Deloitte's Roadmap: Distinguishing Liabilities From Equity
Preface
Preface
We are pleased to present the
2023 edition of Distinguishing Liabilities From Equity. This Roadmap provides an
overview of the guidance in ASC 480-101 as well as insights into and interpretations of how to apply it in practice. ASC
480-10 requires (1) issuers to classify certain types of shares of stock and certain
share-settled contracts as liabilities or, in some circumstances, as assets and (2) SEC
registrants to classify certain types of redeemable equity instruments as temporary equity.
The 2023 edition of the Roadmap
includes updated and expanded guidance on distinguishing between put warrants and
net-cash-settled written call options, the application of the deemed liquidation exception
in ASC 480-10-S99-3A, determining whether remeasurement is required when the holders of a
convertible instrument control the issuer, and other topics. Appendix F highlights substantive changes made to the
Roadmap since issuance of the 2022 edition.
Be sure to check out On the Radar (also
available as a stand-alone publication),
which briefly summarizes emerging issues and trends related to the accounting
and financial reporting topics addressed in the Roadmap.
We hope you will find this
Roadmap to be a useful resource in determining the
appropriate accounting for contracts within the
scope of ASC 480-10, and we welcome your suggestions for
future improvements to it. If you have questions
about the guidance or would like assistance
applying it, we encourage you to consider
consulting our technical specialists and other
professional advisers.
Footnotes
1
For a list of abbreviations used in this publication, see Appendix E. For the full titles of
standards, topics, and regulations used in this publication, see Appendix D.
On the Radar
On the Radar
Entities raising capital must apply the highly complex, rules-based guidance in U.S.
GAAP to determine whether the securities they issue are classified as liabilities,
permanent equity, or temporary equity. To reach the proper accounting conclusion,
they must consider the following key questions:
All entities are capitalized with debt or equity. The mix of debt and equity
securities that comprise an entity’s capital structure, and an entity’s decision
about the type of security to issue when raising capital, may depend on the stage of
the entity’s life cycle, the cost of capital, the need to comply with regulatory
capital requirements or debt covenants (e.g., capital or leverage ratios), and the
financial reporting implications. For example, early-stage and
smaller growth companies are often financed with preferred stock and warrants with
complex and unusual features, whereas larger, more mature entities often have a mix
of debt and equity securities with more plain-vanilla common stock capitalization.
Under U.S. GAAP, securities issued as part of an entity’s capital structure are
classified within one of the following three categories on an entity’s balance
sheet:
An instrument’s classification on the balance sheet will affect how returns on the
instrument are reflected in an entity’s income statement. Returns on
liability-classified instruments are reflected in net income (e.g., interest expense
or mark-to-market adjustments), whereas returns on equity-classified instruments are
generally reflected in equity, without affecting net income. However, dividends and
remeasurement adjustments on equity securities that are classified as temporary
equity may reduce an entity’s reported EPS.
In addition to the effect on net income and EPS, entities often seek to avoid
classifying capital securities as liabilities or within temporary equity for other
reasons, including:
-
The effect of the classification on the security’s credit rating and stock price.
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Regulatory capital requirements.
-
Debt covenant requirements (e.g., leverage or capital ratios).
The SEC staff closely
scrutinizes the balance sheet classification of capital
securities to determine whether they have been
appropriately categorized as liabilities, permanent
equity, or temporary equity. This is evident in the
staff’s comment letters on registrants’ filings and the
number of restatements arising from inappropriate
classification. Accordingly, entities are encouraged to
consult with their professional advisers on the
appropriate application of GAAP.
ASC 480 is the starting point for determining whether an instrument must be
classified as a liability. SEC registrants and non-SEC registrants that elect to
apply the SEC’s guidance on redeemable equity securities must also consider the
classification within equity. The relevant accounting guidance has existed for a
number of years without substantial recent changes. In addition, we are not aware of
any plans of the FASB or SEC to significantly change the guidance in the near
future.
Equity Versus Liability Treatment
Securities issued in the legal form of debt must be classified as liabilities.
In addition, ASC 480 requires liability classification for three types of
freestanding financial instruments that are not debt in legal form:
In evaluating whether an
instrument must be classified as a liability under ASC 480, entities must
consider three key questions:
ASC 480 applies to each freestanding financial instrument.
