “[A]t the option of the holder” (e.g., preferred shares that the holder can elect to redeem for cash, assets, or the issuer’s debt securities).
- “[U]pon the occurrence of an event that is not solely within the control of the issuer” (e.g., preferred shares that become redeemable for cash upon a change in control, the violation of financial statement covenant, a change in law, or the occurrence of a deemed liquidation event).
Further, instruments that are redeemable for cash or other assets in any of the circumstances described above are classified as temporary equity:
- “[R]egardless of their other attributes such as voting rights, dividend rights or conversion features” (see CFRP 211.02).
- “[W]ithout regard to probability” (see ASC 480-10-S99-3A(5)). As noted by the SEC staff at the 1991 AICPA Conference on Current SEC Developments, temporary equity classification is required even if the likelihood of redemption is “insignificant, unlikely, or remote.” (Although an instrument’s likelihood of becoming redeemable does not affect its classification, such likelihood may affect its subsequent measurement; see Section 9.5.2.)
- Even if redemption is outside the control of the holder. It is sufficient that redemption “not [be] solely within the control of the issuer” (see ASC 480-10-S99-3A(5)).
In a letter dated April 12, 1990, and addressed to the SEC staff, Donald Moulin,
then chairman of the AICPA SEC Regulations Committee, provided the following
observations about common misconceptions in the application of the SEC’s
temporary equity guidance:
Our practice experience indicates that the following are
the two aspects of ASR No. 268 that are most commonly misunderstood:
-
The probability that the event triggering redemption (or the holder’s right to demand redemption) will occur is not a factor in deciding whether redeemable equity treatment is required under ASR No. 268; and
-
The condition or event that will trigger redemption (or the holder’s right to demand redemption) does not have to be within the control of the holder, but merely outside the control of the issuer.
Connecting the Dots
The SEC’s temporary equity guidance
must be applied on the basis of the unit of account for the equity
instrument under U.S. GAAP. For example, assume that an entity issues 1
million shares of $1,000 stated value per share of preferred stock. The
gross proceeds from the issuance therefore total $1 billion. Further
assume that each share is puttable by the holder upon the mere passage
of time for $1,000; however, in no circumstance is the issuer required
to redeem more than $500 million of such preferred stock. In this
example, all 1 million shares of the preferred stock (or $1 billion
aggregate stated value) must be classified in temporary equity. This is
because the unit of account is each $1,000 stated value of preferred
stock (i.e., each share). Each share of preferred stock is fungible and
redeemable; the issuer cannot identify specific shares that are not
redeemable. Therefore, on the basis of the unit of account, all of the
preferred stock must be classified in temporary equity. This conclusion
is consistent with views expressed by the SEC staff on the
classification of publicly traded common shares of SPACs. For example,
the SEC staff has objected to a registrant’s conclusion that because a
SPAC must maintain a minimum level of net tangible capital, some portion
of its publicly traded redeemable common shares may be classified in
permanent equity. The staff indicated that since the unit of account was
an individual share, and all such shares were redeemable, it was
inappropriate for a SPAC to report an amount in temporary equity that
was less than the aggregate redemption amount of such shares.
A feature does not need to be explicitly described as a cash-settled redemption
or put-option feature to potentially trigger temporary equity classification.
For example, a redemption feature that causes temporary equity classification
may be established through contractual terms that are described as a call option
(see Section
9.4.4), conversion feature (see Sections 9.4.6, 9.4.7, and 9.4.8), or liquidation provision (see
Section 9.4.5).
Further, a feature does not necessarily need to explicitly provide for
settlement in cash or other assets. If an issuer could be forced to settle all
or part of a share-settled feature (e.g., a conversion feature) in cash or other
assets, temporary equity classification may be required (see Section 9.4.6).
When an entity issues shares or other equity instruments without complying with applicable registration or qualification requirements (e.g., under federal securities laws or certain state laws), the holder may have a legal right to rescind its purchase of those equity instruments. If a legal determination has been made that the holder has in fact the right to rescind its purchase, redemption will be outside the issuer’s control. The SEC staff has indicated that equity instruments subject to rescission rights should be presented in temporary equity. The SEC’s Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance (March 31, 2001) states, in part:
The staff considers [the temporary equity] guidance to be applicable to all equity securities (not only preferred stock) the cash redemption of which is outside the control of the issuer, including stock subject to rescission rights.
ASC 480-10-S99-3A contains a number of exceptions that permit an issuer to disregard certain types of redemption features in evaluating whether the related equity instrument (or component) should be classified as temporary equity. These include the following obligations and features:
- Redemption features that are contingent on an event that is under the sole control of the issuer (see Section 9.4.2).
- Redemption obligations upon the death or disability of the holder if the redemption amount will be funded from the proceeds of an insurance policy that meets certain criteria (see Section 9.4.3).
- Redemption obligations upon an ordinary liquidation event (see Section 9.4.5).
- Redemption obligations upon a deemed liquidation event “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)” (see Section 9.4.5).
- Redemption obligations associated with the equity component of certain convertible debt that is not currently redeemable or convertible for cash or other assets on the balance sheet date (see Section 9.4.8).
- Certain features in share-based payment arrangements (see Section 9.4.9).
9.4.2 Evaluation of Whether an Event Is Under the Sole Control of the Issuer
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(9)
[Examples in which temporary equity classification is
appropriate] Example 4. An equity instrument may
contain provisions that allow the holder to redeem the
instrument for cash or other assets upon the occurrence
of events that are not solely within the issuer’s
control. Such events may include:
-
The failure to have a registration statement declared effective by the SEC by a designated date
-
The failure to maintain compliance with debt covenants
-
The failure to achieve specified earnings targets
-
A reduction in the issuer’s credit rating.
Since these events are not solely within the control of the issuer, the equity instrument is required to be classified in temporary equity.
If the terms of an equity instrument require or may require the issuer to redeem
the instrument for cash or other assets upon the occurrence of an event that is
not solely within the issuer’s control, it is classified as temporary equity,
irrespective of the likelihood that the event will occur. Conversely, a term
that requires or may require redemption upon an event that is solely within the
issuer’s control does not result in temporary equity classification, since the
issuer has the discretion to avoid redemption by preventing the event from
occurring. In prepared remarks before the 2009 AICPA Conference on Current SEC and
PCAOB Developments, then SEC Professional Accounting Fellow Brian Fields stated
the following:
A key question . . . is whether the company can avoid
settling the instrument in cash or other assets even in contingent
scenarios that may be improbable. [An] equity share is generally
presented as mezzanine temporary equity if it could require cash
settlement for reasons beyond the company’s control.
Moreover, at the 2000 AICPA Conference on Current SEC Developments, then SEC
Professional Accounting Fellow Dominick J. Ragone III said, in part:
The [SEC] staff believes that securities with redemption
features that are “outside of the control of the issuer” include those
securities that are redeemable either based on mandatory or certain events
(for example, the death or retirement of the holder) or on uncertain events
(for example, change in control of the company, violation of specified
financial covenants, or the attainment of specific earnings or a stock
market price).
Accordingly, temporary equity classification is required if an equity instrument
must be redeemed or becomes redeemable at the election of the holder upon any
event not solely within the issuer’s control. The table below provides examples
of events that may be considered solely within and not solely within the
issuer’s control when an instrument becomes redeemable upon the occurrence of
the event. Note, however, that the determination of whether an event is within
the issuer’s control may differ from that indicated in the table depending on
the facts and circumstances. An event that would ordinarily be deemed solely
within the issuer’s control may not qualify as such if, for example, (1) the
holder controls the issuer’s decision to cause the event to occur through board
representation or other rights (see Section 9.4.4) or (2) the issuer is firmly
committed to undertaking an action that will cause the event to occur.
Solely Within the Issuer’s Control | Not Solely Within the Issuer’s Control |
|---|---|
|
|
In determining whether redemption may be required because of circumstances
outside the issuer’s control, the issuer should consider the interaction between
different contractual provisions. For example, one of the terms of an
outstanding perpetual equity share may permit the issuer to call the instrument
for a stated amount of cash at any time. By itself, such a term typically would
not cause the instrument to be classified in temporary equity (unless, for
example, the holder controls the issuer’s decision; see Section 9.4.4) since the
issuer could not be forced to exercise the call. Further, the holder may have no
right to put the instrument to the issuer for cash unless the issuer elects not
to exercise its call option by a specified date in the future. Typically, a put
right that is contingent on a discretionary decision of the issuer would not
result in temporary equity classification since the issuer could prevent the put
right from becoming exercisable. In such a scenario, however, the instrument
would be classified in temporary equity because the only event that prevents the
holder from being able to redeem the instrument is the issuer’s election to
redeem it by a certain date. In other words, either it will be redeemed by the
issuer or it will become redeemable by the holder by the specified date.
The issuer should also consider any applicable legal requirements that may affect whether redemption is within its control. For example, a provision in an instrument may require the instrument’s redemption upon the issuer’s merger with another entity. Further, state law may require approval of the issuer’s board of directors before any merger can occur. If the holders of the instrument are not able to control the board’s vote through direct representation or other rights, the decision to merge with another entity may be within the issuer’s control.
9.4.3 Redemption Features Triggered by Holder’s Death or Disability
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(g)
Certain redemptions covered by insurance
proceeds. As a limited exception that should not be
analogized to, an equity instrument that becomes
redeemable upon the death of the holder (at the option
of the holder’s heir or estateFN9) or upon
the disability of the holder is not subject to ASR 268
if the redemption amount will be funded from the
proceeds of an insurance policy that is currently in
force and which the registrant has the intent and
ability to maintain in force.
__________________________________
FN9 If an equity instrument is
required to be redeemed for cash or other assets
upon the death of the holder, the instrument is
classified as a liability pursuant to Subtopic
480-10 even if an insurance policy would fund the
redemption.
As a general rule, an equity-classified instrument that becomes redeemable for
cash or other assets upon the death or disability of the holder must be
classified in temporary equity because those events are outside the issuer’s
control (see Section
9.4.2). However, the SEC does not require temporary equity
classification if upon death or disability a redemption “will be funded from the
proceeds of an insurance policy that is currently in force,” provided that the
issuer has the intent and ability to maintain the policy in force. This guidance
does not apply to nonconvertible stock that is mandatorily (as opposed to
optionally) redeemable for cash or other assets upon the holder’s death because
ASC 480 requires liability classification for an instrument that is certain to
be redeemed. (Unlike disability, death is certain to occur; see Section 4.1.) Further, if
a nonconvertible equity instrument becomes mandatorily redeemable upon the
disability of the holder, the instrument would need to be reclassified from
equity to a liability (see Section 4.4.1).
9.4.4 Special Considerations When the Holder Has the Ability to Control Issuer Decisions
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(7)
[Examples in which temporary equity classification is
appropriate] Example 2. A preferred security
that is not required to be classified as a liability
under other applicable GAAP may have a redemption
provision that states it may be called by the issuer
upon an affirmative vote by the majority of its board of
directors. While some might view the decision to call
the security as an event that is within the control of
the company because the governance structure of the
company is vested with the power to avoid redemption, if
the preferred security holders control a majority of the
votes of the board of directors through direct
representation on the board of directors or through
other rights, the preferred security is redeemable at
the option of the holder and classification in temporary
equity is required. In other words, any provision that
requires approval by the board of directors cannot be
assumed to be within the control of the issuer. All of
the relevant facts and circumstances should be
considered.
S99-3A(10)
[Examples in which permanent equity classification is
appropriate] Example 5. A preferred security may
have a provision that the decision by the issuing
company to sell all or substantially all of a company’s
assets and a subsequent distribution to common
stockholders triggers redemption of the security. In
this case, the security would be appropriately
classified in permanent equity if the preferred
stockholders cannot trigger or otherwise require the
sale of the assets through representation on the board
of directors, or through other rights, because the
decision to sell all or substantially all of the
issuer’s assets and the distribution to common
stockholders is solely within the issuer’s control. In
other words, if there could not be a “hostile” asset
sale whereby all or substantially all of the issuer’s
assets are sold, and a dividend or other distribution is
declared on the issuer’s common stock, without the
issuer’s approval, then classifying the security in
permanent equity would be appropriate.
S99-3A(11)
Example 6. A preferred security may have a
provision that provides for redemption in cash or other
assets if the issuing company is merged with or
consolidated into another company, and pursuant to state
law, approval of the board of directors is required
before any merger or consolidation can occur. In that
case, assuming the preferred stockholders cannot control
the vote of the board of directors through direct
representation or through other rights, the security
would be appropriately classified in permanent equity
because the decision to merge with or consolidate into
another company is within the control of the issuer.
Again, all of the relevant facts and circumstances
should be considered when determining whether the
preferred stockholders can control the vote of the board
of directors.
Sometimes, equity instruments contain a stated redemption feature that is
ostensibly controlled by the issuer, such as a call option or redemption
requirement upon the issuer’s decision to undertake a specified action (e.g.,
through an affirmative vote of the majority of its shareholders or board of
directors). Even though such a feature may appear to be controlled by the
issuer, temporary equity classification is required if the instrument’s holder
(or the holders acting together as a class) has the ability to control whether
the issuer will redeem the instrument or cause the instrument to become
redeemable under the redemption feature through board representation, voting
rights, or other rights. Accordingly, an equity instrument that contains any of
the following features would be classified in temporary equity:
-
A call option permitting the issuer to call the instrument for cash when the holder controls the issuer’s decision to call the instrument through board representation or other rights.
-
A redemption feature requiring the issuer to redeem the instrument upon a vote by a majority of the holders of the instrument.
-
A redemption feature requiring the issuer to redeem the instrument upon the occurrence of a specified corporate transaction (e.g., sale of assets) if the holder controls whether the issuer will undertake the transaction through board representation or other rights.
-
A conversion feature if the holder could prevent the issuer from having a sufficient number of authorized and unissued shares available to share settle the feature (i.e., authorization of additional shares requires approval of the issuer’s board of directors and the holder controls the issuer’s board of directors). (As discussed in Section 9.4.6, share-settled features are assumed to be cash-settled if the issuer does not have a sufficient number of authorized and unissued shares to settle the feature in shares.)
-
A conversion feature that is subject to a down-round feature (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) if the holder controls the issuer’s decision to sell shares for an amount less than the currently stated conversion price and the issuer could potentially not have a sufficient number of authorized and unissued shares to settle the conversion. See also Example 9-17.
The determination of whether the holders of an equity instrument (e.g.,
convertible preferred stock) control the ability to direct corporate actions
depends on the facts and circumstances (e.g., relevant provisions of shareholder
and other agreements, contracts, and state laws). Even if the holder of an
equity-classified instrument currently has no power to direct the issuer to
redeem the instrument, an entity should consider whether the holder would obtain
such power if an event not solely within the issuer’s control were to occur.
Example 9-2
Evaluation of the Issuer’s Ability to Avoid a
Redemption of Preferred Stock
For example, a perpetual preferred share with a stated perpetual dividend rate payable in cash and a redemption feature may permit the issuer to call the instrument for cash. However, if the holder does not hold voting stock or sit on the board, and the issuer fails to pay the stated dividend on the preferred stock for four consecutive quarters, the holder will obtain the right to appoint a majority of the directors on the board and thereby direct the issuer’s decision of whether to call the share. The share would be classified in temporary equity because the issuer does not control whether it always will have sufficient cash to pay the dividend (see Section 9.4.2). If the issuer does not have sufficient cash, the holder will obtain the ability to direct the issuer’s decision of whether to call the instrument by taking control of the board.
A board of directors’ fiduciary duty under state law to act prudently and in the best interests of the company is not by itself sufficient to cause a redeemable equity instrument to be classified as permanent equity.
Example 9-3
Consideration of Fiduciary Responsibilities of a Board
of Directors
Company A has issued preferred stock that is redeemable for cash at the option of the holder (Investor B) if A’s board of directors agrees to such redemption. Under state law applicable to the preferred stock, the directors have a fiduciary responsibility to the company, which requires that they act prudently and in the best interests of the company. The board includes directors appointed by B as well as independent directors who would need to consent to any cash redemption. However, B is contractually able to replace any directors who object to a cash redemption. There are no specific contractual safeguards to protect other shareholders (e.g., there is no requirement for other shareholders to approve a redemption). In the evaluation of whether the preferred stock should be classified as temporary equity, the existence of fiduciary responsibility under state law does not take precedence over the redemption terms of the contractual agreements. Accordingly, the preferred stock should be classified as temporary equity.
Mr. Fields stated the following at the 2009 AICPA Conference on Current SEC and PCAOB Developments:
[The] SEC staff guidance on redeemable shares . . . notes that there may be situations in which control by the governance structure of an entity, such as the Board of Directors, may be insufficient to demonstrate that a settlement option is within the company’s control. These are often situations in which specific shareholders have the ability to seize control of the governance structure and require redemption of their interests in a preferential manner using another feature of the instrument. A typical example is a provision whereby a class of preferred shareholders can take control of the Board upon failure to pay dividends and thereby exercise a preexisting embedded call option on their preferred stock. Unless there were a third provision that makes the call inoperable when the preferred shareholders are in control, the shares would be classified in temporary equity because the combination of the contingent control right and the call could be used in the same manner as a put option by the preferred shareholder. Of course, whenever the analysis becomes this involved a healthy attention to appropriate disclosure is probably in order.
Connecting the Dots
As noted above, equity instruments, such as callable
preferred stock, may need to be classified in temporary equity even if
the holder or holders do not have a stated right to put (redeem) them.
In evaluating whether callable preferred stock must be classified in
temporary equity, an issuer should consider whether its holder or
holders control the decision to exercise the call option through board
representation or other voting rights provided by the preferred stock.
For example, if the agreements for callable preferred stock entitle the
holders to elect three out of five seats on the issuer’s board of
directors, the preferred stockholders control the ability to require the
issuer to redeem the preferred stock unless specific contractual
provisions exist that prevent the holders from doing so (e.g., the
contractual terms of the preferred stock stipulate that only independent
directors elected by common shareholders that are not preferred
stockholders can choose to exercise the call right in the preferred
stock).
In addition, even if the holder or holders of callable
preferred stock do not control the right to force the issuer to exercise
the call option as a result of the rights and privileges given to such
investors as a result of the ownership of the preferred stock, the
callable preferred stock may still need to be classified in temporary
equity. For example, if callable preferred stock is held by an investor
that separately holds a majority of the issuer’s common stock, the
investor can force the issuer to redeem the preferred stock unless
specific contractual provisions in the preferred stock or the entity’s
governance documents prevent the investor from doing so.
Some entities have multiple classes of outstanding equity instruments with
stated redemption features that cannot be triggered without the issuer’s
involvement (e.g., the issuer’s exercise of a call feature or its decision to
undertake a specified corporate transaction that would activate a holder put
feature). Sometimes, no single class of holders of such instruments controls the
issuer’s decision to trigger the redemption feature in any individual class of
equity instruments. However, if some or all classes of holders can force the
issuer to trigger a redemption feature in any or all classes by acting in
concert (e.g., by voting together or giving their consent), the entity should
consider whether holders of different classes would be aligned in any action to
trigger the redemption feature (e.g., by considering the dividend rights and
liquidation preferences of each class). If the holders of more than one class
are able to trigger a redemption of one or more classes by acting together and
their economic interests related to such redemptions do not conflict, temporary
equity classification is required for all classes of outstanding equity
instruments that would become subject to redemption upon such action, since the
redemption feature would be considered not solely within the issuer’s control.
Generally, this situation occurs when entities have issued multiple classes of
preferred stock. Except in rare cases, the investors in the various classes of
preferred stock do not have conflicting economic interests. As a result, if the
issuer does not control the decision to exercise an option to redeem the
preferred shares because, for example, the holders of all the classes as a group
control the majority of the representation on the entity’s board of directors,
all such classes must be classified in temporary equity.
In the absence of a stated redemption feature (regardless of whether it is
described as a call, put, liquidation, redemption, or conversion feature), an
issuer is not required to classify an instrument as temporary equity even though
the holder might be able to use its influence to compel the issuer to purchase
the instrument (e.g., through board representation or voting rights). Further,
temporary equity classification is not required, in the separate financial
statements of a subsidiary, for a redeemable equity instrument if, upon
redemption, the redemption amount will be paid by the parent and not the
subsidiary (see Section 9.3.10).
Questions sometimes arise related to whether temporary equity
classification is required for preferred securities on the basis that while the
preferred stockholders do not currently control the issuing entity’s board of
directors or vote of its stockholders, they could potentially obtain such
control by purchasing shares of common stock from third parties. The example
below addresses this scenario.
Example 9-4
Preferred Stock Redeemable at Holder’s Option Upon
Certain Events That Require Approval of the Issuing
Entity’s Board of Directors
Entity D issues preferred stock that is only redeemable,
at the option of the holders, upon (1) a merger or
consolidation for which D is a constituent party (a
“merger”) or (2) a sale of all or substantially all of
D’s assets (an “asset sale”). Both a merger and an asset
sale can occur only with approval of D’s board of
directors. The preferred security is not redeemable upon
what is often referred to in practice as a “change of
control” (which is generally outside an entity’s
control) because any redemption can occur only with
approval of D’s board of directors.
The holders of the preferred stock do not currently
control (1) D’s board of directors through direct
representation or other rights or (2) the vote on
matters submitted to D’s stockholders. Furthermore, in
accordance with the terms of the preferred stock, the
holders do not have the ability to obtain control of D’s
board of directors or the vote of D’s stockholders. The
holders of the preferred stock could only possibly
obtain control over D’s board of directors or the vote
of D’s stockholders by acquiring D’s common shares from
third-party holders (i.e., by purchasing shares from
other common stockholders that do not own the preferred
stock).
The preferred stock does not have to be
classified in temporary equity on the basis that D may
be unable to prevent the preferred stockholders from
obtaining control over D’s board of directors or the
vote of D’s stockholders by acquiring common shares of D
from third-party investors (e.g., by acquiring a
controlling interest in D’s common stock from
third-party holders of common stock). Decisions that
require approval of an entity’s board of directors are
considered to be within the issuing entity’s control
unless the holders of preferred stock (or other equity
instruments that are being evaluated for temporary
equity classification) currently control or could obtain
control of the entity’s board of directors or vote of
the entity’s stockholders through direct representation
or other contractual rights that arise from the terms of
the preferred stock instrument or any other instrument
that the preferred stockholders otherwise own. For
example, if the terms of the preferred stock allow the
preferred stockholders to obtain control of the issuing
entity’s board of directors if the entity fails to
timely pay dividends on the preferred stock, the entity
would not be able to conclude that decisions of its
board of directors are within its control because it is
outside an entity’s control to timely pay dividends. (In
that circumstance, temporary equity classification is
required.) However, an entity is not required to
consider the possibility that holders of preferred stock
(or other equity instruments) could seize control over
the entity’s board of directors or vote of its
stockholders by purchasing common stock or other
securities from third-party investors. Such a view would
result in the classification as temporary equity of all
equity securities with any redemption feature
(conditional or otherwise) that does not meet the
limited exception in ASC 480-10-S99-3A(3)(f) for deemed
liquidation events, which is inconsistent with the
application of ASC 480-10-S99-3A in practice. This view
is supported by ASC 480-10-S99-3A(7), (10), and (11).
While the above fact pattern involves
preferred stock that is redeemable upon a merger or
asset sale, which is considered to be within D’s
control, the same conclusion would apply if the
preferred stock was redeemable upon the occurrence of
other events that are within D’s control, including:
-
A call option that permits but does not require D to repurchase the instrument for cash.
-
An equity conversion feature that D has the ability to settle in common shares but can elect to settle in cash.
-
A redemption feature that requires D to redeem the instrument if D’s board of directors decides to undertake an IPO of common stock.
However, if the preferred stockholders
currently own a majority of D’s common stock and thereby
control the election of D’s board of directors,
classification of the preferred stock in temporary
equity would be required unless specific contractual
provisions support a conclusion that such holders could
not require the preferred stock to be redeemed (i.e.,
the decisions that would lead to any such redemption
must be approved by independent common stockholders or
directors appointed by those common stockholders).
9.4.5 Evaluation of Liquidation Provisions
9.4.5.1 Overview
Sometimes, a feature of an equity instrument that makes it redeemable is characterized as a liquidation provision. Even if an equity instrument (e.g., convertible preferred stock) does not contain an explicit redemption feature (i.e., a stated call option or stated put option), an entity must evaluate the instrument’s liquidation provisions to determine whether the instrument should be classified as temporary equity. The liquidation provisions applicable to an instrument may be contained in the contractual agreement or in the entity’s bylaws, shareholder agreements, charter, or certificate of incorporation. Practitioners should consider all of the pertinent agreements that contain liquidation provisions related to the instrument.
ASC 480-10-S99-3A(3)(f) distinguishes between an “ordinary” and a “deemed” liquidation and provides separate requirements for each:
- A provision whose application will result in the redemption or liquidation of an equity instrument upon an event that qualifies as an ordinary liquidation does not cause the instrument to be classified in temporary equity (see Section 9.4.5.2).
- A provision whose application will result in the redemption of an equity instrument upon an event that does not represent an ordinary liquidation (i.e., a deemed liquidation) typically causes the instrument to be classified in temporary equity (see Section 9.4.5.3) unless a narrow and limited exception applies (see Section 9.4.5.4) or the events that could trigger a liquidation are solely within the entity’s control (see Section 9.4.2).
The SEC’s Division of Corporation Finance: Frequently Requested Accounting
and Financial Reporting Interpretations and Guidance (March 31,
2001) states, in part:
[Clauses] describing [deemed liquidation] events are
commonly included in the “Liquidation” section of the preferred
stock indentures. By characterization of the provisions as
liquidation provisions, registrants have sought to avoid ASR 268
treatment. However, the staff believes that these types of
provisions are equivalent to ordinary redemption clauses that would
cause the securities to be classified outside of permanent
equity.
9.4.5.2 Ordinary Liquidation Events
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. . . .
Classification in temporary equity is not required if redemption is contingent only upon the occurrence of an ordinary liquidation event. An ordinary liquidation involves the redemption and liquidation of all of an entity’s equity instruments for cash or other assets of the entity and represents the termination, dissolution, and winding up of the entity’s affairs (i.e., the final liquidation of the issuer). ASC 205-30-20 defines a liquidation as follows:
The process by which an entity converts its assets to cash or other assets and settles its obligations with creditors in anticipation of the entity ceasing all activities. Upon cessation of the entity’s activities, any remaining cash or other assets are distributed to the entity’s investors or other claimants (albeit sometimes indirectly). Liquidation may be compulsory or voluntary. Dissolution of an entity as a result of that entity being acquired by another entity or merged into another entity in its entirety and with the expectation of continuing its business does not qualify as liquidation.
In the evaluation of whether an event qualifies as an ordinary liquidation, the following factors are typically not relevant:
- Whether the holders of the instrument have control over the entity (i.e., whether the holders can force an ordinary liquidation).
- The preference in liquidation.
- The form of consideration that will be received by the holders of the instrument.
However, entities should consider all relevant facts and circumstances in assessing the substance of the instrument’s provisions.
If an equity instrument does not contain any stated redemption features (e.g.,
call options or put options) or deemed liquidation provisions and therefore
is redeemable only upon an ordinary liquidation of the entity,
classification in temporary equity is not required even if the holders of
the instrument have control over the entity. That is, if, under the stated
terms of the instrument and other pertinent agreements (i.e., the entity’s
bylaws, shareholder agreements, charter, or certificate of incorporation),
the instrument is redeemable only upon an ordinary liquidation, temporary
equity classification is not required even if the holders of the instrument
may have the ability to effectuate a liquidation of only the instrument
(outside its contractual terms) by virtue of the holder’s control over the
entity. Any such redemption of an instrument outside its contractual terms
is a modification of the contractual terms that would be recognized only
upon its occurrence.
9.4.5.3 Deemed Liquidation Events
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(f) . . . 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. . . .
S99-3A(8)
[Examples in which temporary equity
classification is appropriate] Example 3. A
preferred security that is not required to be
classified as a liability under other applicable
GAAP may contain a deemed liquidation clause that
provides that the security becomes redeemable if the
common stockholders of the issuing company (that is,
those immediately prior to a merger or
consolidation) hold, immediately after such merger
or consolidation, common stock representing less
than a majority of the voting power of the
outstanding common stock of the surviving
corporation. This change-in-control provision would
require the preferred security to be classified in
temporary equity if a purchaser could acquire a
majority of the voting power of the outstanding
common stock without company approval, thereby
triggering redemption.
An equity instrument that includes a deemed liquidation provision is presented in temporary equity unless the limited exception discussed in Section 9.4.5.4 is met or the events that could trigger a liquidation are solely within the issuer’s control (see Section 9.4.2). A deemed liquidation encompasses the redemption and liquidation of one or more classes of an entity’s equity instruments in a transaction that does not result in the final liquidation of the entity (i.e., transactions that do not qualify as ordinary liquidation events; see Section 9.4.5.2).
The table below illustrates some examples of transactions or events that might be identified in a deemed liquidation provision.
|
Transaction or Event
|
Solely Within the Entity’s
Control?2
|
ASC 480-10-S99-3A
|
|---|---|---|
|
A change in control of the
entity
|
No. An entity cannot prevent its
equity holders from transferring a controlling
interest.
|
(3)(f) and (8)
|
|
A merger or consolidation of the
entity with or into another entity
|
It depends. If the applicable state
law requires board approval for a merger or
consolidation, such an event may be within the
entity’s control unless the board is controlled by
the instrument holder (see Section
9.4.4).
|
(8) and (11)
|
|
A sale, lease, or license of all or
substantially all of the entity’s assets
|
Yes, unless the Board is controlled
by the instrument holder (see Section
9.4.4).
|
(10)
|
|
A delisting of the entity’s
securities
|
No. An entity cannot control whether
its securities will continue to be listed.
|
(3)(f)
|
|
The entity’s compliance with a debt
covenant
|
It depends on the nature of the debt
covenant (see Section
9.4.2).
|
(3)(f) and (9)
|
|
The entity’s ability to issue a
specified monetary amount of securities (e.g., a
securities offering with proceeds in excess of a
specified dollar amount)
|
No, unless investors are already
firmly committed to purchase securities for the
specified amount.
|
N/A
|
|
The entity’s ability to have an IPO
registration statement declared effective by a
particular date
|
No. An entity cannot control whether
the SEC will declare its registration statement
effective.
|
(9)
|
|
The ability to deliver common shares
under a conversion provision
|
It depends on whether share
settlement is within the entity’s control (see
Section 9.4.6).
|
(6)
|
In certain situations, the relevant liquidation
provisions will include the entity’s definition of a deemed liquidation. For
example, the entity’s certificate of incorporation may include a provision
such as the following:
Example 9-5
Sample Deemed Liquidation Clause
Amount Payable in Mergers, etc. Upon, and in all cases subject to, the closing of (each of the following, a “Deemed Liquidation Event”): (i) any merger or consolidation of the Corporation with or into another corporation or entity (except a merger or consolidation in which the holders of capital stock of the Corporation immediately prior to such merger or consolidation continue to hold at least a majority of the voting power of the capital stock of the surviving or resulting corporation or entity following such merger or consolidation); (ii) any sale, lease, license, or transfer of all or substantially all of the Corporation’s assets or sale or exclusive license of all or substantially all of the Corporation’s intellectual property (an “Asset Sale”); or (iii) any other transaction pursuant to, or as a result of which, a single person (or group of Affiliated persons), other than holders of Preferred Stock or Common Stock prior to such transaction, acquires or holds capital stock of the Corporation representing a majority of the Corporation’s voting power, all consideration payable to the stockholders of the Corporation in connection with any such Deemed Liquidation Event, or all consideration payable to the Corporation and distributable to its stockholders, together with all other available assets of the Corporation (net of obligations owned by the Corporation that are senior to the Preferred Stock), in connection with any such Deemed Liquidation Event, shall be, as applicable, paid by the purchaser to the holders of, or distributed by the Corporation in redemption (out of funds legally available therefor) of, the Preferred Stock, in accordance with the preferences and priorities set forth above, with such preferences and priorities specifically intended to be applicable in any such Deemed Liquidation Event as if such transaction were a Liquidation Event.
In other situations, the relevant liquidation provisions do not include a
definition of, and may not explicitly refer to, a deemed liquidation.
Irrespective of whether the term “deemed liquidation” is used, however,
entities must carefully consider all relevant liquidation provisions to
distinguish ordinary liquidation events from deemed liquidation events. The
inclusion of any deemed liquidation redemption feature in an instrument
triggers temporary equity classification (unless the exception discussed in
Section
9.4.5.4 is met or the events that could trigger a redemption
are solely within the issuer’s control, as discussed in Section 9.4.2) even
if all the other redemption provisions in the instrument qualify as ordinary
liquidation provisions.
9.4.5.4 Limited Exception Applicable to Certain Deemed Liquidation Provisions
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable
Securities
S99-3A(3)(f) . . . 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).
Although deemed liquidation redemption features typically cause an instrument to be classified as temporary equity, there is a narrow and limited exception under ASC 480-10-S99-3A(3)(f) for equity instruments that are subject to a deemed liquidation provision “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).”
Given the types of deemed liquidation provisions that are common in practice,
the narrow and limited exception to temporary equity classification as a
result of a deemed liquidation does not apply to preferred securities. For
an entity to apply the exception in ASC 480-10-S99-3A(3)(f) to preferred
securities, the following two conditions must be met:
-
The agreements pertaining to the equity instrument contain a provision explicitly stating that upon a deemed liquidation event, all of the holders of equally and more subordinated equity instruments of the entity are always entitled to receive the same form of consideration (e.g., cash or shares) upon the occurrence of the event that gives rise to the redemption (i.e., all subordinate classes would also be entitled to redemption). It must also be objectively determinable under the agreements’ explicit terms that there are no possible circumstances in which the holders of equally or more subordinated equity instruments of the entity may not be entitled to receive, wholly or in proportion, the same form of consideration that the holders of the equity instrument are entitled to receive.
-
The provisions related to the same form of consideration that is payable upon the occurrence of a deemed liquidation event are substantive. If, under the terms of the agreements, the holders of the instrument can “override” a provision related to the same form of consideration, the provision regarding the form of consideration that is payable upon a deemed liquidation may not be substantive. In addition, if the amount of consideration payable to the holders of the instrument is leveraged to such an extent that there is no reasonable possibility that consideration will remain after distribution to the holders of the instrument, any explicit provisions regarding the form of consideration may be deemed nonsubstantive.
Since deemed liquidations often involve a change in control (i.e., 50 percent or more of the voting control over an entity is held by new investors, which is typically considered outside the control of the issuing entity), the relevant liquidation provisions will rarely qualify for the narrow and limited exception in ASC 480-10-S99-3A(3)(f). For that exception to apply, the provisions must clearly indicate that the holders of the instrument would be entitled to a form of consideration only on a basis that is proportionate to the consideration that each holder of equally or more subordinated equity instruments is entitled to receive.
Connecting the Dots
The conditions for meeting the deemed liquidation exception are not
the same as those for equity classification in ASC 815-40-25. An
instrument that is classified as equity under ASC 815-40-25 may not
qualify for the deemed liquidation exception. This is because in
accordance with ASC 480-10-S99-3A(3)(f), all the holders of equally
and more subordinated equity instruments of the entity must always
be entitled to receive the same form of consideration (e.g., cash or
shares) upon the occurrence of the event that gives rise to the
redemption. This requirement does not exist in ASC 815-40-25. We
have confirmed this view in informal discussions with the OCA staff.
See also Examples 9-6 and
9-7 below.
In practice, it is common for the liquidation provisions of convertible preferred stock to fall into one of three categories. That is, they often specify one of the following:
- That the holders of the convertible preferred stock are entitled to receive cash (with respect to the liquidation preference, the if-converted value, or both) upon the occurrence of a deemed liquidation event.
- That, upon the occurrence of a deemed liquidation event, all holders of each preferred share class are entitled to receive the same form of consideration, and all holders of each common share class are entitled to receive the same form of consideration, as opposed to specifying that all holders of equity instruments are entitled to receive the same form of consideration.
- The amount of consideration to which the holders of convertible preferred stock are entitled to receive upon the occurrence of a deemed liquidation event is specified, but the provisions are silent regarding the form of consideration.
In each circumstance, the convertible preferred stock should be classified in
temporary equity because the exception in ASC 480-10-S99-3A(3)(f) is
inapplicable. It would generally be inappropriate for an entity to conclude,
on the basis of an interpretation by legal counsel or consideration of
fiduciary obligations (as opposed to an explicit provision addressing the
form of consideration to be distributed to equity holders in all possible
deemed liquidation events), that a deemed liquidation provision qualifies
for the narrow and limited exception in ASC 480-10-S99-3A(3)(f). Rather, in
a manner consistent with the SEC staff’s views on the effect of a contract’s
silence on an entity’s ability to settle in unregistered shares or defer
settlement until registered shares could be delivered (see Section 5.3.2.1 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity), it is appropriate to apply this exception to
temporary equity classification only when there is language in the pertinent
agreements that explicitly provides for the distribution of consideration to
equity holders upon the occurrence of a deemed liquidation event in the
manner described above.
Note that shares of the most subordinate class of equity
instruments (e.g., common stock) are generally not classified as temporary
equity because, other than in a final liquidation of the issuing entity,
they typically do not contain any redemption features.
Example 9-6
Convertible
Preferred Stock — Holders Entitled to Full Cash
Settlement Upon a Change in Control
Entity A has issued preferred stock that the holder
may elect to convert into shares of A’s common stock
at any time. Upon conversion, A must deliver a
number of common shares equal to the greater of (1)
the liquidation preference divided by a fixed
conversion price (a conversion feature) or (2) the
liquidation preference divided by the current fair
value of A’s common stock subject to a cap on the
maximum number of shares deliverable (a
share-settled redemption feature). The liquidation
preference is a stated amount plus unpaid cumulative
dividends.
The convertible preferred stock agreement specifies
that in the event of a change in control of A in
which the consideration paid for A’s common stock is
only cash, the holders of the convertible preferred
stock are entitled to receive cash for all the
common shares that would otherwise be issuable
according to the stated conversion terms described
above. That is, in a change in control, the holders
of the convertible preferred stock are “cashed out”
for all their convertible preferred shares on the
basis of the stated conversion terms described
above. A change of control includes any transaction
or series of related transactions in which a person
or group of related persons acquires capital stock
of A that represents more than 50 percent of the
voting power of A. Entity A has determined that it
does not control the ability to avoid a change in
control.
The convertible preferred stock must be classified in
temporary equity for the following reasons:
- It is redeemable for cash upon a change in control, which is outside of A’s control.
- The settlement provision in the event of a change in control does not qualify for the narrow and limited exception in ASC 480-10-S99-3A(3)(f) for deemed liquidation events. This is because a change in control can involve less than all of A’s common stock (the most residual class of shares), in which case all of A’s common stockholders are not entitled to receive cash for their shares.
Entity A is required to classify the convertible
preferred stock in temporary equity even if the
settlement provision discussed above would meet the
equity classification conditions in ASC 815-40-25
(i.e., it would qualify for the exception in ASC
815-40-55-5, which is discussed in Section 5.2.3.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
Example 9-7
Convertible
Preferred Stock — Holders Not Entitled to Full
Cash Settlement Upon a Change in Control
Entity B has issued preferred stock
that the holder may elect to convert into shares of
B’s common stock at any time. Upon conversion, B
must deliver a number of common shares equal to the
greater of (1) the liquidation preference divided by
a fixed conversion price (a conversion feature) or
(2) the liquidation preference divided by the
current fair value of B’s common stock subject to a
cap on the maximum number of shares deliverable (a
share-settled redemption feature). The liquidation
preference is a stated amount plus unpaid cumulative
dividends.
The convertible preferred stock
agreement specifies that in the event of a change in
control of B in which the consideration paid for B’s
common stock is only cash, the holders of the
convertible preferred stock are entitled to receive
common shares according to the stated conversion
terms described above by electing to convert their
convertible preferred shares into common stock
immediately before the consummation of the change in
control. Electing this conversion would not ensure
that the convertible preferred stockholders would
receive cash for their shares because the
convertible preferred stockholders do not have
priority over the common stockholders regarding the
receipt of cash in a change in control. A change of
control includes any transaction or series of
related transactions in which a person or group of
related persons acquires capital stock of B that
represents more than 50 percent of the voting power
of B. Entity B has determined that it does not
control the ability to avoid a change in
control.
Assuming that there are no other
features that result in temporary equity
classification, B would not be required to classify
the convertible preferred stock instrument in
temporary equity for the following reasons:
- The holders of the convertible preferred stock do not have priority over other common stockholders regarding the receipt of cash in a change in control. Rather, after converting their shares into common stock immediately before the change in control, the holders of the convertible preferred stock would have the same rights as all other holders of B’s common stock (i.e., they would “stand in line” and participate with all other common stockholders regarding the receipt of cash for their shares in a change in control). Therefore, in a change in control that involves less than all of B’s common shares, the holders of the convertible preferred stock would not be entitled to receive cash for all of their convertible preferred shares.
- The settlement provision in the event of a change in control is not subject to evaluation under the narrow and limited exception for deemed liquidation events in ASC 480-10-S99-3A(3)(f). This is because the convertible preferred stock is merely converted into common shares before a change in control according to the stated conversion terms described above. (Note that the settlement provision in this example only allows the convertible preferred stockholders to elect to convert their shares into common stock solely on the basis of whether the change in control is complete.)
9.4.5.5 Convertible Preferred Stock With a Liquidation Provision Upon a Change in Control
Example 9-8
Convertible Preferred Stock That Contains a Deemed
Liquidation Provision
Company X, an SEC registrant, has issued convertible
preferred stock. As part of the preferred stock
agreement, the investors in preferred stock are
entitled to a liquidation preference upon any
voluntary or involuntary liquidation, dissolution,
or winding down of X. The agreement defines
liquidation as including mergers, reorganizations,
transfers of a majority of the voting rights of
outstanding common stock, and other transactions
that result in a change in control and would not
cause the legal dissolution of X with the redemption
and liquidation of all of its outstanding equity
securities.
Further, X’s ordinary equity
securities do not become redeemable upon a change in
control. The investors in the preferred stock do not
control the board’s vote, and the board does not
have to approve a change of control. Company X has
determined that the convertible preferred stock is
not required to be accounted for as a liability
under ASC 480 and that it contains no embedded
feature that requires bifurcation as a derivative
instrument under ASC 815-15.
In this scenario, the convertible
preferred stock would be classified as temporary
equity. Under the temporary equity guidance, X must
assess whether the preferred stock is redeemable
upon the occurrence of an event that is not solely
within its control. Redemption is not solely within
X’s control because a purchaser could acquire a
majority of the voting power of the outstanding
common stock without company approval, thereby
giving the preferred shareholders a right to require
redemption of their preferred shares. A change in
control is considered outside the control of the
issuer even if the preferred shareholders do not
control the shareholder vote. The liquidation
feature does not qualify as an “ordinary
liquidation” feature because a change in control
will not result in the legal dissolution of X with
the redemption and liquidation of all of its
outstanding equity securities.
Under the “deemed liquidation exemption” (see
Section
9.4.5.4), upon the occurrence of the
event that gives rise to the redemption (change in
control), if one or more classes of equity security
become redeemable, all of the holders of equally and
more subordinated equity securities of the entity
would need to be entitled to the same form of
consideration. Company X’s preferred securities do
not qualify for this exemption because its ordinary
securities do not become redeemable in the event of
a change in control.
A preferred stock agreement’s provision for redemption of the preferred security
if the issuing company is merged with another company may not by itself
trigger classification of the preferred stock outside of permanent equity.
If state law requires approval of the board of directors before any merger
can occur, and preferred stockholders cannot control the board’s vote
through direct representation or other rights, the decision to merge with
another company may be within the control of the issuer. See also Examples 9-6 and
9-7.
9.4.6 Features That the Issuer Must or May Settle in Its Equity Shares
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(6)
[Examples in which temporary equity classification is
appropriate] Example 1. A preferred security
that is not required to be classified as a liability
under other applicable GAAP may be redeemable at the
option of the holder or upon the occurrence of an event
that is not solely within the control of the issuer.
Upon redemption (in other than a liquidation event that
meets the exception in paragraph 3(f)), the issuer may
have the choice to settle the redemption amount in cash
or by delivery of a variable number of its own common
shares with an equivalent value. For this instrument,
the guidance in Section 815-40-25 should be used to
evaluate whether the issuer controls the actions or
events necessary to issue the maximum number of common
shares that could be required to be delivered under
share settlement of the contract. If the issuer does not
control settlement by delivery of its own common shares
(because, for example, there is no cap on the maximum
number of common shares that could be potentially
issuable upon redemption), cash settlement of the
instrument would be presumed and the instrument would be
classified as temporary equity.
The redeemable-equity guidance applies to equity instruments that are redeemable for cash or other assets in circumstances not under the sole control of the issuer. It does not apply to equity-classified instruments that require or permit the issuer to settle a redemption feature in its equity shares as long as (1) those shares qualify as permanent equity and (2) the issuer could not be forced to deliver cash or other assets to settle the feature. (If the obligation is unconditional, liability classification may be required for the share under ASC 480-10-25-14 even if the issuer has the right and is able to settle the redemption obligation in a variable number of its equity shares; see Chapter 6.)
An equity-classified instrument may specify that the issuer must or may settle a
redemption feature in its equity shares (e.g., because the contract permits the
issuer to settle the feature in either cash or shares of equivalent value). If
those shares qualify as permanent equity (see Section 9.4.7), ASC 480-10-S99-3A(6)
requires the issuer to evaluate whether it has the ability to settle the
instrument in its equity shares. If the issuer could ever be forced to cash
settle the feature (e.g., because of the lack of a share cap in the contract),
the equity instrument should be classified as temporary equity even if the
contract ostensibly requires or permits the issuer to settle in its equity
shares. (See Section
9.4.9 for guidance on evaluating whether an issuer could be
forced to cash settle a share-based payment arrangement within the scope of ASC
718.)