In some cases, securities are issued on a stand-alone basis and it is readily
apparent that there is only one unit of account. In other financing
transactions, there are two or more components that individually represent
separate units of accounting (e.g., preferred stock is issued with detachable
warrants). When an entity enters into a financing transaction that includes
items that can be legally detached and exercised separately, those items are
separate freestanding financial instruments and ASC 480 must be applied to them
individually.
To be a liability under ASC 480, an instrument must contain
an obligation that requires the issuer to transfer cash, other assets, or equity
shares (e.g., an obligation to redeem an instrument). ASC 480 defines
“obligation” broadly to include any “conditional or unconditional duty or
responsibility to transfer assets or to issue equity shares.”
Conditional obligations are treated differently than
unconditional obligations. To be a liability under ASC 480, an instrument that
is a share in legal form must contain an unconditional obligation of the issuer
to redeem it in cash, assets, or a variable number of equity shares. However,
other obligations that are not outstanding shares may require classification as
liabilities under ASC 480 whether the obligation is conditional or
unconditional. For example, an obligation to repurchase an issuer’s equity
shares is a liability whether the obligation is conditional or unconditional.
Permanent Equity Versus Temporary Equity
SEC registrants are required to apply the SEC’s guidance
on redeemable equity securities. An entity that has
filed a registration statement with the SEC is
considered an SEC registrant. Other entities, such as
companies that anticipate an IPO in the future, may
elect to apply this guidance.
Equity-classified securities that contain any obligation
outside the issuer’s control (whether conditional or
unconditional) that may require the issuer to redeem the
security must be classified as temporary equity. Equity
securities that are classified as temporary equity are
subject to the recognition, measurement, and EPS
guidance in ASC 480-10-S99-3A, which is often complex to
apply. The remeasurement guidance in ASC 480-10-S99-3A
may negatively affect an entity’s reported EPS because
adjustments to the redemption amount are often treated
as dividends that reduce the numerator in EPS
calculations.
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An entity
must apply the SEC’s guidance on the
classification of redeemable equity securities in
its SEC filings made in contemplation of an IPO or
a merger with a SPAC.
|
Earnings per Share
ASC 480-10 does not comprehensively address how to determine EPS for
instruments within its scope. Instead, an entity applies ASC 260 except as specified
in ASC 480-10-45-4, which requires the entity to make certain adjustments to the EPS
calculation performed under ASC 260 for (1) mandatorily redeemable financial
instruments and (2) forward contracts that require physical settlement by repurchase
of a fixed number of equity shares of common stock in exchange for cash. Special
considerations are necessary for contracts that may be settled in stock or cash.
Under ASC 260 as amended
by ASU 2020-06, an entity may not overcome the
presumption of share settlement for a contract that may
be settled in stock or cash. Certain contracts within
the scope of ASC 480-10 may be settled in stock or cash.
The calculation of diluted EPS must include the
potential shares issuable under such contracts.
This Roadmap provides a comprehensive
discussion of the classification, recognition, measurement,
presentation and disclosure, and EPS guidance in ASC 480 and
ASC 480-10-S99-3A. Entities should also consider Deloitte’s
Roadmap Contracts on an Entity’s Own
Equity for guidance on equity-linked
instruments that are not outstanding shares as well as
Deloitte’s Roadmap Earnings
per Share for guidance on the
calculation of basic and diluted EPS.
Contacts
Contacts
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Ashley Carpenter
Partner
Deloitte & Touche
LLP
+1 203 761 3197
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Jonathan Howard
Partner
Deloitte & Touche
LLP
+1 203 761 3235
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Magnus Orrell
Managing Director
Deloitte & Touche
LLP
+1 203 761 3402
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For information about Deloitte’s financial instruments service
offerings, please contact:
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Jamie Davis
Partner
Deloitte & Touche LLP
+1 312 486 0303
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Chapter 1 — Overview
Chapter 1 — Overview
ASC 480-10
05-1 The Codification contains separate Topics for liabilities and equity, including a separate Topic for debt. The Distinguishing Liabilities from Equity Topic contains only the Overall Subtopic. This Subtopic establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. Section 480-10-25 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer.