In evaluating whether it controls the ability to share settle a redemption or
another feature, an entity should consider all facts and circumstances,
including but not limited to the equity classification conditions in ASC
815-40-25. The issuer should reassess whether it could be forced to cash settle
the feature under ASC 815-40 as of each balance sheet date and whenever
circumstances change.
Further, the issuer should evaluate whether it controls the ability to share
settle a feature irrespective of whether it is described as a redemption feature
or a conversion feature (including a conversion feature that requires the issuer
to deliver a fixed number of equity shares upon conversion). For example, a
perpetual convertible preferred share may have no explicit redemption feature.
Upon the holder’s election to convert the preferred stock into common stock, the
issuer may be required to deliver a variable number of equity shares that is
determined by using a formula. There is no contractual cap on the number of
common shares that the issuer could be required to deliver. Because the contract
contains no explicit share limit, the issuer must assume that it might be forced
to cash settle the conversion feature in accordance with the accounting analysis
under ASC 815-40-25. Accordingly, the preferred stock would be classified in
temporary equity. (See Section 5.3.4 of Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity for further discussion.)
Speaking before the 2000 AICPA Conference on Current SEC Developments, Mr. Ragone provided the following example:
A company issues preferred stock that is redeemable for common shares upon receipt by the company of a conversion notice from the holders of the preferred securities. The legal agreements state that if the company is unable to fully convert the preferred shares into common stock, it would be required to redeem the securities for cash. That is, if the company does not have enough shares authorized to convert the preferred securities to common stock, the company would be required to deliver cash. Further assume that as of the preferred stock issuance date, there were not enough shares authorized to convert the preferred stock to common stock and that a shareholder meeting would be required to authorize additional shares. . . .
The staff believes that the requirement to obtain shareholder approval to authorize additional shares is outside of the control of the issuer. The staff therefore would conclude that because the redemption of the preferred security for cash could be triggered by an event that is outside of the control of the issuer, the preferred securities would be required to [be] classified outside of permanent equity.
Changing Lanes
Before ASC 815-40-25 was amended by ASU 2020-06,
an equity-linked instrument could not be classified in stockholders’
equity unless the following conditions were met:
-
The contract permitted the entity to settle it in unregistered shares.
-
No counterparty rights ranked higher than shareholder rights.
-
There was no requirement in the contract for the issuing entity to post collateral at any point for any reason.
Even though these conditions no longer need to be met for an
equity-linked instrument to qualify as equity under ASC 815-40, a
contract that does not satisfy any of them would generally need to be
classified as temporary equity. For example, assume that an entity must
settle a convertible preferred stock instrument in shares of common
stock that are registered for resale. Since the entity does not control
the ability to issue registered shares, temporary equity classification
is required for this instrument. That is, in the absence of preclearance
with the SEC, an entity should classify a contract as temporary equity
if it does not meet one of the three conditions in ASC 815-40-25 that
ASU 2020-06 removed.
9.4.7 Features That the Issuer Must or May Settle in Redeemable Instruments
Sometimes an outstanding equity share does not contain any redemption feature
that meets the temporary equity classification criteria except that it is
convertible or exchangeable — at the election of the holder or upon the
occurrence of an event that is not solely within the control of the issuer or at
a fixed or determinable date — into an instrument that contains such a
redemption feature (e.g., a redeemable share or a debt instrument). If the
issuer cannot prevent the conversion or exchange, the currently outstanding
equity share should be classified as temporary equity because the conversion or
exchange feature makes the instrument redeemable.
For example, a class of nonredeemable preferred shares (Series A) may be
convertible, at the holder’s option, into a different class of preferred shares
(Series B) that are redeemable in cash, at the holder’s option, upon an event
that is outside the issuer’s control. Even though the Series A shares — when
viewed in isolation — do not contain an explicit redemption feature, the issuer
cannot prevent the holder from converting the Series A shares into Series B
shares, which do contain a redemption feature that meets the temporary equity
classification criteria. Accordingly, the Series A shares are classified as
temporary equity.
9.4.8 Convertible Debt Instruments Separated Into Liability and Equity Components
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(e)
Convertible debt instruments that contain a
separately classified equity component. Other
applicable GAAP may require a convertible debt
instrument to be separated into a liability component
and an equity component.FN8 In these
situations, the equity-classified component of the
convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can
be required to settle the convertible debt instrument
for cash or other assets (that is, the instrument is
currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether
the convertible debt instrument will become redeemable
or convertible for cash or other assets at a future date
should not be made. For example, a convertible debt
instrument that is not redeemable at the balance sheet
date but could become redeemable by the holder of the
instrument in the future based on the passage of time or
upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet
date.
__________________________________
FN8 See Subtopics 470-20 and 470-50;
and Paragraph 815-15-35-4.
The SEC’s temporary equity guidance applies to the equity-classified component
of convertible debt instruments that are separated into liability and equity
components (see Section
9.3.5), only if the instruments are currently redeemable as of
the balance sheet date. A convertible debt instrument is currently redeemable if
the issuer could be forced to settle all or part of the instrument in cash or
other assets upon a redemption or conversion as of the balance sheet date. For
instance, an instrument would be considered currently redeemable if it contains
a cash-settled embedded put option that permits the holder to redeem the
instrument at any time or if the instrument is convertible as of the balance
sheet date and the issuer could be required to settle all or part of its
obligation in cash upon conversion (e.g., if the issuer has an obligation upon
conversion to pay the principal amount in cash and the excess conversion spread
in shares).
If a convertible debt instrument is not currently redeemable, the instrument is
exempt from the scope of the temporary equity guidance under ASC
480-10-S99-3A(3)(e) even if the equity component meets the temporary equity
classification criteria (e.g., because the instrument will become redeemable as
of a specified date in the future or is redeemable upon the occurrence of an
uncertain future event that is not solely within the control of the issuer; see
Section 9.4.1).
The special guidance described in ASC 480-10-S99-3A(3)(e) applies only to
convertible debt instruments (i.e., it does not apply to convertible preferred
securities that are classified in equity).
Connecting the Dots
Convertible debt instruments will have a separately
recognized equity component when (1) they are issued at a substantial
premium, (2) they are modified or exchanged in a transaction that does
not qualify as an extinguishment for accounting purposes and there is an
increase in the fair value of the embedded conversion option, and (3) an
embedded conversion option must no longer be bifurcated under ASC
815-15-25-1.
9.4.9 Share-Based Payment Arrangements
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(d)
Share-based payment awards. Equity-classified
share-based payment arrangements with employees are not
subject to ASR 268 due solely to either of the
following:
-
Net cash settlement would be assumed pursuant to Paragraphs 815-40-25-11 through 25-16 solely because of an obligation to deliver registered shares.FN7
-
A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s statutory tax withholding requirements (as discussed in Paragraph 718-10-25-18).
__________________________________
FN7 See footnote 84 of Section
718-10-S99.
SEC Staff Accounting Bulletins
SAB Topic 14.E, FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain
Redeemable Financial Instruments [Reproduced in ASC
718-10-S99-1.]
Certain financial instruments awarded in
conjunction with share-based payment arrangements have
redemption features that require settlement by cash or
other assets upon the occurrence of events that are
outside the control of the issuer.FN77 FASB
ASC Topic 718 provides guidance for determining whether
instruments granted in conjunction with share-based
payment arrangements should be classified as liability
or equity instruments. Under that guidance, most
instruments with redemption features that are outside
the control of the issuer are required to be classified
as liabilities; however, some redeemable instruments
will qualify for equity classification.FN78
SEC Accounting Series Release No. 268, Presentation in
Financial Statements of “Redeemable Preferred Stocks,”
FN79 (“ASR 268”) and related
guidanceFN80 address the classification
and measurement of certain redeemable equity
instruments.
Facts: Under a
share-based payment arrangement, Company F grants to an
employee shares (or share options) that all vest at the
end of four years (cliff vest). The shares (or shares
underlying the share options) are redeemable for cash at
fair value at the holder’s option, but only after six
months from the date of share issuance (as defined in
FASB ASC Topic 718). Company F has determined that the
shares (or share options) would be classified as equity
instruments under the guidance of FASB ASC Topic 718.
However, under ASR 268 and related guidance, the
instruments would be considered to be redeemable for
cash or other assets upon the occurrence of events
(e.g., redemption at the option of the
holder) that are outside the control of the issuer.
Question 1:
While the instruments are subject to FASB ASC Topic 718,
is ASR 268 and related guidance applicable to
instruments issued under share-based payment
arrangements that are classified as equity instruments
under FASB ASC Topic 718?
Interpretive
Response: Yes. The staff believes that
registrants must evaluate whether the terms of
instruments granted in conjunction with share-based
payment arrangements that are not classified as
liabilities under FASB ASC Topic 718 result in the need
to present certain amounts outside of permanent equity
(also referred to as being presented in “temporary
equity”) in accordance with ASR 268 and related
guidance.FN81
When an instrument ceases to be subject
to FASB ASC Topic 718 and becomes subject to the
recognition and measurement requirements of other
applicable GAAP, the staff believes that the company
should reassess the classification of the instrument as
a liability or equity at that time and consequently may
need to reconsider the applicability of ASR 268.
__________________________________
FN77 The terminology “outside the
control of the issuer” is used to refer to any of
the three redemption conditions described in Rule
5-02.28 of Regulation S-X that would require
classification outside permanent equity. That rule
requires preferred securities that are redeemable
for cash or other assets to be classified outside
of permanent equity if they are redeemable (1) at
a fixed or determinable price on a fixed or
determinable date, (2) at the option of the
holder, or (3) upon the occurrence of an event
that is not solely within the control of the
issuer.
FN78 FASB ASC paragraphs 718-10-25-6
through 718-10-25-19A.
FN79 ASR 268, July 27, 1979, Rule
5-02.27 of Regulation S-X.
FN80 Related guidance includes EITF
Topic No. D-98, Classification and Measurement
of Redeemable Securities, included in the FASB
ASC paragraph 480-10-S99-3A.
FN81 Instruments granted in
conjunction with share-based payment arrangements
with employees that do not by their terms require
redemption for cash or other assets (at a fixed or
determinable price on a fixed or determinable
date, at the option of the holder, or upon the
occurrence of an event that is not solely within
the control of the issuer) would not be assumed by
the staff to require net cash settlement for
purposes of applying ASR 268 in circumstances in
which FASB ASC Section 815-40-25, Derivatives and
Hedging — Contracts in Entity’s Own Equity —
Recognition, would otherwise require the
assumption of net cash settlement. See FASB
ASC paragraph 815-40-25-11 (See FASB ASC
paragraph 815-10-65-1 for the transition and
effective date information related to FASB ASU No.
2020-06, Debt — Debt With Conversion and Other
Options (Subtopic 470-20) and Derivatives and
Hedging — Contracts in Entity’s Own Equity
(Subtopic 815-40): Accounting for Convertible
Instruments and Contracts in an Entity’s Own
Equity, which superseded FASB ASC paragraph
815-40-25-11.), which states, in part: “ . . . the
events or actions necessary to deliver registered
shares are not controlled by an entity and,
therefore, except under the circumstances
described in FASB ASC paragraph 815-40-25-16, if
the contract permits the entity to net share or
physically settle the contract only by delivering
registered shares, it is assumed that the entity
will be required to net cash settle the contract.”
See also FASB ASC subparagraph
718-10-25-15(a).
The SEC has provided certain exceptions to the guidance in ASC 480-10-S99-3A on
determining whether share-based payment arrangements within the scope of ASC 718
should be classified as temporary equity. Specifically, temporary equity
classification is not required for such arrangements when:
-
“Net cash settlement would be assumed . . . solely because of an obligation to deliver registered shares.”
-
“A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s . . . statutory tax withholding requirements.”
These exceptions cease to apply when an arrangement is no longer within the
scope of ASC 718 (see Section
9.3.9). See Deloitte’s Roadmap Share-Based Payment Awards for
further discussion.
9.4.10 Classification of ESOP Shares Within Temporary Equity
9.4.10.1 Outstanding Shares
ASC 480-10-S99-3A(2) requires that equity securities be classified in temporary equity if they are redeemable at the option of the holder or upon the occurrence of an event not solely within the issuer’s control. Thus, shares of common stock or convertible preferred stock held by an ESOP, whether nonleveraged or leveraged, that are redeemable at the option of the participant or upon any event outside the sponsor’s control must be classified within temporary equity.
The shares of stock held by an ESOP may meet the requirements for classification in temporary equity because of various redemption features and terms. As discussed in EITF Issue 89-11, a sponsor of an ESOP is required to provide participants with a put option on their shares of stock when those shares are not readily tradable. EITF Issue 89-11 states, in part:3
Under federal income tax regulations, employer securities (such as convertible preferred stock) that are held by participants in an employee stock ownership plan (ESOP) and that are not readily tradeable on an established market must include a put option. The put option is a right to demand that the sponsor redeem shares of employer stock held by the participant for which there is no market for an established cash price. The employer may have the option to issue marketable securities for all or a portion of that option rather than to pay cash. The provisions of the ESOP may permit the ESOP to substitute for the sponsor as buyer of the employer stock; however, in no case can the sponsor require the ESOP to assume the obligation for the put option.
ASC 718-40-25-2 also discusses this put option requirement and other situations in which sponsors must repurchase shares of stock held by participants that withdraw their shares. ASC 718-40-25-2 states:
Regardless of whether an employee stock ownership plan is leveraged or nonleveraged, employers are required to give a put option to participants holding employee stock ownership plan shares that are not readily tradable, which on exercise requires the employer to repurchase the shares at fair value. Public entity sponsors sometimes offer cash redemption options to participants who are eligible to withdraw traded shares from their accounts, which on exercise requires the employer to repurchase the shares at fair value. Employers shall report the satisfaction of such option exercises as purchases of treasury stock.
In addition to the situations described above, shares of stock held by an ESOP may be redeemable as a result of various other features and terms, including, but not limited to, the following:
- Shares of convertible preferred stock held by the ESOP may be redeemable upon the occurrence of a change of control or another deemed liquidation event involving the sponsor.
- The sponsor may not have sufficient authorized and unissued shares of common stock to satisfy the conversion of convertible preferred stock. For example, upon withdrawal, the holder may be entitled to receive a variable number of shares of common stock based on a minimum stated value without any stated cap on the maximum number of shares of common stock that may need to be delivered. In the absence of a stated cap on the number of shares of common stock that must be delivered, the sponsor does not control the ability to deliver shares of common stock to satisfy such settlement requirements.
Connecting the Dots
The plan documents for an ESOP that holds common stock listed on a stock
exchange may contain a stated put option that becomes operable only
if the sponsor’s shares of common stock are no longer readily
tradable (e.g., the shares are delisted from the stock exchange). In
these situations, temporary equity classification of the shares of
common stock held by the ESOP is required because it is not within
an entity’s control to maintain the readily tradable status of its
common stock. However, when the plan documents for an ESOP that
holds common stock listed on a stock exchange do not contain a
stated put option in the event that the sponsor’s shares of common
stock are no longer readily tradable, additional consideration is
necessary. In these situations, the sponsor does not control the
ability to maintain the listing of its shares of common stock on a
stock exchange. If the sponsor’s shares of common stock are
delisted, they would no longer be considered readily tradable and
put options would be issued to ESOP participants or their
beneficiaries. However, an entity is not required to classify those
shares of common stock in temporary equity if the sponsor has not
yet legally conveyed a put option to the ESOP participants or their
beneficiaries and if, upon receipt of a delisting notice or another
event that would cause the sponsor’s shares to no longer be readily
tradable, the sponsor has the unilateral ability to (1) terminate
the ESOP, (2) accelerate the vesting of all shares of common stock
held by the ESOP, and (3) distribute all the shares of common stock
held by the ESOP participants or their beneficiaries before the
sponsor’s shares become no longer readily tradable. That is, if the
holder of the shares does not have a current redemption right and
the sponsor controls the ability to avoid the holder’s redemption of
the shares of common stock back to the sponsor under all
circumstances (i.e., the sponsor controls the ability to effect a
plan termination, which would avoid its requirement to provide a
redemption option to the holders), temporary equity classification
of the common stock held by the ESOP is not required. Note that
entities must carefully evaluate the facts and circumstances to
determine whether ESOP shares must be classified in temporary
equity. As part of this evaluation, it may be necessary to legally
interpret certain ERISA and IRC provisions related to the
requirement to provide put options on shares that are not readily
tradable.
In accordance with ASC 718-40-45-9, all shares held by a
nonleveraged ESOP are treated as outstanding except the suspense account
shares of a pension reversion ESOP, which are not treated as outstanding
until they are committed to be released for allocation to participant
accounts. Further, in accordance with ASC 718-40-45-3, shares held by a
leveraged ESOP that have either been allocated or committed for release (on
the basis of debt service payments) should be considered outstanding.
However, when shares of stock held by an ESOP are redeemable (i.e., subject
to a put option or other redemption upon the occurrence of events outside
the sponsor’s control), the sponsor must classify all such shares in
temporary equity. The SEC’s guidance does not distinguish between allocated
and unallocated shares. See Section 9.4.10.2 for discussion of
classification of the contra-equity account related to unearned ESOP shares.
This guidance would also apply to nonleveraged ESOPs with suspense pension
reversion shares.
Connecting the Dots
For both nonleveraged and leveraged ESOPs, the vested status of shares of stock held by the ESOP is not relevant to the classification of such shares within temporary equity.
9.4.10.2 Classification of Unearned ESOP Shares of Leveraged ESOP
When the outstanding shares of stock of a leveraged ESOP must be classified in temporary equity, it is also appropriate to classify all or a portion of the related contra-equity account for unearned ESOP shares in temporary equity. Although not codified, EITF Issue 89-11 states, in part:
The Task Force reached a consensus that when ASR 268 (as presented in Section 211 of the “Codification of Financial Reporting Policies”) requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section of the sponsor’s balance sheet (sometimes described as loan to ESOP or deferred compensation), if any, should be similarly classified.
Footnotes
2
The entity’s specific facts
and circumstances may affect this determination
(see Section
9.4.2).
3
Although not codified, the guidance in EITF Issue 89-11 is still relevant.
9.5 Measurement
9.5.1 Initial Measurement
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule
5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts
reported as stockholders’ equity, and that their
redemption amounts are to be shown on the face of the
balance sheet. However, the Commission’s rules and
regulations do not address the carrying amount at which
redeemable preferred stock should be reported, or how
changes in its carrying amount should be treated in
calculations of earnings per share . . . .
Question 1: How
should the carrying amount of redeemable preferred stock
be determined?
Interpretive
Response: The initial carrying amount of
redeemable preferred stock should be its fair value at
date of issue. . . .
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12)
Initial measurement. The SEC staff believes the
initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows:
FN12 . . . .
__________________________________
FN12 SAB Topic 3C, Redeemable
Preferred Stock, states that the initial
carrying amount of redeemable preferred stock
should be its fair value at date of issue. The SEC
staff believes this guidance should also be
applied to other similar redeemable equity
instruments. Consistent with Paragraph
820-10-30-3, the transaction price will generally
represent the initial fair value of the equity
instrument when the issuance occurs in an
arm’s-length transaction with an unrelated party
and there are no other unstated rights or
privileges.
When an equity instrument subject to the temporary equity guidance is first
recognized, it is initially measured at its fair value at issuance unless an
exception applies. This measurement requirement applies irrespective of whether
the redemption value is higher or lower than fair value. ASC 820 contains
guidance on measuring fair value. In many cases, the transaction price (the
proceeds received at issuance) will equal the initial fair value (see ASC
820-10-30-2 through 30-6). ASC 820-10-30-3A discusses circumstances in which the
transaction price might not equal fair value at initial recognition (e.g.,
related-party transactions and forced transactions).
For example, an entity may issue a preferred stock instrument for net proceeds of $1,000, which equals its issuance-date fair value. If the instrument contains a redemption feature that permits the holder to put the instrument to the issuer at any time for cash of $950, the amount initially presented in temporary equity is $1,000 even though the redemption value is $950.
Exceptions to the requirement to measure an instrument classified as temporary
equity initially at fair value include the following:
-
An equity host that remains after the bifurcation of an embedded derivative (see Section 9.5.6).
-
Equity-classified components of convertible debt (see Section 9.5.7).
-
An equity instrument issued with another freestanding financial instrument (see Section 9.5.9).
-
Noncontrolling interests (see Section 9.5.10).
-
Equity securities held by ESOPs (see Section 9.5.11).
-
Share-based payment arrangements (see Section 9.5.12).
Further, it would generally be appropriate for an entity to deduct, from the
related proceeds, specific incremental costs that are directly attributable to
the issuance of an instrument classified in temporary equity when the entity
initially measures the instrument at fair value, because SAB Topic 5.A
(reproduced in ASC 340-10-S99-1) states, in part:
Specific incremental costs directly attributable to a
proposed or actual offering of securities may properly be deferred and
charged against the gross proceeds of the offering.
Further, AICPA Technical Q&As Section 4110.01 states, in part:
Direct costs of obtaining capital by issuing stock should be deducted from the related proceeds, and the net amount recorded as contributed stockholders’ equity. . . . Such costs should be limited to the direct cost of issuing the security. Thus, there should be no allocation of officers’ salaries, and care should be taken that legal and accounting fees do not include any fees that would have been incurred in the absence of such issuance.
See Section 3.3.4.4 for further discussion of what qualifies as an issuance cost.
9.5.2 Subsequent Measurement
9.5.2.1 Overview
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(13)
Subsequent measurement. The SEC staff’s views
regarding the subsequent measurement of a redeemable
equity instrument that is subject to ASR 268 are
included in paragraphs 14–16. Paragraphs 14 and 15
discuss the general views regarding subsequent
measurement. Paragraph 16 discusses the application
of those general views in the context of certain
types of redeemable equity instruments.
S99-3A(14) If an equity
instrument subject to ASR 268 is currently
redeemable (for example, at the option of the
holder), it should be adjusted to its maximum
redemption amount at the balance sheet date. . .
.
S99-3A(15) If an equity
instrument subject to ASR 268 is not currently
redeemable (for example, a contingency has not been
met), subsequent adjustment of the amount presented
in temporary equity is unnecessary if it is not
probable that the instrument will become redeemable.
If it is probable that the equity instrument will
become redeemable (for example, when the redemption
depends solely on the passage of time), the SEC
staff will not object to either of the following
measurement methods provided the method is applied
consistently:
-
Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
-
Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
S99-3A(17)
Application of the fair value option.
Measurement of a redeemable equity instrument (or
host contract) subject to ASR 268 at fair value
through earnings in lieu of the measurement guidance
provided in paragraphs 14–16 is not
appropriate.FN16
__________________________________
FN16 Paragraph 825-10-15-5(f)
prohibits the election of the fair value option
for financial instruments that are, in whole or in
part, classified in stockholder’s equity
(including temporary equity).
While the probability that an instrument will become redeemable does not affect
its classification as temporary equity (see Section 9.4.1), such probability may
affect the instrument’s subsequent measurement. Unless an exception applies,
the measurement of an instrument classified as temporary equity after
initial recognition differs depending on whether, as of the balance sheet
date, (1) the instrument is currently redeemable or, if it is not currently
redeemable, (2) it is probable that the instrument will become redeemable.
The table below provides an overview of the subsequent measurement
requirements that apply in each circumstance.
Circumstance | Subsequent Measurement |
|---|---|
The instrument is currently redeemable. | Maximum redemption amount (i.e., the current redemption value) subject to a floor equal to the initial carrying amount. |
The instrument is not currently redeemable, but it is probable that the instrument will become redeemable in the future (e.g., as a result of the passage of time). | Accounting policy choice between (1) accreted redemption value and (2) current redemption value. In both cases, the measurement is subject to a floor equal to the initial carrying amount. |
The instrument is not currently redeemable, and it is not probable that the instrument will become redeemable in the future. | Not required to be remeasured. |
As of each balance sheet date and on an ongoing basis, the issuer reassesses
whether the instrument is currently redeemable or it is probable that it
will become redeemable. The issuer may need to exercise significant judgment
in determining whether it is probable that the security will become
redeemable and must consider all relevant information. See Section 9.5.4 for additional discussion of
the assessment of whether it is probable that a security will become
redeemable.
If the instrument is not currently redeemable, but it is probable that the instrument will become redeemable, the SEC staff expects consistent application of the accounting method selected (i.e., measurement either at the accreted redemption value or the current redemption value), along with appropriate disclosure of the selected policy in the footnotes to the financial statements. In addition, entities that elect to “accrete changes in the redemption amount” over the period from the date of issuance to the earliest redemption date must disclose the “redemption amount of the equity instrument as if it were currently redeemable” (see Section 9.8.2).
Adjustments to the carrying amount of instruments classified as temporary equity
are recognized as a deemed dividend against retained earnings or, in the
absence of retained earnings, paid-in capital (see Section 9.5.5).
Special considerations apply to preferred stock with a stated dividend rate
that increases over time (see Section 9.5.2.6).
Exceptions to the subsequent-measurement guidance apply to:
- Equity-classified components of convertible debt (see Section 9.5.7).
- Noncontrolling interests (see Section 9.5.10).
- Equity securities held by ESOPs (see Section 9.5.11).
- Share-based payment arrangements (see Section 9.5.12).
In accordance with ASC 480-10-S99-3A(17) and ASC 825-10-15-5(f), an issuer may not elect to measure an instrument presented in temporary equity at fair value with changes in fair value recognized in earnings.
9.5.2.2 Current Redemption Value
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(14) If an equity
instrument subject to ASR 268 is currently
redeemable (for example, at the option of the
holder), it should be adjusted to its maximum
redemption amount at the balance sheet date. 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). The redemption amount at
each balance sheet date should also include amounts
representing dividends not currently declared or
paid but which will be payable under the redemption
features or for which ultimate payment is not solely
within the control of the registrant (for example,
dividends that will be payable out of future
earnings).FN13
S99-3A(15) . . . If it is
probable that the equity instrument will become
redeemable (for example, when the redemption depends
solely on the passage of time), the SEC staff will
not object to . . . the following measurement
[method] provided the method is applied
consistently: . . .
b. Recognize changes in the redemption value
(for example, fair value) immediately as they
occur and adjust the carrying amount of the
instrument to equal the redemption value at the
end of each reporting period. This method would
view the end of the reporting period as if it were
also the redemption date for the instrument.
__________________________________
FN13 See also Section
260-10-45.
Subsequent measurement at the current redemption value (subject to a floor equal to the initial carrying amount) is required if the instrument is currently redeemable. If it is probable that the instrument will become redeemable, however, such subsequent measurement is elective (as one of two permissible accounting policy options).
The current redemption value is the maximum amount payable if redemption were to
occur as of the balance sheet date (see Section 9.5.6 for a discussion of how
to adjust the measurement for any host contract classified as temporary
equity with a bifurcated derivative). The current redemption value includes
any currently accumulated, undeclared dividends that the issuer would be
required to pay upon a redemption; however, it excludes discretionary,
undeclared dividends irrespective of whether the issuer expects or intends
to pay them.
If the instrument is not currently redeemable (e.g., because the redemption feature is contingent and, although the contingency has not been met, it is probable that it will be met in the future, or the instrument will become redeemable on a specified date in the future), the current redemption value is measured as if the instrument were redeemable at the end of the reporting period (i.e., the balance sheet date). That is, the end of the reporting period is viewed “as if it were also the redemption date for the instrument.”
If the redemption amount fluctuates on the basis of a market price or index
(e.g., the current stock price or the most recent EBITDA), the current
redemption value is determined on the basis of the current market price or
index level as of the balance sheet date. This measurement applies even if
the ability to redeem the instrument is contingent on the attainment of a
specific market price or index level. If the index used for redemptions is
updated periodically (e.g., October 31 of each year), the issuer should use
the most recently calculated index amount for measurements as of the balance
sheet date (e.g., it should use the October 31 index amount for the year
ending on December 31 even if the index has changed from October 31 to
December 31 because any redemptions are contractually based on the index as
of October 31). The issuer should not seek to project what the index level
will be for future redemptions (e.g., based on a trailing or rolling
metric).
If a conversion feature causes an instrument to be classified as temporary
equity (e.g., the issuer could be forced to cash settle the feature in
accordance with ASC 815-40-25; see Section 9.4.6), the current redemption
value would reflect the current conversion value (i.e., the amount of cash
the issuer would be assumed to have to deliver upon a conversion).
Example 9-9
Preferred Stock That Is Redeemable on the Basis of
the Common Stock Price
Entity X issues a perpetual preferred stock instrument for $100 at the beginning of the reporting period, when the stock price was $100. The instrument is redeemable at an amount equal to the quoted market price of X’s common stock one year after the end of the reporting period. At the beginning of the reporting period, X elected to subsequently measure the instrument at its current redemption value. If the quoted market price of the common stock at the end of the reporting period is $150, the current redemption value is $150 even though (1) the instrument is not currently redeemable and (2) the expected future redemption amount (based on the future market price of the common stock) if the instrument is redeemed may be different from $150. Therefore, X would adjust the carrying amount of the instrument from $100 to $150.
9.5.2.3 Accreted Redemption Value
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(15) . . . If it is
probable that the equity instrument will become
redeemable (for example, when the redemption depends
solely on the passage of time), the SEC staff will
not object to . . . the following measurement
[method] provided the method is applied
consistently:
-
Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates. . . .
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule
5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts
reported as stockholders’ equity, and that their
redemption amounts are to be shown on the face of
the balance sheet. However, the Commission’s rules
and regulations do not address the carrying amount
at which redeemable preferred stock should be
reported, or how changes in its carrying amount
should be treated in calculations of earnings per
share . . . .
Question 1:
How should the carrying amount of redeemable
preferred stock be determined?
Interpretive
Response: The initial carrying amount of
redeemable preferred stock should be its fair value
at date of issue. Where fair value at date of issue
is less than the mandatory redemption amount, the
carrying amount shall be increased by periodic
accretions, using the interest method, so that the
carrying amount will equal the mandatory redemption
amount at the mandatory redemption date. The
carrying amount shall be further periodically
increased by amounts representing dividends not
currently declared or paid, but which will be
payable under the mandatory redemption features, or
for which ultimate payment is not solely within the
control of the registrant (e. g., dividends that
will be payable out of future earnings). Each type
of increase in carrying amount shall be effected by
charges against retained earnings or, in the absence
of retained earnings, by charges against paid-in
capital.
The accounting described in the
preceding paragraph would apply irrespective of
whether the redeemable preferred stock may be
voluntarily redeemed by the issuer prior to the
mandatory redemption date, or whether it may be
converted into another class of securities by the
holder. Companies also should consider the guidance
in FASB ASC paragraph 480-10-S99-3A (Distinguishing
Liabilities from Equity Topic).
Subsequent measurement at the accreted redemption value (subject to a floor equal to the initial carrying amount) is one of two permitted accounting policy options if the instrument is not currently redeemable but it is probable that it will become redeemable. The issuer determines the accreted redemption value on the basis of periodic accretions of any difference between the initial carrying amount and the future redemption amount (including dividends not currently declared or paid, but payable upon redemption) over the period from the date of issuance (or the date on which it becomes probable that the instrument is redeemable, if later) to the earliest redemption date. If the redemption amount fluctuates on the basis of a market price or index (e.g., the current stock price or the most recent EBITDA), the future redemption amount is determined on the basis of the current market price or index level as of the balance sheet date. Projections of future changes (e.g., in fair value for an instrument redeemable at fair value) are not permitted.
The issuer uses an appropriate method (i.e., the interest method) to calculate
the periodic accretion under which the accreted redemption value equals the
redemption amount on the earliest redemption date. As stated in ASC
835-30-35-2, under the interest method, the issuer amortizes the difference
between the present value and the redemption value to the earliest
redemption date “in such a way as to result in a constant rate of interest
when applied to the amount outstanding at the beginning of any given
period.” The accretion calculation under the interest method should include
all dividends that will be payable on the redemption date. Special
considerations apply to preferred stock with an increasing dividend rate
(see Section
9.5.2.6).
Calculating the accreted redemption value by using the interest method tends to
be straightforward when the timing and amount of the future cash flows
(including the redemption amount) are fixed. If the timing or amount of the
future cash flows varies, determining the accreted redemption value and the
associated accretion pattern is more complex. If the redemption value varies
on the basis of an index or other similar variable (e.g., fair value), the
amortization schedule of periodic accretions needs to be updated regularly
to reflect periodic changes in the redemption value. Similarly, the
accretion pattern needs to be adjusted if the earliest redemption date
changes (e.g., on the basis of estimates of when it is probable that an
exercise contingency will be met). As the redemption value changes over
time, the issuer adjusts the accretion pattern by using an appropriate
method (e.g., a retrospective or prospective interest method). An entity
should select one method as its accounting policy and apply it consistently
to similar instruments. If an entity applies a retrospective interest method
(similar to that under ASC 310-20-35-26 or ASC 320-10-35-41), the impact of
the recalculation of the effective interest on the carrying amount of the
instrument is recognized in the current period; prior-period financial
statements are not restated.
A policy of measuring an instrument for which the timing or amount of redemption varies at its accreted redemption value may mitigate some of the volatility in the carrying amount associated with measuring the instrument at its current redemption value, since changes in the redemption value are amortized over the period until the earliest redemption date under the accreted redemption value method but recognized immediately under the current redemption value method. To avoid some of the complexity associated with measuring such instruments at their accreted redemption value, however, the issuer may instead elect an accounting policy under which the instruments are measured at their current redemption value.
If an instrument is not currently redeemable, nor is it probable that the instrument will become redeemable, the issuer is not required to accrete a difference between the current carrying amount and the redemption amount even if the redemption amount exceeds the current carrying amount.
Example 9-10
Accounting for a Change in Redemption Amount —
Prospective Method
Entity Y issues a perpetual preferred stock instrument at the beginning of the annual reporting period for $100.00, when the stock price was $133.10. The instrument is redeemable at an amount equal to the quoted market price of the issuer’s common stock two years after the end of the annual reporting period. The stock price remained constant at $133.10 during the year until the end of the annual reporting period, when it increased to $177.80. At the beginning of the annual reporting period, Y elected to subsequently measure the instrument at its accreted redemption value and to use a prospective interest method to reflect subsequent changes in the timing and amount of future cash flows. To amortize the difference between $100.00 and $133.10 over three years, Y prepared an amortization schedule that uses an effective interest rate of 10 percent. After one year, therefore, the accreted redemption value before adjustment for the changes in the redemption value is $110.00 (= $100 + [10% × $100]). Because the stock price increased to $177.80 at the end of the reporting period, however, Y would update its accretion pattern for the remaining two years. Under the prospective interest method and in accordance with the revised amortization schedule prepared at the end of the reporting period, the difference between the current carrying amount of $110.00 and the current redemption value of $177.80 would be amortized over the remaining two years (i.e., the new effective interest rate is 25 percent).
9.5.2.4 Multiple Redemption Features
The measurement of the redemption value (whether the instrument is measured at
its current redemption value or its accreted redemption value) reflects the
amount that would be payable under redemption features that both (1) cause
the instrument to be classified in temporary equity (e.g., holder redemption
options or redemption features outside the control of the issuer) and (2)
require it to be remeasured (i.e., features that cause the instrument to be
considered currently redeemable or will probably cause it to become
redeemable). Redemption features that do not cause the instrument to be
classified as temporary equity (e.g., redemption features solely within the
control of the issuer or upon ordinary liquidation events) are not reflected
in the measurement of the redemption value.
Example 9-11
Preferred Stock That Is Callable and Puttable at
Different Amounts
An equity instrument includes a holder put option exercisable at $90 and an issuer call option exercisable at $110. The redemption value is $90 (provided that the holder cannot direct the issuer to exercise the call option) even though the redemption amount would be higher should the issuer elect to exercise its call option. The call option does not affect the measurement of the redemption value because it does not result in a requirement to classify the equity instrument in temporary equity (only the put option does).
Similarly, redemption features that do not require the instrument to be
remeasured (i.e., features that do not cause the instrument to be considered
currently redeemable or do not cause its redeemability to become probable)
do not affect the measurement of the redemption value.
Example 9-12
Preferred Stock With Contingent and Noncontingent
Redemption Features
Entity Z issues an instrument that includes the following two redemption features: (1) upon a change of control (which is not probable), the instrument will be mandatorily redeemed for $120 and (2) the holder has a noncontingent put option with an exercise price of $100 that will become exercisable on a specified date in the future. In measuring the redemption value, Z takes into account the put option, but not the contingent redemption feature, because it is not probable that the instrument will become redeemable under the contingent redemption feature.
If an instrument contains more than one redemption feature that (1) causes the instrument to be classified as temporary equity and (2) is currently exercisable or will probably become exercisable, the redemption value reflects the maximum amount that the issuer might have to pay under those features.
Example 9-13
Preferred Stock With Two Contingent Redemption
Features
An equity-classified instrument includes a contingent put option with an exercise price of $100 and another contingent put option with an exercise price of $110. If it is probable that each feature will become exercisable, the redemption value is the higher of $100 and $110 (i.e., $110).
9.5.2.5 Limit on Reductions to the Carrying Amount
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(16) [Subsequent
measurement.] The following additional
guidance is relevant to the application of the SEC
staff’s views in paragraphs 14 and 15: . . .
e. For a redeemable equity instrument other
than those discussed in (a), (b), and (d) of this
paragraph, regardless of the accounting method
applied in paragraphs 14 and 15, the 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 from the application of paragraphs 14
and 16 are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument from the application of paragraphs 14
and 15.
In accordance with ASC 480-10-S99-3A(16)(e), an issuer is not permitted to
reduce the carrying amount of an instrument classified as temporary equity
below its initial carrying amount except for share-based payment
arrangements, ESOPs, and convertible debt instruments with a separated
equity component (for which special measurement guidance applies). For
example, if the current redemption value of a currently redeemable
instrument is $100 (e.g., the instrument can be put by the investor to the
issuer for $100) and the initial fair value of the instrument was $105, the
issuer is not permitted to reduce the amount presented for the instrument in
temporary equity below $105 even though the carrying amount exceeds the
redemption value.
9.5.2.6 Increasing-Rate Preferred Stock
In accordance with SAB Topic 5.Q, the SEC staff believes that an entity must
use the interest method to recognize dividends on increasing-rate preferred
stock. Although SAB Topic 5.Q specifically discusses nonconvertible
preferred stock issued at a discount to its liquidation preference, with
stated dividends that increase over time, the guidance also applies to (1)
preferred stock issued at its liquidation preference that contains a stated
dividend rate that increases over time and (2) convertible preferred stock
that contains a stated dividend rate that increases over time.
Connecting the Dots
An issuer cannot avoid applying the SEC’s guidance on increasing-rate
preferred stock on the basis that the holder may convert a preferred
stock instrument into the issuer’s common shares before the stated
dividend rate increases. The issuer does not control the ability to
require the instrument to be converted into common stock and
therefore does not have the unilateral ability to avoid an increase
in the dividend rate. The same conclusion applies to a convertible
preferred stock instrument that is mandatorily convertible into the
issuer’s common shares if the issuer’s stock price increases to a
stated amount per share.
Although ASC 480-10-S99-3A(15) gives an entity the option of recognizing
redemption-amount measurement adjustments related to redeemable preferred
stock by using one of two methods when preferred stock is not redeemable on
the balance sheet date but it is probable that it will become redeemable
(see Section
9.5.2.1), the entity must apply the effective yield method
when SAB Topic 5.Q applies. Under SAB Topic 5.Q, it is not appropriate to
immediately recognize the entire discount between the issuance price and the
liquidation preference related to increasing-rate preferred stock. Rather,
an entity applies the SEC’s guidance on increasing-rate preferred stock
independently from the guidance on redeemable equity securities. However,
some preferred stock instruments may be subject to both sets of
requirements.
For further discussion of the scope and application of SAB Topic 5.Q, see
Section
3.2.2.3 of Deloitte’s Roadmap Earnings per Share.
9.5.3 Assessment of Whether an Instrument Is Currently Redeemable
If a holder of an instrument classified as temporary equity currently has the
right to exercise a redemption feature (e.g., a put right) and no conditions
need to be met (or those conditions are currently met) to effect a redemption,
the instrument is considered currently redeemable. An instrument would not be
considered currently redeemable if the redemption feature cannot be exercised by
the holder on the balance sheet date (e.g., if it can only be exercised on a
specified future date [or dates] or if a redemption would require the
satisfaction of conditions outside the holder’s control that are not met as of
the balance sheet date).
If a condition needs to be met for the holder to exercise a redemption feature,
and the holder controls whether the condition is met as of the balance sheet
date, the instrument should be considered currently redeemable even if the
condition was not met as of the balance sheet date (i.e., the condition is not
substantive in the analysis). For example, an equity instrument is redeemable at
the option of the holder upon the holder’s voluntary decision to terminate
employment with the issuer. In such a case, the instrument is considered
currently redeemable as of the balance sheet date even if the holder has made no
decision to terminate employment, because the holder controls whether the
condition is satisfied as of the balance sheet date. Similarly, if an instrument
is redeemable upon a vote by a majority of the holders of the outstanding
instrument, the instrument would be considered currently redeemable, because the
holder (as a class) controls whether the condition is met as of the balance
sheet date (i.e., the shareholder vote is not a substantive contingency, but an
exercise of a current redemption right).
The issuer’s option to redeem the instrument as of the balance sheet date does not affect the assessment of whether the instrument is currently redeemable unless the holder has the power to control the issuer’s decision to exercise the redemption feature (see Section 9.4.4). If the holder has the power to direct the issuer to exercise the call option as of the balance sheet date, however, the instrument would be considered currently redeemable, because the option is not contingent.
When an instrument is redeemable upon a change of control, merger,
consolidation, sale of substantially all assets, or other similar deemed
liquidation event, and the holder controls the issuer’s board of directors, it
is acceptable, but not required, to view the instrument as currently redeemable.
Some view the deemed liquidation condition as nonsubstantive (i.e., the
instrument should be viewed as currently redeemable) because the holder has the
power to direct the issuer’s actions through its control of the issuer’s board
of directors. Others view the same condition as substantive (i.e., the
instrument should be viewed as not currently redeemable) because redemption is
contingent on the identification of a market participant willing to purchase the
assets for consideration in an amount sufficient to distribute the redemption
amount to the holders of the redeemable equity instruments (see Section 9.5.4.5).
9.5.4 Assessing Whether It Is Probable That an Instrument Will Become Redeemable
9.5.4.1 Overview
The measurement of a redeemable equity instrument that is not currently redeemable depends on whether it is probable that the instrument will become redeemable. The ASC master glossary defines “probable” as the “future event or events are likely to occur” (i.e., probable is a higher threshold than “reasonably possible” or “more likely than not,” but near certainty is not required).
In evaluating whether it is probable that an instrument will become redeemable, an entity does not assess the
likelihood that the instrument will be redeemed.
Even if an instrument’s redemption is not probable, the instrument’s
becoming redeemable may be probable. For example, an equity share may
contain (1) a noncontingent redemption feature that permits the holder to
put the instrument to the issuer for cash two years from the reporting date
and (2) no other feature relevant to the analysis. On the basis of its
contractual terms, the instrument is certain to become redeemable with the
passage of time irrespective of whether it is probable that the holder will
exercise its put option. Similarly, it is probable that an equity share that
contains a put feature that will become exercisable upon the occurrence of
an uncertain future event (e.g., a project milestone) will become redeemable
if it is probable that the event will occur even if the put option is not
expected to be exercised if or when it becomes exercisable. Further, it is
probable that an equity share that will, on the basis of the passage of
time, become redeemable by the holder unless an uncertain future event
occurs will become redeemable unless there is a more than remote chance that
the event will occur that will negate the holder’s ability to redeem the
instrument (irrespective of the likelihood of the holder’s exercise of the
contingent redemption right).
The table below provides an overview of the evaluation of whether it is probable that various features will become redeemable.
Probable That Feature Will Become Redeemable | Not Probable That Feature Will Become Redeemable |
|---|---|
|
|
Because of the uncertainties associated with the completion of a business
combination (including, e.g., the completion of due diligence and the
obtaining of any necessary shareholder or regulatory approval), the
occurrence of a business combination generally would not be considered
probable until it has been consummated. Similarly, the successful completion
of an IPO or the completion of an IPO at a targeted stock price generally
would not be considered probable until the IPO is effective and the stock
target price is reached. Further, it is typically not probable that a change
of control or sale of all or substantially all of an entity’s assets will
occur until the transaction has been consummated, because such transactions
require the agreement of a third party that is willing to acquire the entity
or all or substantially all of its assets, and there are typically
substantive contingencies associated with the transactions before their
closing, as discussed above.
If an entity does not remeasure an instrument presented in temporary equity because it is not probable that it will become redeemable, the entity should disclose “the reasons why it is not probable that the instrument will become redeemable” (see Section 9.8.2).
Example 9-14
Assessment of
the Probability That an Equity Instrument Will
Become Redeemable
Company A, an SEC registrant, owns and operates supermarkets in Alaska. On January 1, 20X4, A issues 100,000 shares of redeemable convertible preferred stock for $1,000 per share, with the following terms:
- Written put option — The preferred shares are redeemable by the holder any time after five years from issuance (i.e., on or after January 1, 20X9) for $1,100 per share if A has not opened 10 new supermarkets by January 1, 20X9.
- Conversion option — The preferred shares are convertible by the holder, any time after issuance, into common shares of A at a conversion rate of 1:1.
Company A should assess whether it is probable that the preferred shares will become redeemable by considering whether it is probable that it will not open 10 new supermarkets by January 1, 20X9. (In its probability assessment, A would not take into account the fact that the holders of the preferred stock can exercise their option to convert the preferred shares into common shares at any time after issuance of the preferred shares.)
Company A might conclude that, at inception of the preferred stock, it is reasonably possible (but not probable) that it will not open 10 new supermarkets before January 1, 20X9, and that therefore it is not probable that the preferred shares will become redeemable. On the basis of that conclusion, A would initially record the preferred stock at fair value (i.e., $1,000) and would not need to adjust that amount subsequently until it determines that it is probable that 10 new supermarkets will not be opened by January 1, 20X9. Company A should disclose the reasons why it believes that it is not probable that the preferred stock will become redeemable.