ASC 480-10 provides guidance on determining whether (1) certain financial instruments with both debt-like and equity-like characteristics should be accounted for “outside of equity” (i.e., as liabilities or, in some cases, assets) by the issuer and (2) SEC registrants should present certain redeemable equity instruments as temporary equity.
Examples of contracts and transactions that may require evaluation under ASC 480-10 include:
- Redeemable shares.
- Redeemable noncontrolling interests.
- Forward contracts to repurchase own shares.
- Forward contracts to sell redeemable shares.
- Written put options on own stock.
- Warrants (and written call options) on redeemable equity shares.
- Warrants on shares with deemed liquidation provisions.
- Puttable warrants on own stock.
- Equity collars.
- Share-settled debt (this term is used in this Roadmap to describe a share-settled obligation that is not in the legal form of debt but has the same economic payoff profile as debt).
- Preferred shares that are mandatorily convertible into a variable number of common shares.
- Unsettled treasury stock transactions.
- Accelerated share repurchase programs.
- Hybrid equity units.
However, ASC 480-10 does not apply to legal-form debt, which is always classified as a liability by the issuer (see Section 2.2.4).
ASC 480-10 requires an issuer to classify three classes of financial instruments (e.g., outstanding shares and contracts on the issuer’s shares) as assets or liabilities:
- Mandatorily redeemable financial instruments (see Chapter 4) — The issuer of a financial instrument that is in the form of a share must classify the share as a liability if it embodies an unconditional obligation requiring the issuer to redeem the share by transferring assets unless redemption would occur only upon the liquidation or termination of the reporting entity. Examples include those mandatorily redeemable shares and mandatorily redeemable noncontrolling interests that do not contain any substantive conversion features.
- Obligations to repurchase the entity’s equity shares by transferring assets (see Chapter 5) — A financial instrument other than an outstanding share is classified as an asset or a liability if it both (1) embodies an obligation to repurchase the issuer’s equity shares (or is indexed to such an obligation) and (2) requires (or may require) the issuer to settle the obligation by transferring assets. Examples include those forward purchase contracts and written put options on the entity’s own equity shares that are either physically settled or net cash settled.
- Certain obligations to issue a variable number of equity shares (see Chapter 6) — An outstanding share that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies an obligation, is classified as an asset or a liability if the issuer must or may settle the obligation by issuing a variable number of its equity shares and the obligation’s monetary value is based solely or predominantly on one of the following: (1) a fixed monetary amount, (2) variations in something other than the fair value of the issuer’s equity shares, or (3) variations inversely related to changes in the fair value of the issuer’s equity shares. Examples include share-settled debt and those forward purchase contracts and written put options on the entity’s own equity shares that are net share settled.
Financial instruments that are accounted for as assets or liabilities under ASC 480 are initially recognized at fair value, with one exception (see Sections 4.3, 5.3, and 6.3). A forward contract that requires the entity to repurchase a fixed number of its equity shares for cash is initially measured at the fair value of the shares at inception (i.e., not the fair value of the forward contract), with certain adjustments, and the offsetting entry is presented in equity (i.e., the transaction is treated as if the repurchase had already occurred with borrowed funds).
In subsequent periods, financial instruments classified as assets or liabilities under ASC 480-10 are remeasured at their then-current fair value, and changes in fair value are recorded in earnings, with two exceptions (see Sections 4.3, 5.3, and 6.3). Physically settled forward contracts to repurchase “a fixed number of the issuer’s equity shares [for] cash and mandatorily redeemable financial instruments [are] measured subsequently in either of the following ways,” as applicable:
- If both the amount to be paid and the settlement date are fixed, such instruments are measured subsequently at the present value of the amount to be paid at settlement, and interest cost is accrued at the rate implicit at inception.
- If either the amount to be paid or the settlement date varies on the basis of specified conditions, such instruments are measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement were to occur as of the reporting date, and any change in that amount is recognized as interest cost.