If at some point A concludes that it is probable that it will not open 10 new supermarkets by January 1, 20X9, and thus that it is probable that the shares will become redeemable, A should either (1) use the interest method discussed in ASC 835-30 to accrete the carrying amount of the preferred stock to its redemption value over the remaining period (from the date on which A determines that it is probable that the shares will become redeemable to January 1, 20X9) or (2) immediately adjust the carrying amount of the preferred stock to its redemption value (i.e., $1,100). Company A should elect either method as its accounting policy and apply it consistently.
9.5.4.2 Mutually Exclusive Holder Options
If an instrument contains multiple mutually exclusive options (e.g., both conversion and redemption
features) controlled by the holder, the probability assessment under ASC 480-10-S99-3A does not
reflect the likelihood that the holder may exercise an option other than the redemption feature (e.g., a
conversion option) before the redemption feature becomes exercisable. Thus, the probability that the
holder will exercise a conversion feature before the instrument becomes redeemable is not relevant to
the assessment of whether it is probable that the instrument will become redeemable.
In prepared remarks at the 2005 AICPA Conference on Current SEC and PCAOB Developments,
then SEC Professional Accounting Fellow Mark Northan stated the following:
The staff has become aware of questions in practice regarding the application of ASR 268 [footnote omitted] to equity securities with redemption features and other options. The question that I will address today concerns preferred securities that include multiple mutually exclusive options that are exercisable by the holder. In one example, the first option is a conversion option that is currently exercisable. This option gives the holder the right to convert the security into a fixed number of common shares. The second option, which is not currently exercisable, is a redemption option that gives the holder the right to redeem the shares for cash. The second option would become exercisable following the passage of a specified period of time.
Under the staff guidance in [ASC 480-10-S99-3A], these instruments are required to be classified outside of permanent equity because of the existence of a redemption feature.
The inquiries received by the staff concern the subsequent measurement of these securities following initial measurement at fair value. [ASC 480-10-S99-3A] has differing guidance on subsequent measurement for redeemable securities that depends upon whether the securities are currently redeemable, or whether it is probable or not that the security will become currently redeemable in the future.
When applying this guidance to a security with both a conversion option and a redemption option like the one described earlier, some have argued that it is not probable that the security will become currently redeemable because of the likelihood that the holder will exercise the conversion option first. We have objected to this view because the exercise of the conversion option was controlled entirely by the holder. Absent that action by the holder, the security will become redeemable following only the passage of time. The probability assessment that is required by [ASC 480-10-S99-3A] would not factor in the likelihood that other options held by the holder may or may not be exercised first. Thus, the instrument that I have described would be considered to be probable of becoming currently redeemable regardless of the likelihood of earlier conversion. As a result, the changes in the redemption values for this instrument would be recognized over the period from the date of issuance to the earliest possible redemption date using either of the two methods specified in [ASC 480-10-S99-3A].
9.5.4.3 Holder Option in Instrument With Mandatory Conversion Feature
Although the assessment of whether it is probable that an instrument will become
redeemable does not take into account any holder option to convert an
instrument before redemption (see Section 9.5.4.2), an entity would
consider any feature that does not depend on the holder and could trigger
conversion before the earliest redemption opportunity. It therefore would
not necessarily be probable that an instrument that contains an option that
permits the holder to redeem the instrument on a specified date (or dates)
would become redeemable if it contains a mandatory conversion feature that
requires the instrument to be converted into shares of common stock upon the
occurrence of a specified event that is outside the holder’s control (such
as a qualified IPO). In these circumstances, it would not be probable that
the holder redemption option would become exercisable if it is more than
remote that the specified event (such as the qualified IPO) will occur
before the earliest redemption date. Accordingly, such an instrument would
probably not become redeemable (and it would not be required to be
remeasured under the temporary equity guidance) provided that the issuer
controls the ability to share settle upon conversion (see Section 9.4.6).
In performing this assessment, the entity must consider the likelihood that the
specified event (such as a qualified IPO as defined in the relevant
agreements) would occur before the earliest redemption date as well as
evaluate whether the entity controls the ability to share settle such
conversion. The likelihood of the specified event and the entity’s ability
to share settle the conversion feature should be reassessed as of each
reporting date on the basis of the facts and circumstances as of that date
(see Section
9.7.4). If an instrument becomes mandatorily convertible upon
a qualified IPO as defined by reference to a specified monetary amount, it
may be appropriate to involve valuation specialists in the evaluation of
whether it is more than remote that such an IPO will occur. For a company
that is just starting up, the likelihood that a qualified IPO will occur
would not be expected to be more than remote.
It is probable that a redeemable equity instrument with a mandatory conversion
feature will become redeemable if:
-
It is remote that the specified event (such as the qualified IPO) that would result in mandatory conversion into shares of common stock would occur before the earliest redemption date.
-
The issuer does not control the ability to share settle the mandatory conversion feature upon the specified event (so that the conversion feature would be analyzed for accounting purposes as a cash-settled redemption feature).
-
The holder has the ability to prevent the specified event triggering a mandatory conversion from occurring. (For instance, if mandatory conversion is required upon a qualified IPO and the holders control the entity, the holders can prevent the entity from undertaking a qualified IPO that would result in a mandatory conversion of the instrument.)
-
The holder has the choice to redeem the instrument or convert the instrument into shares of common stock upon the occurrence of the specified event.
In discussions with staff in the SEC’s Division of Corporation Finance, we have
been made aware that the staff believes that the assessment of whether the
occurrence of a qualified IPO is more than remote must be supported by an
appropriate evaluation of all the relevant facts and circumstances on which
the assessment is based. That is, the entity must have sufficiently
persuasive information to support its conclusion that the occurrence of a
qualified IPO is more than remote before an instrument otherwise becomes
redeemable. In evaluating such likelihood, an entity must consider the
manner in which “qualified IPO” is defined in the relevant agreements for
the redeemable equity securities. If a qualified IPO is defined by reference
to a minimum amount of securities sold in a public offering or a minimum
price per security sold, the entity must consider that definition in its
analysis. Further, if the entity has preliminary indications of the total
offering or offering price, for example, on the basis of discussions with
investment bankers, those preliminary indications must also be included in
its analysis. In many situations, the entity will need to consult with its
advisers for assistance in making these determinations.
In addition, the SEC staff has expressed the view that the assessment of such likelihood must be performed as of each reporting date on the basis of the facts and circumstances existing as of that date. The incorporation of subsequent information that was not known or knowable as of the reporting date is inappropriate. For example, if an entity has issued financial statements that are included in a registration statement filed with the SEC for an IPO of common stock, the filing of the IPO is a factor supporting a conclusion that it is more than remote that a qualified IPO will occur before a redemption feature becomes exercisable. However, the SEC staff would not accept an evaluation as of the most recent balance sheet date in support of the entity’s assessment for prior balance sheet dates. Rather, the entity would need to perform an evaluation as of the prior balance sheet dates solely on the basis of the information that was known or knowable on those dates (i.e., the entity could not use the subsequent filing of a registration statement as support for its assessments as of prior balance sheet dates).
Since an entity evaluates, as of each financial reporting period, whether it is more than remote that a qualified IPO will occur before an instrument otherwise becomes redeemable, it is possible that the entity would be required to remeasure a redeemable equity security during some financial reporting periods and not be required to remeasure the security during other financial reporting periods. If an entity has previously remeasured a redeemable equity security and no longer is required to remeasure such a security, the entity should not reverse the prior measurement adjustments.
In the determination of whether the holders of redeemable equity securities control the ability to prevent an entity from consummating a qualified IPO, the relevant governance structure of the entity and the terms of the instrument must be considered. A conclusion that the holders do not control the entity’s board of directors or the voting of shareholders may not be sufficient. For example, if the holders have to consent to an IPO, they control the ability to prevent the entity from consummating a qualified IPO and therefore remeasurement of the redemption amount under ASC 480-10-S99-3A would be required. If the holders have provided any required consents, remeasurement would still be required if the holders are able to revoke such consents.
9.5.4.4 Issuer’s Redemption Option
Unless the holder has the power to control the issuer’s decision to exercise an
option (see Section
9.4.4), the existence of an issuer option to redeem the
instrument does not affect the assessment of whether it is probable that an
instrument will become redeemable or the determination of the earliest
redemption date in accordance with the temporary equity guidance. SAB Topic
3.C states that the accounting for redeemable preferred stock “would apply
irrespective of whether the redeemable preferred stock may be voluntarily
redeemed by the issuer prior to the mandatory redemption date.”
9.5.4.5 Deemed Liquidation Features
The consummation of a change of control, merger, consolidation, sale of substantially all assets, or other similar deemed liquidation event typically is not probable. Because an issuer is not required to remeasure instruments when they are not currently redeemable or when it is not probable that they will become redeemable, the issuer is generally not required to remeasure an instrument that is redeemable only upon the consummation of a deemed liquidation event that requires the involvement or action of a third party. This conclusion is acceptable even if the holders of the instrument have control over the entity. Even with such control, the redemption event may be viewed as contingent since redemption would require the agreement of a third party that is willing to acquire the entity or all or substantially all of its assets. It is typically not probable that a change of control or sale of all or substantially all of an entity’s assets will occur until the consummation of such transaction. Alternatively, it would be acceptable for a reporting entity to choose, as an accounting policy, to remeasure redeemable convertible preferred stock to its redemption amount when the redemption will occur only upon the consummation of a deemed liquidation and the holders of the redeemable convertible preferred stock have control over the entity (see Section 9.5.3).
9.5.4.6 Issuer Does Not Control Share Settlement
As discussed in Section 9.4.6, an entity may be
required to classify an outstanding equity share in temporary equity because
it does not control the ability to share settle a conversion of the
instrument into other shares of the entity’s stock (e.g., preferred stock
convertible into common stock). In these situations, subsequent measurement
of the instrument to its redemption amount may not be required, although it
would always be acceptable.
If the equity instrument is currently redeemable and the
entity does not have a sufficient number of authorized and unissued shares
to settle it on the balance sheet date, remeasurement to the redemption
amount is always required. In other situations, the entity can evaluate the
probability that there would be an insufficient number of shares available
to settle the instrument. Such an evaluation should not take into account
the likelihood that a holder would choose not to convert the instrument
(i.e., it must be assumed that the holder will elect to convert the
instrument). The equity instrument would need to be subsequently measured
under ASC 480-10-S99-3A if it is probable that it would become redeemable
for cash or other assets because of the inability of the issuer to share
settle it. In making that determination, the entity would focus on the
likelihood that it would have enough shares to settle a conversion on any
date that the holder could elect to convert. If conversion itself is
contingent, the evaluation would also take into account the likelihood that
the instrument would become convertible. The examples in Section 9.5.4.6.1 illustrate the application
of this guidance.
If the holder has the unilateral ability to convert the
instrument and controls the entity’s board of directors or vote of its
stockholders, subsequent measurement to the redemption amount is required if
the entity would need to authorize additional shares to settle the
instrument because the holder can prevent the entity from authorizing those
shares. However, the mere fact that an entity is controlled by the holders
of a convertible instrument (e.g., convertible preferred stock) does not
mean that subsequent measurement to the redemption amount is always
required. Determining whether such measurement is required depends on the
facts and circumstances. The examples in Section
9.5.4.6.1 illustrate the application of this guidance.
An equity instrument may be redeemable for cash or other
assets if the issuing entity does not complete an IPO of its stock by a
stated date. If an IPO of stock occurs before the stated date, the
instrument is automatically converted into common stock. If the entity does
not control the ability to share settle such a conversion, it would be
required to remeasure the instrument to its redemption amount (i.e., the
amount of cash or other assets that would be owed if the IPO of stock did
not occur). It is not appropriate for the entity to avoid such remeasurement
on the basis that it is reasonably possible that a conversion would occur
before the stated redemption date since the entity does not control the
ability to share settle such conversion.4 Similarly, if the holders of the instrument control the entity’s board
of directors, the entity would be required to subsequently measure the
instrument to its redemption amount even if it controls the ability to share
settle such a conversion because the holders can prevent the entity from
completing an IPO of its stock. The examples in the next section illustrate
the application of this guidance.
9.5.4.6.1 Examples
The three examples below illustrate the application of
the guidance in Section 9.5.4.6 and are followed by a discussion of the
rationale for each example’s conclusion. The examples do not address all
situations that may affect whether an entity needs to subsequently
measure a preferred stock instrument that is classified in temporary
equity to its redemption amount. Significant judgment is often required,
and consultation with an entity’s accounting advisers is
recommended.
Example 9-15
Convertible
Preferred Stock — Issuer Needs to Authorize
Additional Shares to Settle a Conversion
Option
An entity issues preferred stock
that the holder may elect to convert into a fixed
number of shares of common stock at any time after
two years from the issuance date. Under the
contractual terms of the instrument, any
conversion must be settled in common shares.
However, the instrument does not specifically
state that in no circumstances would the issuer be
required to settle a conversion in cash if the
issuer does not have sufficient authorized and
unissued shares of common stock. Any adjustments
to the number of shares of common stock that must
be issued upon conversion (e.g., stock splits,
stock dividends) are within the issuer’s control.
There are no redemption features in the
convertible preferred stock (i.e., no other
features in the instrument that could potentially
require the issuer to settle the instrument in
cash or other assets upon events or circumstances
outside the issuer’s control).
The issuer does not currently
have enough authorized and unissued common shares
to settle conversion of the preferred stock into
common stock, and authorization of the additional
common shares needed to settle the conversion
would have to be approved by the issuer’s board of
directors and shareholders, which is outside of
the issuer’s control. Therefore, the convertible
preferred stock is classified in temporary equity.
The holders of the convertible preferred stock do
not control the issuer’s board of directors or the
vote of its stockholders.
If the issuer intends to seek
authorization for the additional common shares
needed to settle conversion of the preferred stock
and it is not probable that the issuer will not
receive such authorization before the preferred
stock becomes convertible, subsequent measurement
of the convertible preferred stock to its
redemption amount is not required. This is because
it is not probable that the convertible preferred
stock will become redeemable for cash or other
assets. Such treatment is based on an
interpretation of ASC 480-10-S99-3A(15); however,
it would also be acceptable under that guidance to
subsequently measure the convertible preferred
stock to its redemption amount. An entity should
consistently apply the approach it elects as an
accounting policy.
For an issuer to be able to
conclude that it is not probable that it will be
unable to settle conversion of the convertible
preferred stock in common shares, it would have to
assess the likelihood of the events that could
prevent the issuer’s ability to share settle a
conversion. In this example, the issuer should
consider factors including, but not limited to,
other obligations that will require the issuance
of shares and the likelihood that the board of
directors and shareholders would reject an
increase in the number of authorized and unissued
shares. An entity’s past practice with similar
situations may also be a relevant consideration.
Note that subsequent measurement
to the redemption amount would be required in the
following circumstances:
- It is probable that the entity would be unable to authorize the additional common shares needed to satisfy conversion of the preferred stock before the instrument becomes convertible.
- The instrument contains any other redemption feature that would require subsequent measurement to the redemption amount. For example, if the instrument was redeemable for cash at the option of the holder in the absence of an IPO of the issuer by a specified date, subsequent measurement to the redemption amount would be required even if the issuer believes that it is reasonably possible that an IPO would occur. This is because an entity cannot use a conversion feature for which it does not control the ability to settle in shares to avoid subsequent measurement of a convertible instrument that has another redemption feature that would require the instrument to be remeasured to its redemption amount.
- The holders of the preferred stock control the issuer’s board of directors or the vote of its stockholders.
- The instrument is convertible at the balance sheet date.
Example 9-16
Convertible
Preferred Stock — Issuer May Need to Authorize
Additional Shares to Settle a Share-Settled
Redemption Option
An entity issues preferred stock
that the holder may elect to convert into a
variable number of shares of common stock equal to
a fixed monetary amount at any time after two
years from the issuance date (i.e., a
share-settled conditional redemption option).
Under the contractual terms of the instrument, any
conversion must be settled in common shares.
However, the instrument does not specifically
state that in no circumstances would the issuer be
required to settle a conversion in cash if the
issuer does not have sufficient authorized and
unissued shares of common stock. Any adjustments
to the number of shares of common stock that must
be issued upon conversion (e.g., stock splits,
stock dividends) are within the issuer’s control.
There are no other redemption features in the
preferred stock (i.e., no other features in the
instrument that could potentially require the
issuer to settle the instrument in cash or other
assets upon events or circumstances outside the
issuer’s control).
The issuer currently has enough
authorized and unissued common shares to settle
conversion of the preferred stock into common
stock. However, because the instrument does not
have a cap on the number of shares that may need
to be issued, it is possible that the issuer would
not have enough authorized and unissued common
shares to settle a conversion in the future.
Therefore, the preferred stock is classified in
temporary equity because the issuer would have to
obtain the approval of its board of directors and
shareholders to authorize the additional common
shares that may be needed upon a conversion, which
is outside the issuer’s control. The holders of
the preferred stock do not control the issuer’s
board of directors or the vote of its
stockholders.
If the issuer concludes that it
is not probable that it will be unable to share
settle a conversion of the preferred stock because
either (1) it is not probable that the number of
shares issuable upon conversion would increase
because of a drop in the entity’s common stock
price or (2) it is not probable that it would be
unable to authorize the additional common shares
necessary to settle conversion of the preferred
stock before the instrument becomes convertible,
subsequent measurement of the preferred stock to
its redemption amount is not required. This is
because it is not probable that the preferred
stock will become redeemable for cash or other
assets. Such treatment is based on an
interpretation of ASC 480-10-S99-3A(15); however,
it would be acceptable under that guidance to
subsequently measure the preferred stock to its
redemption amount. An entity should consistently
apply the approach it elects as an accounting
policy.
For an issuer to be able to
conclude that it is not probable that it will be
unable to settle conversion of the preferred stock
in common shares, it would have to assess the
likelihood of the events that could result in the
issuer’s inability to share settle a conversion.
In this example, the issuer should consider
factors including, but not limited to, the
likelihood that its common share price would
decrease in such a manner that it would no longer
have enough authorized and unissued shares to
settle a conversion, other obligations that will
require shares to be issued during the term of the
preferred stock, and the likelihood that the board
of directors and shareholders would reject an
increase in the number of authorized and unissued
shares. An entity’s practice in similar situations
may also be a relevant consideration.
Note that subsequent measurement
to the redemption amount would be required in the
following circumstances:
- It is probable that (1) the entity would need additional common shares to settle a conversion because of a drop in the common stock price and (2) the issuer would be unable to obtain authorization to increase the number of issuable shares before the instrument becomes convertible.
- The instrument contains any other redemption feature that would require subsequent measurement to the redemption amount. An entity cannot use a conversion feature for which it does not control the ability to settle in shares to avoid subsequent measurement of an instrument that has another redemption feature that would require the instrument to be remeasured to its redemption amount.
- The holders of the preferred stock control the issuer’s board of directors or the vote of stockholders and it is probable that the issuer will need additional common shares to settle conversion of the preferred stock because of a drop in the common stock price.
- The instrument is convertible as of the balance sheet date and the issuer does not have a sufficient number of authorized and unissued shares to settle a conversion.
Example 9-17
Convertible
Preferred Stock — Adjustments to Conversion
Terms
An entity issues preferred stock
that the holder can elect to convert into a fixed
number of shares of common stock. The entity
concludes that it currently has enough authorized
and unissued shares to settle a conversion of the
preferred stock, and there are no other share
issuance obligations of the issuer that could
change this conclusion. The convertible preferred
stock has no stated redemption features (call or
put options, contingent or otherwise) that could
require the issuer to settle the instrument in
cash or other assets. Under the contractual terms
of the instrument, the conversion price would be
adjusted for standard antidilutive events (e.g.,
stock splits, stock dividends) and a down-round
feature. However, the instrument does not
specifically state that in no circumstances would
the issuer be required to settle a conversion in
cash if the issuer does not have sufficient
authorized and unissued shares of common stock.
If the issuer had to authorize
additional common shares to settle a conversion of
the convertible preferred stock because of an
adjustment to the conversion price, it would need
the approval of the issuer’s board of directors
and shareholders. The holders of the convertible
preferred stock (as a group) control the entity’s
board of directors. Therefore, because the issuer
does not control the ability to avoid an
adjustment to the conversion price and does not
control the ability to authorize additional common
shares, the convertible preferred stock is
classified in temporary equity.
If the issuer concludes that it
is not probable that it will be unable to share
settle the conversion feature, subsequent
measurement of the convertible preferred stock to
its redemption amount is not required. This
conclusion is based on the following:
- Convertible preferred stock agreements commonly contain adjustments to the conversion price in the event of an antidilutive event. Even though the holders of the convertible preferred stock control the issuer’s board of directors or the vote of stockholders, it is acceptable to evaluate the probability of the occurrence of this type of adjustment to the instrument. Such an approach is commonly applied in practice; otherwise, entities would be required to subsequently remeasure all convertible preferred stock instruments that are owned by a group that controls the issuer to their redemption amount. (Note that the evaluation of probability is only relevant to measurement; classification in temporary equity is still required regardless of the likelihood of redemption for cash or other assets.)
- A third party (i.e., a purchaser of the issuer’s newly issued financial instruments) would need to be involved in the events that would have to occur for an issuer to no longer have enough authorized and unissued shares to settle a convertible preferred stock instrument as a result of a down-round feature. In a manner similar to its assessment of a deemed liquidation event (see Section 9.5.4.5), it is acceptable for an entity to evaluate the probability of the occurrence of a down-round feature.
While the entity in this example
would not have to subsequently measure the
convertible preferred stock instrument to its
redemption amount, it would be acceptable for an
entity to adopt an accounting policy under which
such remeasurement is required.
Note that although there are no
other redemption features in the convertible
preferred stock discussed in this example, the
conclusion would be the same if the convertible
preferred stock was redeemable for cash or other
assets only upon a deemed liquidation event for
which the involvement of a third party was
required provided that the occurrence of such an
event was not considered probable (see further
discussion in Section
9.5.4.5).
As the examples above demonstrate, entities will need to
assess their facts and circumstances to determine whether the subsequent
measurement of convertible preferred stock to its redemption amount is
required when an issuer does not control the ability to share settle the
instrument. This assessment would include whether the holders of the
preferred stock control the issuer’s board of directors or the vote of
its stockholders. While the conclusions related to subsequent
measurement in the examples may differ when the preferred stockholders
control the issuer, the supporting rationale for the conclusions is
consistent. That is, if the issuer is controlled by the holders of the
preferred stock, it cannot avoid subsequent measurement of that stock on
the basis of an assessment of the likelihood of obtaining authorization
to issue additional common shares.5 In each example, this principle is illustrated as follows:
- Example 9-15 — In this example, the issuer needs to authorize additional common shares. That is, there is no condition or event that triggers the need for the additional common shares because they are already needed. If the holders of the convertible preferred stock control the issuer, subsequent measurement to the redemption amount is required because the holders can reject the issuer’s request for authorization of additional common shares.
- Example 9-16 — In this example, the issuer would need to authorize additional common shares only if its share price dropped to such a level that the issuer would not be able to settle a conversion with the existing unissued shares available to be issued. The issuer first assesses whether it is probable that the share price would drop. If a price drop is not probable, subsequent measurement is not required. If a price drop is probable, subsequent measurement is required if the holders of the preferred stock control the issuer because the holders can reject the issuer’s request for authorization of additional common shares.
- Example 9-17 — In this example, the issuer would need to authorize additional common shares only if (1) a conversion price adjustment occurs or the down-round feature is triggered and (2) the issuer no longer has sufficient authorized and unissued shares to settle a conversion of the convertible preferred stock. The probability assessment under which the issuer would be allowed to avoid subsequent measurement of the preferred stock to its redemption amount is related to a conversion price adjustment or the triggering of the down-round feature. It is therefore acceptable to evaluate the likelihood that such conditions would occur. If it is not probable that either event would occur, subsequent measurement to the redemption amount is not required. If it is probable that either event would occur, subsequent measurement to the redemption amount is required because the holders can reject the issuer’s request for authorization of additional common shares.
9.5.5 Recognition of Measurement Changes and Dividends
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(20)
Preferred stock instruments
issued by a parent (or single reporting
entity). Regardless of the accounting
method selected in paragraph 15 and the redemption terms
(that is, fixed price or fair value), the resulting
increases or decreases in the carrying amount of a
redeemable instrument other than common stock should be
treated in the same manner as dividends on nonredeemable
stock and should be effected by charges against retained
earnings or, in the absence of retained earnings, by
charges against paid-in capital. . . .
S99-3A(21)
Common stock instruments issued by a parent (or
single reporting entity). Regardless of the
accounting method selected in paragraph 15, the
resulting increases or decreases in the carrying amount
of redeemable common stock should be treated in the same
manner as dividends on nonredeemable stock and should be
effected by charges against retained earnings or, in the
absence of retained earnings, by charges against paid-in
capital. . . .
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule
5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts
reported as stockholders’ equity, and that their
redemption amounts are to be shown on the face of the
balance sheet. However, the Commission’s rules and
regulations do not address the carrying amount at which
redeemable preferred stock should be reported, or how
changes in its carrying amount should be treated in
calculations of earnings per share . . . .
Question 2: How
should periodic increases in the carrying amount of
redeemable preferred stock be treated in calculations of
earnings per share . . . ?
Interpretive
Response: Each type of increase in carrying
amount described in the Interpretive Response to
Question 1 should be treated in the same manner as
dividends on nonredeemable preferred stock.
Because temporary equity represents equity, an issuer recognizes dividends, and
changes in the carrying amount of a redeemable instrument classified as
temporary equity, as equity transactions in a manner similar to the way it
recognizes a dividend to the holder of a nonredeemable instrument; that is, it
does not report them in net income or comprehensive income in its financial
statements (see Section
9.6 for a discussion of how such changes affect the calculation
of EPS).
Connecting the Dots
The redemption amount of redeemable stock may vary (e.g., it may be the fair value of the stock or it may be based on an index). In these situations, ASC 480-10-S99-3A allows an entity to reverse prior increases in the carrying amount of the stock that resulted from the application of the subsequent-measurement guidance in ASC 480-10-S99-3A (see Section 9.5.2.1). These increases would reverse the “deemed dividends” recorded in prior periods and would be treated as a “deemed contribution” by the stockholder. However, on a cumulative basis, adjustments to remeasure redeemable preferred stock to its redemption amount may not be negative. That is, decreases to the carrying amount that result from the application of ASC 480-10-S99-3A may only be recognized to the extent that such decreases reflect recoveries of previously recognized increases to the carrying amount as a result of the application of ASC 480-10-S99-3A (see Section 9.5.2.5).
To the extent that there are retained earnings,
an entity recognizes against retained earnings dividends and changes in the
carrying amount of an instrument classified as temporary equity. Thus, if the
carrying amount increases, the entity would record the following entry:
Equity — retained earnings
Temporary equity
If there are no retained earnings, an entity recognizes against APIC the dividends and changes in the carrying amount. Thus, the following entry might be appropriate upon an increase in the carrying amount:
Equity — APIC
Temporary equity
If APIC is reduced to zero, an entity recognizes as an increase to the accumulated deficit the dividends and changes in the carrying amount. It would not be appropriate to measure APIC at a negative amount. Accordingly, the following entry might be appropriate upon an increase in the carrying amount when the issuer has a deficit:
Accumulated deficit
Temporary equity
In determining the appropriate recognition of dividends within equity, an entity should consider the state law of the jurisdiction in which it is incorporated. State law may specifically address the equity account from which distributions to stockholders can be made (e.g., surplus, net profits for the fiscal year in which the dividend is paid or the preceding fiscal year, or capital surplus). The entity should also consider the terms of its bylaws, charter, or articles of incorporation for any potentially applicable requirements.
Example 9-18
Recognition of an Increase in Redemption
Amount
Entity E has redeemable common stock outstanding with a carrying amount of $100
million, a retained earnings balance of $100 million,
and an APIC balance of $50 million. The stock is
redeemable at its fair value.
Assume that on December 31, 20X1, E is required to record a redemption amount
adjustment of $200 million for its redeemable common
stock (which increases its carrying amount to $300
million). As a result, E would first record a charge
against retained earnings of $100 million to reduce
retained earnings to zero and then would record a charge
of $50 million to reduce APIC to zero. Given that both
retained earnings and APIC have been reduced to zero, E
would finally record a $50 million charge to create an
accumulated deficit of $50 million.
Assume that in the period ended December 31, 20X2, the redemption value of the
common stock increased to $400 million and that during
such period, 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 would increase the
accumulated deficit to $225 million.
If a down-round feature is triggered in a convertible preferred share that is
classified in temporary equity, the issuing entity is required to recognize a
dividend for the value of the effect of the down-round feature in accordance
with ASC 260-10-25-1 and ASC 260-10-30-1 (i.e., debit to retained earnings;
credit to APIC). As discussed in Section
9.5.8, the SEC staff would object to the classification of the
credit to APIC within temporary equity. Therefore, the recognition of a
down-round feature that has been triggered will affect reported EPS for the
deemed dividend but will not affect the carrying amount of the redeemable
preferred share that is classified in temporary equity. Consequently, an entity
cannot treat this dividend as an increase to the carrying amount of the
instrument when determining the amount of decreases to the carrying amount for
recoveries of previous increases to the carrying amount as a result of applying
ASC 480-10-S99-3A (see Section
9.5.2.5).
9.5.5.1 Paid-in-Kind Dividends
The terms of some redeemable equity instruments (e.g., preferred stock) include
a paid-in-kind (PIK) dividend feature that requires or permits the issuer to
satisfy any required dividend payments by issuing additional shares of the
same redeemable equity instrument. The following are two types of such PIK
dividend features:
-
On each dividend payment date, the issuer satisfies the dividend payment obligation by issuing additional redeemable equity securities to the holder(s). That is, additional fungible securities are issued.
-
On each dividend payment date, the issuer increases the liquidation preference of the original equity instrument to reflect the dividend accrued to the benefit of the holder. Economically, other than with respect to potential differences due to the compounding terms of the instrument, the PIK feature has the same effect as delivering additional instruments.
The initial measurement of
the additional shares that are issued as PIK dividends depends on whether
the PIK feature is discretionary or nondiscretionary:
|
PIK Feature
|
Description
|
Measurement Date for PIK
Dividends
|
|---|---|---|
Discretionary | A PIK feature is discretionary if either of the following conditions exist:
| The date that the dividends are accrued |
Nondiscretionary | A PIK feature is nondiscretionary if both of the following conditions exist:
| The measurement date for the original equity instrument |
There are two acceptable
views on how to interpret the condition that for PIK dividend payments to be
nondiscretionary, the holder must always receive the number of equity shares
upon conversion as if all dividends have been paid in kind if the original
instrument (or part of it) is converted before accumulated dividends are
declared or accrued. An entity should select one interpretation and apply it
consistently as an accounting policy election:
-
View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that would have accrued during the entire life of the security (i.e., to the contractual maturity date).Under this view, the issuer must know at the inception of the original convertible instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument adjusted for PIK dividends or, if PIK dividends are paid through the issuance of additional convertible instruments, conversion of both the original convertible instrument and any additional convertible instruments. Potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot determine the number of equity shares that will be issued or if the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. In most cases, PIK dividend payments would be discretionary under View A since entities typically do not issue convertible instruments that allow the holder to effectively earn future dividends that would not have accrued on an early conversion.
-
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that have accrued during the entire period in which the security has been outstanding (i.e., to the conversion date).Under this view, the holder always receives upon conversion the number of equity shares as if all dividends that have been earned to date are paid in equity shares (i.e., no dividends are payable in cash). If the conversion date falls between periodic contractual dividend dates (i.e., accrual, declaration, or payment dates) and the holder forfeits any dividends that would have accrued from the last dividend date, this forfeiture does not prevent the dividends from being nondiscretionary since they are still not payable in cash.
The view selected will not affect the conclusion that PIK dividends are
discretionary in cases in which a convertible (or nonconvertible) equity
instrument allows either the holder or issuer to choose to pay dividends in
cash or in kind. In these circumstances, the PIK dividends would be
considered discretionary regardless of whether the entity adopted View A or
View B above. In applying the above alternatives to a nonconvertible
instrument, an entity should substitute the “redemption date” for the
“conversion date.”
9.5.6 Bifurcated Embedded Derivatives
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12)
Initial measurement. The SEC staff believes the
initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
e. For host equity contracts (see paragraph
3(b)), the initial amount presented in temporary
equity should be the initial carrying amount of
the host contract pursuant to Section 815-15-30. .
. .
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
For a redeemable equity instrument other than
those discussed in (a), (b), and (d) of this
paragraph, regardless of the accounting method
applied in paragraphs 14 and 15, the 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 from the application of paragraphs 14
and 16 are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument from the application of paragraphs 14
and 15.
Irrespective of whether an embedded feature is bifurcated as a derivative instrument under ASC 815-15 from an equity-classified host contract (e.g., preferred stock), the issuer should evaluate whether any of the temporary equity classification criteria are met for the hybrid contract in its entirety (inclusive of the embedded derivative). However, the initial amount presented in temporary equity is the amount attributable to the hybrid instrument that remains after separation of the embedded derivative in accordance with ASC 815-15-30-2.
Example 9-19
Initial Carrying Amount of Redeemable Preferred Stock
With a Bifurcated Embedded Derivative
Issuer A issues preferred stock for net proceeds of $100. The stock is redeemable by the holder at any time for $98. Further, the stock contains a call option with an exercise price indexed to a foreign currency. Assume that A concludes that it should bifurcate the embedded call option. If the initial amount allocated to the embedded derivative is $5 (an asset), the initial carrying amount of the host contract after separation of the embedded derivative is $105. Therefore, the initial carrying amount presented in temporary equity is $105. Even though the redemption value is $98, A cannot reduce the amount of temporary equity to this amount because the SEC precludes reductions in the amount of temporary equity recorded for a redeemable equity instrument below the initial carrying amount unless an exception applies (see Section 9.5.2.5).
Example 9-20
Initial Carrying Amount of Redeemable Preferred Stock
With a Bifurcated Embedded Derivative That Includes
PIK Dividends
Issuer B has issued preferred stock with the following terms and features:
- It is redeemable at the holder’s option or upon the occurrence of an event that is not solely within B’s control. Upon redemption, B would be obligated to pay the liquidation preference amount in cash.
- It is convertible into B’s common stock. Upon the stock’s conversion, the parties determine the number of common shares B is required to issue by dividing the liquidation preference amount of the preferred stock by a fixed price.
- It accrues dividends on the liquidation preference amount at a fixed dividend rate (8 percent quarterly).
- On each dividend payment date, B has a choice of either paying accrued dividends in cash or delivering additional preferred stock instruments (i.e., PIK dividends).
Issuer B classifies the preferred stock in temporary equity because of the redemption option. Assume that B concludes that the conversion option embedded in the preferred stock should be separately accounted for as an embedded derivative liability at fair value, with changes in fair value recognized in earnings.
If B elects to pay the dividend by issuing additional preferred stock instruments, it recognizes the PIK dividend in accordance with ASC 505-20-30-3 as a reduction (debit) to retained earnings in an amount equal to the fair value of the additional preferred stock issued. The embedded conversion option in the additional preferred stock issued is recognized as a liability at its fair value. Further, in accordance with ASC 815-15-30-2 and ASC 480-10-S99-3A(12)(e), temporary equity is increased in an amount equal to the fair value of the additional preferred stock issued less the initial fair value of the conversion option. If, however, B elects to pay the dividends in cash, the amount recognized as a reduction in retained earnings should be based on the amount of the cash payment.
ASC 480-10-S99-3A does not specifically address the subsequent measurement of a
host contract classified as temporary equity that remains after its separation
from an embedded derivative.
Example 9-21
Subsequent Measurement of Host Contract
A convertible preferred stock instrument is redeemable in cash at the greater of
(1) the conversion value and (2) the original issue
price plus accrued cumulative unpaid dividends. The
issuer has concluded that the conversion option must be
bifurcated as a derivative under ASC 815-15 (including a
portion of the cash-settled redemption feature equal to
the difference between the conversion value and the
original issue price plus accrued and cumulative unpaid
dividends). Assume that (1) the instrument (a) is not
currently redeemable and (b) will probably become
redeemable and (2) the issuer has elected to measure the
instrument at its accreted redemption value. In these
circumstances, it is generally acceptable to accrete
only the host contract to its redemption amount (i.e.,
original issue price plus accrued cumulative unpaid
dividends). Under this approach, the remeasurement of
the host contract does not reflect the possibility of a
redemption that is based on the conversion value since
the conversion spread is recognized separately as a
derivative liability. Note that it is also acceptable to
adjust the carrying amount of the host contract to a sum
equal to the instrument’s redemption value less the
current carrying amount of the bifurcated derivative
liability.
9.5.7 Convertible Debt With a Separated Equity Component
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12) Initial
measurement. The SEC staff believes the initial
carrying amount of a redeemable equity instrument that
is subject to ASR 268 should be its issuance date fair
value, except as follows: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should initially be presented in
temporary equity only if the instrument is
currently redeemable or convertible at the
issuance date for cash or other assets (see
paragraph 3(e)). The portion of the
equity-classified component that is presented in
temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the issuance
date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the issuance date. . . .
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should be presented in temporary equity
only if the instrument is currently redeemable or
convertible at the balance sheet date for cash or
other assets (see paragraph 3(e)). The portion of
the equity-classified component that is presented
in temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the balance
sheet date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the balance sheet
date.FN15 . . .
__________________________________
FN15 ASR 268 does not impact the
application of other applicable GAAP to the
accounting for the liability component or the
accounting upon derecognition of the liability
and/or equity component.
The equity-classified component of a convertible debt instrument that is
separated into liability and equity components (see Section 9.3.5) should be evaluated under
the temporary equity guidance only if the instrument is currently redeemable or
convertible as of the balance sheet date (see Sections 9.4.8 and 9.5.3). However, the
issuer would not necessarily present the entire amount of the equity component
as temporary equity. The amount of temporary equity is limited to the excess (if
any) of “(1) the amount of cash or other assets that would be required to be
paid to the holder upon a redemption or conversion . . . over (2) the carrying
amount of the liability-classified component of the convertible debt instrument”
as of both initial measurement and the subsequent balance sheet dates. (In
measuring the liability-classified component, the issuer may appropriately
include any bifurcated embedded derivative.)
There is an exception to ASC 480-10-S99-3A(16)(e) (see Section 9.5.2.5) under
which an entity is not precluded from reducing the amount of temporary equity
below the initial amount reported for the equity component of a convertible debt
instrument that is separated into liability and equity components. If the
separation of an equity component results in the recognition of a debt discount
that is amortized over the life of the debt instrument, for example, the
periodic increase in the net carrying amount of the liability component would
cause a corresponding reduction in the amount presented in temporary equity for
an instrument for which the current redemption amount remains constant (e.g., a
convertible debt instrument with a separated equity component that is puttable
at par anytime).
Depending on the applicable taxation requirements, the separation of an equity
component may cause the carrying amount of the liability component under GAAP
(the book basis) to be different from the tax basis of the debt that is
determined in accordance with ASC 740. In practice, such basis differences will
usually result in the recognition of a deferred tax liability under ASC 740 if
the tax basis exceeds the book basis after the separation of an equity
component. Because the separation of the equity component from the debt creates
the basis difference in the debt, the establishment of a deferred tax liability
for the basis difference results in a charge to the related component of equity
(see ASC 740-20-45-11(c) and ASC 470-20-25-27). Therefore, the temporary equity
guidance should be applied to the amount of the equity-classified component
before any adjustment for the related tax effects, because the issuer’s deferred
tax liability does not affect the amount payable by the issuer to the investor
upon any redemption.
If the amount of cash or other assets that the issuer would be required to pay to
the holder upon a redemption or conversion on the balance sheet date exceeds the
carrying amount of the liability component by an amount greater than the
carrying amount of the equity component, the issuing entity should first
evaluate whether the carrying amount of the liability component is appropriately
stated. If there is no requirement to adjust the carrying amount of the
liability component under other U.S. GAAP, the entity can apply either of the
following two approaches as an accounting policy since ASC 480-10-S99-3A does
not explicitly address this situation:
-
Limit the amount of temporary equity to the amount allocated to the equity-classified component in accordance with GAAP.
-
Reclassify an amount from permanent equity (APIC) to temporary equity so that the total of the carrying amounts of the liability and equity components equals the amount of cash or other assets that the issuer would be required to pay to the holder upon a redemption or conversion on the balance sheet date.
In either case, an entity is well advised to provide transparent disclosure.
9.5.8 Convertible Preferred Stock With a Separated Equity Component
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12)
Initial measurement. The SEC staff believes the
initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
e. . . . Similarly, the initial amount
presented in temporary equity for a preferred
stock instrument that contains a beneficial
conversion feature . . . should be the amount
allocated to the instrument in its entirety
pursuant to Subtopic 470-20 less any beneficial
conversion feature recorded at the issuance
date.
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
e. For a redeemable equity instrument other
than those discussed in (a), (b), and (d) of this
paragraph, regardless of the accounting method
applied in paragraphs 14 and 15, the 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 from the application of paragraphs 14
and 16 are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument from the application of paragraphs 14
and 15.
While ASC 480-10-S99-3A includes specific classification, measurement, and EPS
guidance for convertible debt with a separated equity component (see Sections 9.4.8 and
9.5.7), it does
not apply to equity-classified convertible stock with a separated equity
component (e.g., an equity component that resulted from a modification or
exchange that affected the conversion option, a reclassification of the embedded
conversion option from a liability to equity, or an equity component that has
been recorded as a result of a down-round feature that was triggered). As
discussed in more detail in Section 3.2.5.2.4 of Deloitte’s Roadmap Earnings per
Share, assuming that the equity component does not result from
the recognition of a down-round feature that has been triggered, an entity can
elect either of the following two views as an accounting policy related to
classifying a separately recognized equity component associated with such an
equity instrument:
-
View A — Classify the equity component in permanent equity.
-
View B — Classify the equity component in temporary equity.
The classification view applied will affect the measurement and EPS accounting as follows when a convertible preferred stock instrument must be remeasured to its redemption amount under ASC 480-10-S99-3A:
- View A — An entity should remeasure the carrying amount of the convertible preferred stock to its current redemption amount (or in accordance with its policy elected under ASC 480-10-S99-3A(15) if the convertible preferred stock is not currently redeemable but it is probable that it will become redeemable) without regard to the amount recognized in permanent equity for the equity component.
- View B — An entity considers the aggregate of the carrying amounts of the convertible preferred stock and separately recognized equity component in determining the amount of any measurement adjustment required under ASC 480-10-S99-3A. While the amount reported in temporary equity for the separately recognized equity component is not subsequently adjusted, that amount will indirectly affect the amount of the ASC 480-10-S99-3A measurement adjustment that needs to be made to the carrying amount of the convertible preferred stock reported in temporary equity.
Unless an exception applies (see Section 9.5.2), an issuer is not permitted
to reduce the amount of temporary equity below the initially recorded amount
even if that amount exceeds the redemption value.
Connecting the Dots
ASC 260-10-30-1 states, in part:
As
of the date that a down round feature is triggered
(that is, upon the occurrence of the triggering event that
results in a reduction of the strike price) in . . .
equity-classified convertible preferred stock (if the
conversion feature has not been bifurcated in accordance with other
guidance), an entity shall measure the value of the effect of the
feature as the difference between the following amounts determined
immediately after the down round feature is triggered:
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
ASC 260-10 further indicates that the amount calculated
in accordance with the guidance above should be recognized as a debit to
retained earnings (which reduces the numerator in the calculation of
EPS) and a credit to APIC.
On the basis of discussions with the staff in the SEC’s
OCA, we understand that the SEC will object if an entity classifies this
credit entry as APIC within temporary equity. Therefore, if the
convertible preferred stock is subject to remeasurement under the SEC’s
temporary equity guidance, any remeasurement adjustments must be made
without regard to the amount recognized in APIC (permanent equity) when
the down-round feature was triggered. The SEC staff indicated that its
view must be applied by SEC registrants even though such application may
result in “double-counting” the effect on EPS for a convertible
preferred share that is being remeasured to its redemption amount for
which a down-round feature has been triggered. In addition, we have
confirmed with the OCA staff that this view applies only to convertible
preferred stock arrangements that are subject to the down-round guidance
in ASC 260. Therefore, we believe that the two alternative views
discussed above on the classification of a separately recognized equity
component in a redeemable convertible preferred share are still
acceptable in all other situations.
9.5.9 Redeemable Equity Instruments Issued With Other Instruments
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12)
Initial measurement. The SEC staff believes the
initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
e. . . . Similarly, the initial amount
presented in temporary equity for a preferred
stock instrument that . . . is issued with other
instruments should be the amount allocated to the
instrument in its entirety pursuant to Subtopic
470-20 less any beneficial conversion feature
recorded at the issuance date.
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
e. For a redeemable equity instrument other
than those discussed in (a), (b), and (d) of this
paragraph, regardless of the accounting method
applied in paragraphs 14 and 15, the 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 from the application of paragraphs 14
and 16 are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument from the application of paragraphs 14
and 15.
When a redeemable equity instrument is issued with other freestanding financial
instruments (e.g., a detachable warrant), the issuer allocates the proceeds
received between the redeemable equity instrument and the other units of account
before applying the temporary equity guidance. In such circumstances, the
initial measurement of the redeemable equity instrument is not its initial fair
value but rather the amount allocated to the instrument less any bifurcated
derivative (see Section
9.5.6).
Depending on the characteristics of the other instruments and their subsequent measurement, different allocation methods apply. If one of the instruments will be subsequently measured at fair value and changes in fair value will be recognized in earnings (e.g., a freestanding derivative instrument within the scope of ASC 815), proceeds are typically allocated on the basis of the instrument’s fair value, and the residual proceeds are allocated to the redeemable equity instrument and any other units of account that are not remeasured at fair value (see Section 3.3.4). If the other units of account are not subsequently measured at fair value, it may be appropriate to allocate proceeds on a relative-fair-value basis.