Further, ASC 480-10 includes:
If ASC 480-10 does not require an instrument to be classified outside of equity, an issuer should consider whether such a requirement exists under other GAAP (e.g., ASC 815-40) or whether the SEC guidance in ASC 480-10-S99-3A requires the instrument to be classified outside of permanent equity. Under the SEC’s guidance in ASC 480-10-S99-3A, issuers of certain equity-classified instruments that are redeemable for cash or other assets in circumstances not under the sole control of the issuer must present such instruments in temporary equity and apply specific measurement and disclosure guidance to them (see Chapter 9).
Some entities are affected by both U.S. GAAP and IFRS® Accounting
Standards. There are significant differences between the guidance in ASC 480-10 and
the equivalent guidance under IFRS Accounting Standards (see Chapter 10).
The appendixes of this Roadmap include an overview of the classification and
measurement requirements in ASC 480-10 (Appendix A), a table with sources of SEC
guidance on temporary equity (Appendix B), and glossary terms from ASC 480-10-20 and the ASC
master glossary (Appendix
C).
Although they are doing so less frequently, some practitioners continue to refer to FASB Statement 150, EITF Issue 00-4, and EITF Topic D-98, which were superseded
by ASC 480-10 in 2009 as a result of the FASB’s codification of U.S. GAAP (the
“Codification”). While the guidance in those pronouncements has not changed
significantly since being codified, they are no longer recognized as authoritative
sources of accounting guidance. This Roadmap contains excerpts from FASB Statement
150’s Background Information and Basis for Conclusions, which describes the Board’s
considerations in developing some of the guidance now contained in ASC 480-10.
The following ASUs have amended the guidance in ASC 480-10:
- ASU 2009-04 (issued in August 2009) updated the SEC’s guidance on the accounting for redeemable equity instruments in ASC 480-10-S99-3A (see Chapter 9).
- ASU 2016-19 (issued in December 2016) introduced a scope exception for registration payment arrangements (see Section 2.7).
- ASU 2017-11 (issued in July 2017) recharacterized certain indefinite effective-date deferrals as scope exceptions to improve the readability of the guidance in ASC 480-10 (see Sections 2.1.2 and 4.1.5).
- ASU 2018-07 (issued in June 2018) amended the ASC 480-10 scope exception for obligations under share-based payment arrangements (see Section 2.4). ASU 2018-07 was subsequently amended by ASU 2019-08 to include, within the scope of ASC 718, share-based payment awards to customers.)
- ASU 2018-09 (issued in July 2018) conformed the guidance on certain freestanding options involving noncontrolling interests in ASC 480-10-55 with the guidance in FASB Statement 150 and ASC 480-10-25-15 (see Section 7.1.2).
It is assumed in this Roadmap that an entity has adopted all these
ASUs.
Connecting the Dots
When analyzing financial instruments with characteristics of both liabilities and equity, entities typically must consider multiple Codification subtopics in addition to ASC 480-10, including:
- ASC 260-10 (see Deloitte’s Roadmap Earnings per Share).
- ASC 470-20 (see Deloitte’s Roadmap Convertible Debt (Before Adoption of ASU 2020-06) for entities that have not adopted ASU 2020-06 and Chapter 7 of Deloitte’s Roadmap Issuer’s Accounting for Debt for entities that have adopted ASU 2020-06).
- ASC 815-10 and ASC 815-15 (see Chapter 8 of Deloitte’s Roadmap Issuer's Accounting for Debt).
- ASC 815-40 (see Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
Changing Lanes
In August 2020, the FASB issued ASU 2020-06, which amends ASC 260-10, ASC 470-20, and
ASC 815-40 and significantly affects an issuer’s accounting for convertible
debt instruments as well as contracts on an entity’s own equity and related
EPS calculations. While the amendments will not substantially alter an
entity’s application of ASC 480-10, we have highlighted within this Roadmap
certain changes that will result from them.
ASU 2020-06 is effective as follows:
-
For public business entities that are not smaller reporting companies, fiscal years beginning after December 15, 2021, and interim periods within those fiscal years.
-
For all other entities, fiscal years beginning after December 15, 2023, and interim periods within those fiscal years.
The guidance may be early adopted for fiscal years beginning after December
15, 2020, and interim periods within those fiscal years.
For convertible instruments that include a down-round feature, entities may
early adopt the amendments that apply to down-round features if they have
not yet adopted the amendments in ASU 2017-11.