Unless an exception applies (see Section 9.5.2.5), an issuer is not permitted to reduce the amount of temporary equity below the initially recorded amount even if that amount exceeds the redemption value.
9.5.10 Noncontrolling Interests
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12) Initial
measurement. The SEC staff believes the initial
carrying amount of a redeemable equity instrument that
is subject to ASR 268 should be its issuance date fair
value, except as follows: . . .
c. For noncontrolling interests, the initial
amount presented in temporary equity should be the
initial carrying amount of the noncontrolling
interest pursuant to Section 805-20-30. . .
.
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
c. For noncontrolling interests, the adjustment
to the carrying amount presented in temporary
equity is determined after the attribution of net
income or loss of the subsidiary pursuant to
Subtopic 810-10. . . .
e. For a redeemable equity instrument other
than those discussed in (a), (b), and (d) of this
paragraph, regardless of the accounting method
applied in paragraphs 14 and 15, the 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 from the application of paragraphs 14
and 16 are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument from the application of paragraphs 14
and 15.
S99-3A(22) Noncontrolling
interests. Paragraph 810-10-45-23 indicates that
changes in a parent’s ownership interest while the
parent retains control of its subsidiary are accounted
for as equity transactions, and do not impact net income
or comprehensive income in the consolidated financial
statements. Consistent with Paragraph 810-10-45-23, an
adjustment to the carrying amount of a noncontrolling
interest from the application of paragraphs 14–16 does
not impact net income or comprehensive income in the
consolidated financial statements. Rather, such
adjustments are treated akin to the repurchase of a
noncontrolling interest (although they may be recorded
to retained earnings instead of additional paid-in
capital). . . .
The initial carrying amount that is recognized in temporary equity for
noncontrolling interests is the initial carrying amount determined in accordance
with the accounting requirements for noncontrolling interests (including those
in ASC 805-10, ASC 805-20, and ASC 810-10). After initial recognition, the
issuer applies a two-step approach to measuring noncontrolling interests under
the temporary equity guidance on each balance sheet date. First, the entity
applies the measurement guidance in ASC 810-10 by attributing a portion of the
net income or loss of the subsidiary to the noncontrolling interest. Second, the
entity applies the subsequent measurement guidance in ASC 480-10-S99-3A. The
noncontrolling interest’s carrying amount is the higher
of (1) the cumulative amount that would result from applying the
measurement guidance in ASC 810-10 (i.e., the initial carrying amount, increased
or decreased for the noncontrolling interest’s share of net income or loss — as
well as its share of other comprehensive income or loss — and dividends) or (2)
the redemption value.
Under ASC 480-10-S99-3A(16)(e), an issuer generally cannot reduce the amount of
temporary equity reported for an instrument within the scope of the temporary
equity guidance below its initial carrying amount. However, this limitation does
not apply to reductions in the carrying amount of a noncontrolling interest that
result from the application of the noncontrolling interest guidance in ASC
810-10. It only applies to reductions in the carrying amount that result from
the application of the temporary equity guidance.
Because temporary equity represents equity, changes in the carrying amount of
noncontrolling interests classified as temporary equity are accounted for as
equity transactions and are not reported in net income or comprehensive income
in the issuer’s financial statements (see Section 9.6.3 for a discussion of how such
changes affect the calculation of EPS).
9.5.11 Equity Securities Held by ESOPs
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12)
Initial measurement. The SEC staff believes the
initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
b. For employee stock ownership plans where the
cash redemption obligation relates only to a
market value guarantee feature, the registrant may
elect as an accounting policy to present in
temporary equity either (i) the entire guaranteed
market value amount of the equity securities or
(ii) the maximum cash obligation based on the fair
value of the underlying equity securities at the
balance sheet date. . . .
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15: . . .
b. For employee stock ownership plans where the
cash redemption obligation relates only to a
market value guarantee feature, the registrant may
elect as an accounting policy to present in
temporary equity either (i) the entire guaranteed
market value amount of the equity securities or
(ii) the maximum cash obligation based on the fair
value of the underlying equity securities at the
balance sheet date.
SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan
S99-4 The following is the
text of SEC Observer Comment: Sponsor’s Balance Sheet
Classification of Capital Stock With a Put Option Held
by an Employee Stock Ownership Plan.
ASR 268 (see also paragraph 480-10-S99-3A) requires that to
the extent that there are conditions (regardless of
their probability of occurrence) whereby holders of
equity securities may demand cash in exchange for their
securities, the sponsor must reflect the maximum
possible cash obligation related to those securities
outside of permanent equity. Thus, securities held by an
ESOP (whether or not allocated) must be reported outside
of permanent equity if by their terms they can be put to
the sponsor for cash. With respect to ESOP securities
where the cash obligation relates only to market value
guarantee features, the SEC staff would not object to
registrants only classifying outside of permanent equity
an amount that represents the maximum cash obligation of
the sponsor based on market prices of the underlying
security as of the reporting date; accordingly,
reclassifications of equity amounts would be required
based on the market values of the underlying security.
Alternatively, the SEC staff would not object to
classifying the entire guaranteed value amount outside
of permanent equity due to the uncertainty of the
ultimate cash obligation because of a possible market
value decline in the underlying security.
Provided that “the cash redemption obligation relates only to a market value guarantee feature,” the SEC permits an issuer to elect to measure redeemable equity instruments held by an ESOP at “either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation [of the sponsor] based on the fair value of the underlying equity securities at the balance sheet date.”
This exception should not be applied by analogy. For example, it would not apply when an amount other than the market value guarantee may need to be redeemed by the sponsor for cash or other assets and such redemption could occur upon any event outside the sponsor’s control. If the exception does not apply, the entire carrying amount of the ESOP’s outstanding redeemable shares of stock must be classified in temporary equity.
9.5.12 Share-Based Payment Arrangements
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(12) Initial
measurement. The SEC staff believes the initial
carrying amount of a redeemable equity instrument that
is subject to ASR 268 should be its issuance date fair
value, except as follows: . . .
a. For share-based payment arrangements with
employees, the initial amount presented in
temporary equity should be based on the redemption
provisions of the instrument and the proportion of
consideration received in the form of employee
services at initial recognition. For example, upon
issuance of a fully vested option that allows the
holder to put the option back to the issuer at its
intrinsic value upon a change in control, an
amount representing the intrinsic value of the
option at the date of issuance should be presented
in temporary equity.
S99-3A(16)
[Subsequent measurement.] The following
additional guidance is relevant to the application of
the SEC staff’s views in paragraphs 14 and 15:
a. For share-based payment arrangements with
employees, the amount presented in temporary
equity at each balance sheet date should be based
on the redemption provisions of the instrument and
should take into account the proportion of
consideration received in the form of employee
services (that is, the pattern of recognition of
compensation cost pursuant to Topic
718).FN14. . .
__________________________________
FN14 See also the Interpretative
Response to Question 2 in Section E of Section
718-10-S99.
SEC Staff Accounting Bulletins
SAB Topic 14.E, FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain
Redeemable Financial Instruments [Reproduced in ASC
718-10-S99-1]
Facts: Under a share-based
payment arrangement, Company F grants to an employee
shares (or share options) that all vest at the end of
four years (cliff vest). The shares (or shares
underlying the share options) are redeemable for cash at
fair value at the holder’s option, but only after six
months from the date of share issuance (as defined in
FASB ASC Topic 718). Company F has determined that the
shares (or share options) would be classified as equity
instruments under the guidance of FASB ASC Topic 718.
However, under ASR 268 and related guidance, the
instruments would be considered to be redeemable for
cash or other assets upon the occurrence of events
(e.g., redemption at the option of the
holder) that are outside the control of the issuer. . .
.
Question 2: How should Company F
apply ASR 268 and related guidance to the shares (or
share options) granted under the share-based payment
arrangements with employees that may be unvested at the
date of grant?
Interpretive Response: Under FASB
ASC Topic 718, when compensation cost is recognized for
instruments classified as equity instruments, additional
paid-in-capitalFN82 is increased. If the
award is not fully vested at the grant date,
compensation cost is recognized and additional
paid-in-capital is increased over time as services are
rendered over the requisite service period. A similar
pattern of recognition should be used to reflect the
amount presented as temporary equity for share-based
payment awards that have redemption features that are
outside the issuer’s control but are classified as
equity instruments under FASB ASC Topic 718. The staff
believes Company F should present as temporary equity at
each balance sheet date an amount that is based on the
redemption amount of the instrument, but takes into
account the proportion of consideration received in the
form of employee services. Thus, for example, if a
nonvested share that qualifies for equity classification
under FASB ASC Topic 718 is redeemable at fair value
more than six months after vesting, and that nonvested
share is 75% vested at the balance sheet date, an amount
equal to 75% of the fair value of the share should be
presented as temporary equity at that date. Similarly,
if an option on a share of redeemable stock that
qualifies for equity classification under FASB ASC Topic
718 is 75% vested at the balance sheet date, an amount
equal to 75% of the intrinsicFN83 value of
the option should be presented as temporary equity at
that date.
Question 3: Would the methodology
described for employee awards in the Interpretive
Response to Question 2 above apply to nonemployee awards
to be issued in exchange for goods or services with
similar terms to those described above?
Interpretive Response: See Topic
14.A for a discussion of the application of the
principles in FASB ASC Topic 718 to nonemployee awards.
The staff believes it would generally be appropriate to
apply the methodology described in the Interpretive
Response to Question 2 above to nonemployee awards.
__________________________________
FN82 Depending on the fact pattern,
this may be recorded as common stock and
additional paid in capital.
FN83 The potential redemption amount
of the share option in this illustration is its
intrinsic value because the holder would pay the
exercise price upon exercise of the option and
then, upon redemption of the underlying shares,
the company would pay the holder the fair value of
those shares. Thus, the net cash outflow from the
arrangement would be equal to the intrinsic value
of the share option. In situations where there
would be no cash inflows from the share option
holder, the cash required to be paid to redeem the
underlying shares upon the exercise of the put
option would be the redemption value.
Special considerations apply in the measurement of share-based payment
arrangements under the SEC’s temporary equity guidance. For such arrangements,
the amount presented in temporary equity at initial recognition and each balance
sheet date is “based on the redemption provisions of the instrument and the
proportion of consideration received in the form of employee services” (i.e.,
the measurement of such arrangements consider not only the redemption value, but
also the proportion attributed to the requisite employee services rendered to
date). See Section 12.4.7 of Deloitte’s
Roadmap Share-Based Payment
Awards for further discussion.
Footnotes
4
This is because an entity cannot avoid subsequent
measurement to a redemption amount in accordance with a stated
redemption feature on the basis that it can require conversion of
the instrument into another class of stock if the entity does not
control the ability to issue the shares of such class of stock upon
conversion of the instrument.
5
This view is consistent with the discussion in
Section
9.5.4.6.
9.6 EPS Considerations
9.6.1 Preferred Stock
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(20)
Preferred stock instruments issued by a parent (or
single reporting entity). Regardless of the
accounting method selected in paragraph 15 and the
redemption terms (that is, fixed price or fair value),
the resulting increases or decreases in the carrying
amount of a redeemable instrument other than common
stock should be treated in the same manner as dividends
on nonredeemable stock and should be effected by charges
against retained earnings or, in the absence of retained
earnings, by charges against paid-in capital. Increases
or decreases in the carrying amount should reduce or
increase income available to common stockholders in the
calculation of earnings per share . . . . Additionally,
Paragraph 260-10-S99-2, provides guidance on the
accounting at the date of a redemption or induced
conversion of a preferred stock instrument.
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule
5-02.27 of Regulation S-X states that redeemable
preferred stocks are not to be included in amounts
reported as stockholders’ equity, and that their
redemption amounts are to be shown on the face of the
balance sheet. However, the Commission’s rules and
regulations do not address the carrying amount at which
redeemable preferred stock should be reported, or how
changes in its carrying amount should be treated in
calculations of earnings per share . . . .
Question 2: How
should periodic increases in the carrying amount of
redeemable preferred stock be treated in calculations of
earnings per share . . . ?
Interpretive
Response: Each type of increase in carrying
amount described in the Interpretive Response to
Question 1 should be treated in the same manner as
dividends on nonredeemable preferred stock.
In the EPS calculation, changes in the carrying amount of preferred stock
classified as temporary equity are treated as an adjustment to income available
to common stockholders. Thus, an increase in the carrying amount decreases
income available to common stockholders, and a decrease in the carrying amount
increases it. However, the carrying amount generally cannot be reduced to an
amount below the initial carrying amount (see Section 9.5.2). For additional discussion
of the EPS treatment of redeemable preferred stock, see Sections 3.2.2.4 and
4.8.4.3 of
Deloitte’s Roadmap Earnings
per Share.
9.6.2 Common Stock
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(21)
Common stock instruments issued by a parent (or
single reporting entity). Regardless of the
accounting method selected in paragraph 15, the
resulting increases or decreases in the carrying amount
of redeemable common stock should be treated in the same
manner as dividends on nonredeemable stock and should be
effected by charges against retained earnings or, in the
absence of retained earnings, by charges against paid-in
capital. However, increases or decreases in the carrying
amount of a redeemable common stock should not affect
income available to common stockholders. Rather, the SEC
staff believes that to the extent that a common
shareholder has a contractual right to receive at share
redemption (in other than a liquidation event that meets
the exception in paragraph 3(f)) an amount that is other
than the fair value of the issuer’s common shares, then
that common shareholder has, in substance, received a
distribution different from other common shareholders.
Under Paragraph 260-10-45-59A, entities with capital
structures that include a class of common stock with
different dividend rates from those of another class of
common stock but without prior or senior rights, should
apply the two-class method of calculating earnings per
share. Therefore, when a class of common stock is
redeemable at other than fair value, increases or
decreases in the carrying amount of the redeemable
instrument should be reflected in earnings per share
using the two-class method.FN17 For common
stock redeemable at fair valueFN18, the SEC
staff would not expect the use of the two-class method,
as a redemption at fair value does not amount to a
distribution different from other common
shareholders.FN19
__________________________________
FN17 The two-class method of
computing earnings per share is addressed in
Section 260-10-45. The SEC staff believes that
there are two acceptable approaches for allocating
earnings under the two-class method when a common
stock instrument is redeemable at other than fair
value. The registrant may elect to: (a) treat the
entire periodic adjustment to the instrument’s
carrying amount (from the application of
paragraphs 14–16) as being akin to a dividend or
(b) treat only the portion of the periodic
adjustment to the instrument’s carrying amount
(from the application of paragraphs 14–16) that
reflects a redemption in excess of fair value as
being akin to a dividend. Under either approach,
decreases in the instrument’s carrying amount
should be reflected in the application of the
two-class method only to the extent they represent
recoveries of amounts previously reflected in the
application of the two-class method.
FN18 Common stock that is redeemable
based on a specified formula is considered to be
redeemable at fair value if the formula is
designed to equal or reasonably approximate fair
value. The SEC staff believes that a formula based
solely on a fixed multiple of earnings (or other
similar measure) is not considered to be designed
to equal or reasonably approximate fair
value.
FN19 Similarly, the two-class method
is not required when share-based payment awards
granted to employees are redeemable at fair value
(provided those awards are in the form of common
shares or options on common shares). However,
those share-based payment awards may still be
subject to the two-class method pursuant to
Section 260-10-45.
Changes in the carrying amount of common stock classified as temporary equity (other than a
noncontrolling interest) do not affect income available to common stockholders in the calculation of
EPS. Instead, an entity uses the two-class method under ASC 260-10-45 to reflect such changes unless
the redemption right is for an amount equal to the fair value of the common shares. Accordingly, the
two-class method:
- Applies if the redemption right is for an amount other than fair value (e.g., a fixed price or a price determined on the basis of a non-fair-value formula), because such a right effectively represents a holder right to a distribution (upon redemption) that is different from the distributions to holders of nonredeemable common stock.
- Does not apply if the redemption right is at an amount equal to the fair value of the common stock, because the issuer’s purchase of common stock at fair value conceptually does not represent an economically preferential distribution. While a redemption right at fair value provides the holder with an ability to exit its investment at its current fair value (i.e., liquidity), a redemption would not transfer any value to or from the holder of the redeemable instrument. Accordingly, if the redemption right is at fair value, adjustments to the carrying amount do not affect the calculation of EPS.
If the common stock is redeemable at a fixed amount, it would not be considered redeemable at fair
value, because there is no assurance the fair value on the redemption date will equal the fixed amount.
If the common stock is redeemable at an amount determined on the basis of a formula, it would not be
considered redeemable at fair value unless “the formula is designed to equal or reasonably approximate
fair value.” The SEC does not consider formulas based solely on a fixed multiple of the issuer’s earnings
(e.g., 10 times the issuer’s most recent EBITDA or an average EBITDA) as designed to equal or reasonably
approximate fair value because the appropriate multiple may change over time as a result of changes
in market conditions and entity-specific factors. A formula that is based on the average trading price
of the common stock price for a short period before redemption potentially could be viewed as one
that was designed to reasonably approximate fair value. For a common equity instrument issued by an
investment fund (e.g., noncontrolling interests in consolidated investment funds), the net asset value
(NAV) per share calculated in a manner consistent with the measurement principles of ASC 946 as of the
reporting entity’s measurement date may be a reasonable approximation of fair value (see ASC 820-10-
35-59) depending on whether there are restrictions on redemptions and whether the NAV would have
qualified as a fair value measurement under the practical expedient in ASC 820-15-35-59.
The SEC staff permits an entity that applies the two-class method to common stock redeemable at an
amount other than fair value to choose between the following two approaches of allocating earnings to
the redeemable common stock:
- Treat the entire change in the carrying amount of the redeemable common stock as a dividend to the holders of such stock.
- Treat only the portion of the change in the carrying amount of the redeemable common stock that reflects a redemption in excess of its fair value as a dividend to holders of such stock (e.g., if the redemption value exceeded fair value by $7 at the beginning of the period and $12 at the end of the period, the entity would analyze the increase in the excess of $5 during the period as a distribution to the holders of the redeemable common stock during that period).
Note that the carrying amount generally cannot be reduced to an amount below the initial carrying
amount (see Section 9.5.2).
For additional discussion of the EPS treatment of redeemable common stock, see
Sections
3.2.4.2, 3.3.2.1, 4.8.4.3, 5.4.2, and 5.5.3.1 of Deloitte’s Roadmap Earnings per Share.
9.6.3 Noncontrolling Interests
9.6.3.1 Noncontrolling Interests in the Form of Preferred Stock
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(22) . . . The SEC
staff believes the guidance in paragraphs 20 and 21
should be applied to noncontrolling interests as
follows:
-
Noncontrolling interest in the form of preferred stock instrument. The impact on income available to common stockholders of the parent arising from adjustments to the carrying amount of a redeemable noncontrolling interest other than common stock depends upon whether the redemption feature in the equity instrument was issued, or is guaranteed, by the parent. If the redemption feature was issued, or is guaranteed, by the parent, the entire adjustment under paragraph 20 reduces or increases income available to common stockholders of the parent. Otherwise, the adjustment is attributed to the parent and the noncontrolling interest in accordance with Paragraphs 260-10-55-64 through 55-67. . . .
When a noncontrolling interest in the form of preferred stock is presented in temporary equity, the calculation of EPS depends on whether the redemption feature that triggers temporary equity classification has been issued or guaranteed by the parent entity:
- If the redemption feature has been issued or guaranteed by the parent entity, the EPS treatment is similar to that of a redeemable preferred share issued directly by the parent (see Section 9.6.1), and changes in the carrying amount of the redeemable noncontrolling interest are treated as an adjustment to income available to common stockholders. Thus, an increase in the carrying amount decreases income available to common stockholders, and a decrease in the carrying amount increases income available to common stockholders.
- If the redemption feature has not been issued or guaranteed by the parent entity (i.e., the redemption feature was issued by the subsidiary and has not been guaranteed by the parent), changes in the carrying amount of the redeemable noncontrolling interest are allocated between the parent and the noncontrolling interest.
Redemption features that may be considered issued or guaranteed by the parent include, but are not limited to, (1) put options issued by a parent to the holder of preferred shares issued by the parent’s subsidiary if the put options are considered embedded in the noncontrolling interest at the consolidated level (see Section 3.3) and (2) put features that are embedded in preferred shares issued by a subsidiary if they are subject to a guarantee by its parent.
For additional discussion of the EPS treatment of noncontrolling interest in the
form of redeemable preferred stock, see Sections 3.2.3.3.1 and 8.8.4 of Deloitte’s
Roadmap Earnings per
Share.
9.6.3.2 Noncontrolling Interests in the Form of Common Stock
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(22) . . . The SEC
staff believes the guidance in paragraphs 20 and 21
should be applied to noncontrolling interests as
follows: . . .
b. Noncontrolling interest in the form of
common stock instrument. Adjustments to the
carrying amount of a noncontrolling interest
issued in the form of a common stock instrument to
reflect a fair value redemption feature do not
impact earnings per share. Adjustments to the
carrying amount of a noncontrolling interest
issued in the form of a common stock instrument to
reflect a non-fair value redemption feature do
impact earnings per share; however, the manner in
which those adjustments reduce or increase income
available to common stockholders of the parent may
differ.FN20 If the terms of the
redemption feature are fully considered in the
attribution of net income under Paragraph 810-
10-45-21, application of the two-class method is
unnecessary. If the terms of the redemption
feature are not fully considered in the
attribution of net income under Paragraph
810-10-45-20, application of the two-class method
at the subsidiary level is necessary in order to
determine net income available to common
stockholders of the parent.
__________________________________
FN20 Subtopic 810-10 does not
provide detailed guidance on the attribution of
net income to the parent and the noncontrolling
interest. The SEC staff understands that when a
noncontrolling interest is redeemable at other
than fair value some registrants consider the
terms of the redemption feature in the calculation
of net income attributable to the parent (as
reported on the face of the income statement),
while others only consider the impact of the
redemption feature in the calculation of income
available to common stockholders of the parent
(which is the control number for earnings per
share purposes).
An entity uses the two-class method under ASC 260-10-45 to reflect measurement adjustments made under ASC 480-10-S99-3A related to a noncontrolling interest in the form of redeemable common shares unless either (1) the redemption right is for an amount equal to the fair value of the common shares or (2) the entity fully considers the terms of the redemption feature in the attribution of net income under ASC 810-10-45.
The SEC staff permits an entity that applies the two-class method to common stock redeemable at an amount other than fair value to choose between the following two approaches of allocating earnings to the stock:
- Treat the entire measurement adjustment under ASC 480-10-S99-3A as a dividend to the holders of such stock.
- Treat only the portion of the measurement adjustment under ASC 480-10-S99-3A that reflects a redemption in excess of its fair value as a dividend to holders of such stock.
For additional discussion of the EPS treatment of noncontrolling interest in the
form of redeemable common stock, see Sections 3.2.3.3.2 and 8.8.4 of Deloitte’s
Roadmap Earnings per
Share.
9.6.4 Convertible Debt With Separated Equity Component
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(23)
Convertible debt instruments that contain a
separately classified equity component. For
convertible debt instruments subject to ASR 268 (see
paragraph 3(e)), there should be no incremental earnings
per share accounting from the application of this SEC
staff announcement. Subtopic 260-10 addresses the
earnings per share accounting.
There is no incremental EPS impact associated with the classification of all or
part of an equity component in convertible debt as temporary equity.
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).
9.8 Presentation and Disclosure
9.8.1 Presentation
9.8.1.1 Separate Presentation of Temporary Equity
SEC Rules, Regulations, and
Interpretations
Regulation S-X Rule 5-02, Balance
Sheets [Reproduced in ASC 210-10-S99-1]
The purpose of this rule is to
indicate the various line items and certain
additional disclosures which, if applicable, and
except as otherwise permitted by the Commission,
should appear on the face of the balance sheets or
related notes filed for the persons to whom this
article pertains (see § 210.4–01(a)). . . .
Redeemable Preferred Stocks
27. Preferred stocks subject to mandatory
redemption requirements or whose redemption is
outside the control of the issuer.
(a) Include under this
caption amounts applicable to any class of stock
which has any of the following characteristics:
(1) it is redeemable at a fixed or determinable
price on a fixed or determinable date or dates,
whether by operation of a sinking fund or
otherwise; (2) it is redeemable at the option of
the holder; or (3) it has conditions for
redemption which are not solely within the control
of the issuer, such as stocks which must be
redeemed out of future earnings. Amounts
attributable to preferred stock which is not
redeemable or is redeemable solely at the option
of the issuer shall be included under §
210.5–02.28 unless it meets one or more of the
above criteria. . . .
(d) Securities reported
under this caption are not to be included under a
general heading “stockholders’ equity” or combined
in a total with items described in captions 29, 30
or 31 which follow.
SEC Rules, Regulations, and
Interpretations
CFRP 211, Redeemable Preferred
Stocks [Reproduced in ASC 480-10-S99-1]
.01 General: ASR 268:
On July 27, 1979, the Commission
amended Regulation S-X to modify the financial
statement presentation of preferred stocks subject
to mandatory redemption requirements or whose
redemption is outside the control of the issuer. The
rules adopted do not impact reporting practices of
registrants not having such securities outstanding.
Registrants having such securities outstanding are
required to present separately, in balance sheets,
amounts applicable to the following three general
classes of securities: (i) preferred stocks subject
to mandatory redemption requirements or whose
redemption is outside the control of the issuer;
(ii) preferred stocks which are not redeemable or
are redeemable solely at the option of the issuer;
and (iii) common stocks. A general heading,
“Stockholders’ Equity,” is not to be used and
presentation of a combined total for equity
securities, inclusive of redeemable preferred
stocks, is prohibited. In addition, the rules
require disclosure of redemption terms, five-year
maturity data, and changes in redeemable preferred
stocks in a separate note to the financial
statements captioned “Redeemable Preferred
Stocks.”
There is a significant difference
between a security with mandatory redemption
requirements or whose redemption is outside the
control of the issuer and conventional equity
capital. The Commission believes that it is
necessary to highlight the future cash obligations
attached to this type of security so as to
distinguish it from permanent capital. It is
expected that the rules will provide more meaningful
presentation of the financial obligations of those
companies which finance operations through the use
of such securities.
The Commission noted an increase in
the issuance, by registrants, of preferred stocks to
finance operations, consummate mergers and
acquisitions, or to restructure existing debt
arrangements. Many of the preferred stock issues
included terms which required the issuer to redeem
the stock at a fixed or determinable price on a
fixed or determinable date. Other issues required
the issuer to redeem the stock at the option of the
holder at the time certain prescribed conditions are
met which are not necessarily within the control of
the issuer, such as attainment of a specified level
of earnings.
The Commission believes that
redeemable preferred stocks are significantly
different from conventional equity capital. Such
securities have characteristics similar to debt and
should, in the opinion of the Commission, be
distinguished from permanent capital. The Commission
believes that traditional financial reporting
practices do not provide the most meaningful
presentation of the financial obligations attached
to these types of securities and that improvement in
the financial statement presentation of redeemable
preferred stocks is necessary.
The rules are intended to highlight
the future cash obligations attached to redeemable
preferred stock through appropriate balance sheet
presentation and footnote disclosure. They do not
attempt to deal with the conceptual question of
whether such a security is a liability. Further, the
rules do not attempt to deal with the income
statement treatment of payments to holders of such a
security or with any related income statement
matters, including accounting for its
extinguishment. The Commission is cognizant of these
conceptual problems in determining the appropriate
accounting for and reporting of redeemable preferred
stock and believes that these matters can best be
addressed by the FASB. As an interim measure, the
rules require that the amounts applicable to
redeemable preferred stock be presented in financial
statements as a separate item — and not combined
with equity investments not having similar
redemption requirements. The Commission believes the
presentation required by the rules will highlight
the redemption obligation and the fact that amounts
attributable to these securities are not part of
permanent capital.
.02 Definitions
ASR 268:
The following definitions apply to
the terms listed below as they are used in this
section:
Preferred Stock Subject to Mandatory
Redemption Requirements or Whose Redemption is
Outside the Control of the Issuer (“Redeemable
Preferred Stock”). The term means any stock which
(i) the issuer undertakes to redeem at a fixed or
determinable price on the fixed or determinable date
or dates, whether by operation of a sinking fund or
otherwise; (ii) is redeemable at the option of the
holders, or (iii) has conditions for redemption
which are not solely within the control of the
issuer, such as stocks which must be redeemed out of
future earnings.FN*
Preferred Stocks Which Are Not
Redeemable or Are Redeemable Solely at the Option of
the Issuer (“Non-Redeemable Preferred Stock “). The
term means any preferred stock which does not meet
the criteria for classification as a “redeemable
preferred stock.”
.03 Exemption
ASR 268:
The Commission has concluded that
the necessary refinements concerning the
presentation in financial statements of amounts
applicable to redeemable preferred stocks should not
impact the present reporting practices of
registrants who do not use such securities to
finance their operations. Therefore, registrants not
having such securities may continue to use the
general heading “Stockholders’ Equity” and show a
combined total. Where redeemable preferred stocks
are outstanding, the Commission will not prohibit
the combining of non-redeemable preferred stocks,
common stocks and other equity accounts under an
appropriate designated caption (e. g.,
“Non-Redeemable Preferred Stocks, Common Stocks, and
Other Stockholders’ Equity”) provided that any
combinations be exclusive of redeemable preferred
stocks. . . .
__________________________________
FN* Under this definition,
preferred stock which meet one or more of the
above criteria would be classified as redeemable
preferred stock regardless of their other
attributes such as voting rights, dividend rights
or conversion features.
Regulation S-X, Rule 5-02.27 (reproduced in ASC 210-10-S99-1), contains the basic balance sheet presentation and footnote disclosure requirements for redeemable preferred stocks classified as temporary equity. It requires an entity to present in a separate caption on the face of the balance sheet the amount of such redeemable equity instruments.
Although temporary equity represents equity under GAAP (e.g., in connection with
disclosing information about equity instruments under ASC 505-10-50 or
evaluating whether an embedded derivative qualifies for the scope exception
to derivative accounting for contracts on own equity under ASC
815-10-15-74(a); see ASC 815-10-15-76), the SEC’s rules preclude an entity
from (1) combining the balance sheet line item for redeemable equity with
line items for components of permanent equity (including those preferred
stocks, common stocks, other stockholders’ equity, and noncontrolling
interests that qualify as permanent equity) and (2) including redeemable
equity under a general heading for stockholders’ equity (see also CFRP
211.03).
Accordingly, the SEC staff would object to an entity’s inclusion of redeemable
equity in any total or subtotal titled “stockholders’ equity” or “total
equity” in the entity’s financial statements, including the reconciliation
of total equity under Regulation S-X, Rule 3-04 (reproduced in ASC
505-10-S99-1). As noted in the highlights of the June 23, 2009, CAQ SEC Regulations
Committee joint meeting with the SEC staff, the staff believes that “the
renaming of the caption in the statement of changes in shareholders’ equity
“total equity” to “total” does not make the inclusion of redeemable equity
acceptable.”
9.8.1.2 Liability Classification Prohibited
ASC 480-10 — SEC Materials — SEC
Staff Guidance
SEC Staff Announcement:
Classification and Measurement of Redeemable
Securities
S99-3A(4) . .
. The SEC staff does not believe it is appropriate
to classify a financial instrument (or host
contract) that meets the conditions for temporary
equity classification under ASR 268 as a
liability.FN10
__________________________________
FN10 At the June 14, 2007 EITF
meeting, the SEC Observer stated that a financial
instrument (or host contract) that otherwise meets
the conditions for temporary equity classification
may continue to be classified as a liability
provided the financial instrument (or host
contract) was classified and accounted for as a
liability in fiscal quarters beginning before
September 15, 2007 and has not subsequently been
modified or subject to a remeasurement (new basis)
event.
SEC Rules, Regulations, and
Interpretations
CFRP 211, Redeemable Preferred
Stocks [Reproduced in ASC 480-10-S99-1]
.05 Existing Agreements
ASR 268:
It is not the Commission’s present
intention to establish whether redeemable preferred
stocks are liabilities or components of equity.
Therefore, the rules should not require any change
in the calculations of debt-equity ratios under
existing loan agreements. Further, the Commission
believes that creditors already consider the
distinctive characteristics of the types of
securities which comprise a company’s capital
structure when evaluating a potential loan.
In the past, the SEC staff did not object to liability classification for
certain instruments that meet the conditions for temporary equity
classification. However, at the EITF’s June 14, 2007, meeting, the SEC
observer announced that the SEC staff would “no longer accept liability
classification for financial instruments (or host contracts) that meet the
conditions for temporary equity classification.“ While CFRP 211.01 and CFRP
211.05 suggest that it was not the SEC’s intention to establish whether
redeemable preferred stocks are liabilities or components of equity, it
would be inappropriate for an entity to classify as a liability an
instrument that qualifies as temporary equity (see Section 9.3.2). When
the SEC announced that it would object to liability classification for
instruments that meet the criteria for temporary equity classification, it
grandfathered instruments that had previously been classified as
liabilities. Accordingly, an entity may still have redeemable equity
instruments outstanding that it has classified as liabilities, even though
they do not meet the criteria for liability classification under ASC 480.
However, such classification is not permitted for financial instruments (or
host contracts) “that [were] entered into, modified, or otherwise subject to
a remeasurement (new basis) event in [fiscal quarters] beginning after
September 15, 2007.” Further, a grandfathered instrument that continues to
be classified on the balance sheet as a liability “would not be eligible for
initial application of the fair value option under [ASC 825-10] or initial
adoption of hedge accounting in fiscal quarters beginning after September
15, 2007.” (ASC 825-10-15-5(f) precludes application of the fair value
option in ASC 825 for instruments that are classified in whole or in part in
equity [including temporary equity].)
9.8.1.3 Presentation of Shareholder Loans
SEC Staff Accounting Bulletins
SAB Topic 4.E, Receivables From Sale
of Stock [Reproduced in ASC 310-10-S99-2]
Facts:
Capital stock is sometimes issued to officers or
other employees before the cash payment is received.
Question 2:
How should the receivables from the officers or
other employees be presented in the balance
sheet.
Interpretive
Response: The amount recorded as a receivable
should be presented in the balance sheet as a
deduction from stockholders’ equity. This is
generally consistent with Rule 5-02.[29] of
Regulation S-X which states that accounts or notes
receivable arising from transactions involving the
registrant’s capital stock should be presented as
deductions from stockholders’ equity and not as
assets.
It should be noted generally that
all amounts receivable from officers and directors
resulting from sales of stock or from other
transactions (other than expense advances or sales
on normal trade terms) should be separately stated
in the balance sheet irrespective of whether such
amounts may be shown as assets or are required to be
reported as deductions from stockholders’ equity.
The staff will not suggest that a
receivable from an officer or director be deducted
from stockholders’ equity if the receivable was paid
in cash prior to the publication of the financial
statements and the payment date is stated in a note
to the financial statements. However, the staff
would consider the subsequent return of such cash
payment to the officer or director to be part of a
scheme or plan to evade the registration or
reporting requirements of the securities laws.
If the issuer of a redeemable equity instrument classified as temporary equity receives notes issued by the holders of the redeemable shares instead of cash in exchange for the instrument, Regulation S-X, Rule 5-02(27)(b), requires the issuer to present the shareholder loan as a reduction of temporary equity. The issuer should not present the shareholder loan as an asset or as a reduction of permanent equity.
This is consistent with the consensus in EITF Issue 89-11, in which the Task Force noted, in part:
[W]hen ASR 268 . . . requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section . . . if any, should be similarly classified.
9.8.2 Disclosure
ASC 505-10
Redeemable Securities
50-11 An entity that issues redeemable stock shall disclose the amount of redemption requirements, separately by issue or combined, for all issues of capital stock that are redeemable at fixed or determinable prices on fixed or determinable dates in each of the five years following the date of the latest statement of financial position presented.
SEC Rules, Regulations, and
Interpretations
Regulation S-X, Rule 5-02, Balance
Sheets [Reproduced in ASC 210-10-S99-1]
Redeemable Preferred Stocks
27. Preferred stocks subject to mandatory
redemption requirements or whose redemption is
outside the control of the issuer. . . .
(b) State on the face of
the balance sheet the title of each issue, the
carrying amount, and redemption amount. (If there
is more than one issue, these amounts may be
aggregated on the face of the balance sheet and
details concerning each issue may be presented in
the note required by paragraph (c) below.) Show
also the dollar amount of any shares subscribed
but unissued, and show the deduction of
subscriptions receivable there from.
If the carrying value is
different from the redemption amount, describe the
accounting treatment for such difference in the
note required by paragraph (c) below.
Also state in this note or
on the face of the balance sheet, for each issue,
the number of shares authorized and the number of
shares issued or outstanding, as appropriate (See
§ 210.4–07).
(c) State in a separate
note captioned “Redeemable Preferred Stocks” (1) a
general description of each issue, including its
redemption features (e.g. sinking fund, at option
of holders, out of future earnings) and the
rights, if any, of holders in the event of
default, including the effect, if any, on junior
securities in the event a required dividend,
sinking fund, or other redemption payment(s) is
not made; (2) the combined aggregate amount of
redemption requirements for all issues each year
for the five years following the date of the
latest balance sheet; and (3) the changes in each
issue for each period for which a statement of
comprehensive income is required to be filed. (See
also § 210.4–08(d).) . . .
CFRR 211: Redeemable Preferred Stocks
[Reproduced in ASC 480-10-S99-1]
.04 Footnote Disclosure of Future Cash
Obligations
ASR 268:
In the interest of clear and prominent
disclosure of the future cash obligations attendant with
these types of securities, the rules require disclosure
of the term of redemption, five-year maturity data, and
changes in these securities in a separate note to the
financial statements captioned “Redeemable Preferred
Stocks.” It should be noted that although in the past a
registrant may have disclosed changes in redeemable
preferred stocks in a statement of stockholders’ equity,
such changes are now required to be disclosed in a
separate note as described above. . . .
.06 Ratios and Materiality Tests
ASR 268: (7/27/79).
Where certain ratios or other data
involving amounts attributable to stockholder’s equity
are presented as required or are optionally presented in
filings with the Commission, such ratios or other data
should be accompanied by an explanation as to their
basis of calculation. If material amounts of redeemable
preferred stock are combined with amounts applicable to
non-redeemable preferred and common stocks for purposes
of computing a ratio, there should also be represented a
similar ratio which excludes amounts applicable to
redeemable preferred stock from equity and includes such
amounts as debt. This would also apply to any financial
information such as tables, charts, graphic
illustrations and ratios presented in annual reports to
shareholders if such reports are to meet the
requirements to Rule 14a-3 of the General Rules and
Regulations under the Exchange Act.
In addition, the Commission did not
amend its rules, regulations and releases to the extent
that they provide for various materiality tests for
disclosure purposes using a percentage of total
stockholders’ equity. In making these tests, registrants
may use amounts applicable to all classes of capital
stock.
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(24) ASR 268 and SEC
Regulation S-X require certain disclosures about
redeemable equity instruments. In addition, the SEC
staff expects the following disclosures to be provided
in the notes to the financial statements:
-
A description of the accounting method used to adjust the redemption amount of a redeemable equity instrument (as discussed in paragraphs 14–16).
-
When a registrant elects to accrete changes in the redemption amount of a redeemable equity instrument in accordance with paragraph 15(a), the redemption amount of the equity instrument as if it were currently redeemable.
-
For a redeemable equity instrument that is not adjusted to its redemption amount, the reasons why it is not probable that the instrument will become redeemable.
-
When charges or credits discussed in paragraphs 20 and 22(a) are material, a reconciliation between net income and income available to common stockholders.
-
The amount credited to equity of the parent upon the deconsolidation of a subsidiary (as discussed in paragraph 19).
SEC Staff Accounting Bulletins
SAB Topic 6.B, Accounting Series Release
280 — General Revision of Regulation S-X: Income or Loss
Applicable to Common Stock [Reproduced in ASC
220-10-S99-55]
Facts: A
registrant has various classes of preferred stock.
Dividends on those preferred stocks and accretions of
their carrying amounts cause income applicable to common
stock to be less than reported net income.
Question 2: In
ASR 280, the Commission stated that although it had
determined not to mandate presentation of income or loss
applicable to common stock in all cases, it believes
that disclosure of that amount is of value in certain
situations. In what situations should the amount be
reported, where should it be reported, and how should it
be computed?
Interpretive
Response: Income or loss applicable to common
stock should be reported on the face of the income
statementFN1 when it is materially
different in quantitative terms from reported net income
or lossFN2 or when it is indicative of
significant trends or other qualitative considerations.
The amount to be reported should be computed for each
period as net income or loss less: (a) dividends on
preferred stock, including undeclared or unpaid
dividends if cumulative; and (b) periodic increases in
the carrying amounts of instruments reported as
redeemable preferred stock (as discussed in Topic 3.C)
or increasing rate preferred stock (as discussed in
Topic 5.Q).
__________________________________
FN1 When a registrant reports net
income and total comprehensive income in one
continuous financial statement, the registrant
must continue to follow the guidance set forth in
the SAB Topic. One approach may be to provide a
separate reconciliation of net income to income
available to common stock below comprehensive
income reported on a statement of income and
comprehensive income.
FN2 The assessment of materiality is
the responsibility of each registrant. However,
absent concerns about trends or other qualitative
considerations, the staff generally will not
insist on the reporting of income or loss
applicable to common stock if the amount differs
from net income or loss by less than ten
percent.
Regulation S-X, Rule 5-02.27(b), requires an issuer to provide the following information related to instruments classified as temporary equity on the face of the balance sheet:
- The title of the issue.
- The carrying amount.
- The redemption amount.
If there is more than one issuance, the entity must present the above information for each issuance either on the face of the balance sheet or in the related notes and must provide aggregate amounts on the face of the balance sheet. The issuer should also provide:
- The dollar amount of any shares subscribed but unissued.
- The deduction of subscriptions receivable therefrom.
Rule 5-02.27(c) and ASC 480-10-S99-3A(24) require an issuer to provide the following information about instruments classified as temporary equity in a separate note:
- A “general description of each issue, including its redemption features (e.g. sinking fund, at option of holders, out of future earnings) and the rights, if any, of holders in the event of default, including the effect, if any, on junior securities in the event a required dividend, sinking fund, or other redemption payment(s) is not made.”
- Five-year maturity data; that is, “the combined aggregate amount of redemption requirements for all issues each year for the five years following the date of the latest balance sheet.” The purpose of this guidance is to require “clear and prominent disclosure of the future cash obligations attendant with these types of securities” (CFRP 211.04). (Similar five-year data must be disclosed under ASC 505-10-50-11 by both SEC registrants and nonregistrants for redeemable stock that is redeemable at fixed or determinable prices on fixed or determinable dates.)
- The “changes in each issue for each period for which a statement of comprehensive income is required to be filed.”
- “A description of the accounting method used to adjust the redemption amount,” i.e., the subsequent measurement method (see Section 9.5.2). (Similarly, Rule 5-02.27(b) requires disclosure of the accounting treatment for any difference between the carrying value and the redemption amount.)
- “When a registrant elects to accrete changes in the redemption amount of a redeemable equity instrument [that is not currently redeemable; see Sections 9.5.2 and 9.5.3], the redemption amount of the equity instrument as if it were currently redeemable” (i.e., the current redemption value).
- “For a redeemable equity instrument that is not adjusted to its redemption amount [because it is not probable that it will become redeemable; see Sections 9.5.2 and 9.5.4], the reasons why it is not probable that the instrument will become redeemable.”
- When charges or credits related to preferred stock instruments (including noncontrolling interests in the form of preferred stock) are material, “a reconciliation between net income and income available to common stockholders.”
- “The amount credited to equity of the parent upon the deconsolidation of a subsidiary” (see Section 9.7.5).
When changes in the carrying amount of instruments presented as temporary equity cause income or loss applicable to common stock to be materially different from reported net income or loss, SAB Topic 6.B requires separate disclosure of income or loss applicable to common stock on the face of the income statement.
An issuer (including a nonpublic entity that is not required to apply the SEC’s
temporary equity guidance) should also consider the general disclosure
requirements related to stockholders’ equity and specific outstanding securities
issued by an entity under ASC 505-10-50. For instance, ASC 505-10-50-11 requires
disclosure of “the amount of redemption requirements, separately by issue or
combined, for all issues of capital stock that are redeemable at fixed or
determinable prices on fixed or determinable dates in each of the five years
following the date of the latest statement of financial position presented.”
An entity is not required to provide fair value measurement disclosures under
ASC 825 for items classified in temporary equity, because instruments classified
in temporary equity qualify under the scope exception in ASC 825-10-50-8(i) for
items classified in stockholders’ equity. (ASC 815-10-15-76 notes that
“[t]emporary equity is considered stockholders’ equity . . . even if it is
required to be displayed outside of the permanent equity section.”)
If an issuer is required or elects to present financial information (such as
ratios, tables, charts, and graphic illustrations) that includes amounts of
stockholders’ equity, it should “explain the basis of calculation” (CFRP
211.06). “If material amounts of [temporary equity classified] redeemable
preferred stock are combined with amounts applicable to non-redeemable preferred
and common stocks,” similar information should be provided that “excludes
amounts applicable to redeemable preferred stock from equity.”
Footnotes
5
The version of SAB Topic 6.B
that is reproduced in ASC 220-10-S99-5 differs
from the text published on the SEC’s Web site and
in the Federal Register. That is, whereas
the SEC’s Web site and Federal Register
state, “When a registrant reports net income and
total comprehensive income in one continuous
financial statement,” ASC 220-10-S99-5 states, “If
a registrant elects to follow the encouraged
disclosure discussed in paragraph 23 of Statement
130 [paragraph 220-10-45-9], and displays the
components of other comprehensive income and the
total for comprehensive income using a
one-statement approach.” Although the wording
differs, the guidance is consistent.