For more information about these amendments, including the transition
provisions, see Deloitte’s August 5, 2020, Heads Up.
Chapter 2 — Scope
Chapter 2 — Scope
Before an issuer applies the accounting guidance in ASC 480-10 to a contract, it should evaluate whether the guidance applies to the contract. In this chapter, we discuss the types of entities and instruments that are subject to ASC 480-10 (see Sections 2.1 and 2.2). Further, we describe how the guidance in ASC 480-10 interacts with other GAAP that apply to derivatives (see Section 2.3), share-based payments (see Section 2.4), convertible preferred shares with cash conversion features (CCFs) (see Section 2.5), contingent consideration in a business combination (see Section 2.6), registration payment arrangements (see Section 2.7), and guarantee obligations (see Section 2.8).
This chapter does not address the scope of the SEC’s temporary equity
requirements in ASC 480-10-S99-3A. For a discussion of the
applicability of those requirements, see Sections 9.2 and 9.3.
2.1 Entities
2.1.1 Issuers
ASC 480-10
10-1 The objective of this Subtopic is to require issuers to classify as liabilities (or assets in some circumstances) three classes of freestanding financial instruments that embody obligations for the issuer.
15-2 The guidance in the Distinguishing Liabilities from Equity Topic applies to all entities.
ASC 480-10 — Glossary
Issuer
The entity that issued a financial instrument or may be required under the terms of a financial instrument to issue its equity shares.
ASC 480-10 applies to both public business entities (including SEC registrants) and private companies that are issuers of financial instruments within its scope. Under ASC 480-10-20, an issuer is defined as an entity that either “issued a financial instrument” (e.g., an outstanding common or preferred share) or “may be required under the terms of a financial instrument to issue its equity shares” (e.g., certain obligations to deliver a variable number of equity shares). An entity that enters into an obligation to repurchase its equity shares by transferring assets (e.g., an entity that writes a put option or enters into a forward purchase contract on its equity shares) is also considered an “issuer” under ASC 480-10 because it issued the shares underlying the contract. Conversely, ASC 480-10 does not apply to investors in the entity’s equity shares or to the counterparty to a financial instrument on the entity’s equity shares.
2.1.2 Exempt Entities
Some of the requirements in ASC 480-10 do not
apply to certain mandatorily redeemable financial instruments that either
represent noncontrolling interests or are issued by nonpublic entities that are
not SEC registrants. The following table provides an overview of these
exceptions:
Affected Entities
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Instruments for Which Some or All of the
Guidance in ASC 480-10 Does Not Apply
|
Exempt Guidance
|
Scope Exception in ASC 480-10-15
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---|---|---|---|
Parents preparing consolidated financial statements (both public and nonpublic) | Mandatorily redeemable noncontrolling interests that do not have to be classified as liabilities by the subsidiary under the only-upon-liquidation exception in ASC 480-10- 25-4 and 25-6 | The classification and measurement provisions (but not the disclosure provisions) in ASC 480-10 | 7E(a) |
Other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003 | The measurement provisions (but not the classification and disclosure provisions) in ASC 480-10 | 7E(b) | |
Subsidiaries (both public and nonpublic) | Mandatorily redeemable noncontrolling interests that were issued before November 5, 2003 | The measurement provisions (but not the classification and disclosure provisions) in ASC 480-10 | 7E(b) |
Nonpublic entities that are not SEC registrants | Mandatorily redeemable financial instruments other than those that are mandatorily redeemable on fixed dates for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index | The classification, measurement, and disclosure provisions in ASC 480-10 | 7A |
These exceptions are described in more detail in Section 4.1.5.
2.2 Instruments
ASC
480-10
10-1 The
objective of this Subtopic is to require issuers to classify
as liabilities (or assets in some circumstances) three
classes of freestanding financial instruments that embody
obligations for the issuer.
15-3 The
guidance in the Distinguishing Liabilities from Equity Topic
applies to any freestanding financial instrument, including
one that has any of the following attributes:
- Comprises more than one option or forward contract
- Has characteristics of both a liability and equity and, in some circumstances, also has characteristics of an asset (for example, a forward contract to purchase the issuer’s equity shares that is to be net cash settled). Accordingly, this Topic does not address an instrument that has only characteristics of an asset.
15-4 For
example, an instrument that consists of a written put option
for an issuer’s equity shares and a purchased call option
and nothing else is a freestanding financial instrument
(paragraphs 480-10-55-18 through 55-20 provide examples of
such instruments). That freestanding financial instrument
embodies an obligation to repurchase the issuer’s equity
shares and is subject to the requirements of this
Topic.
ASC 480-10 applies only to items that have all of the following
characteristics:
- They embody one or more obligations of the issuer (see Section 2.2.1).
- They meet the definition of a financial instrument (see Section 2.2.2).
- They meet the definition of a freestanding financial instrument (see Sections 2.2.3 and 3.3); that is, they are not features embedded in a freestanding financial instrument.
- Their legal form is that of a share, or they could result in the receipt or delivery of shares or are indexed to an obligation to repurchase shares (see Section 2.2.4).
ASC 480-10 requires an instrument that has all of the above
characteristics to be classified outside of equity if it falls within one of the
following classes of instruments:
The fact that an instrument is not required to be classified as an
asset or a liability under ASC 480-10 does not necessarily mean that it qualifies
for equity classification. To determine whether an instrument qualifies for
classification in equity in whole or in part, an entity must also consider other
GAAP (e.g., ASC 470-20, ASC 815-10, ASC 815-15, and ASC 815-40). Further, under ASC
480-10-S99-3A, an entity that is subject to SEC guidance should consider whether an
equity-classified instrument must be classified outside of permanent equity (see
Chapter 9).
2.2.1 Obligations of the Issuer
2.2.1.1 The Concept of an Obligation
ASC 480-10 — Glossary
Obligation
A conditional or unconditional duty
or responsibility to transfer assets or to issue
equity shares. Because Topic 480 relates only to
financial instruments and not to contracts to
provide services and other types of contracts, but
includes duties or responsibilities to issue equity
shares, this definition of obligation differs from
the definition found in FASB Concepts Statement No.
6, Elements of Financial Statements, and is
applicable only for items in the scope of that
Topic.
ASC 480-10
05-2 All of the following are
examples of an obligation:
- An entity incurs a conditional obligation to transfer assets by issuing (writing) a put option that would, if exercised, require the entity to repurchase its equity shares by physical settlement. (Further, an instrument that requires the issuer to settle its obligation by issuing another instrument [for example, a note payable in cash] ultimately requires settlement by a transfer of assets.)
- An entity incurs a conditional obligation to transfer assets by issuing a similar contract that requires or could require net cash settlement.
- An entity incurs a conditional obligation to issue its equity shares by issuing a similar contract that requires net share settlement.
05-3 In contrast, by issuing
shares of stock, an entity generally does not incur
an obligation to redeem the shares, and, therefore,
that entity does not incur an obligation to transfer
assets or issue additional equity shares. However,
some issuances of stock (for example, mandatorily
redeemable preferred stock) do impose obligations
requiring the issuer to transfer assets or issue its
equity shares.
ASC 480-10 applies to a freestanding financial instrument only if it embodies one or more obligations of the issuer. Therefore, in evaluating whether the instrument must be classified outside of equity under ASC 480-10, the issuer should determine whether it contains at least one obligation. Paragraph B33 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
Identifying whether a financial instrument embodies
an obligation is the starting point in determining the appropriate
classification of that instrument. . . . A financial instrument that
does not embody an obligation cannot be a liability under the current Concepts Statement 6 definition.
ASC 480-10 defines an obligation as a “conditional or unconditional duty or responsibility to transfer assets or to issue equity shares.” This definition is based in part on the definition of a liability in paragraphs 35 and 36 of FASB Concepts Statement 6. Those paragraphs
state, in part:
Liabilities are
probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past
transactions or events. . . . A liability has three essential
characteristics: (a) it embodies a present duty or responsibility to
one or more other entities that entails settlement by probable
future transfer or use of assets at a specified or determinable
date, on occurrence of a specified event, or on demand, (b) the duty
or responsibility obligates a particular entity, leaving it little
or no discretion to avoid the future sacrifice, and (c) the
transaction or other event obligating the entity has already
happened.
Chapter
4 discusses mandatorily redeemable financial instruments,
which (as noted in Chapter
1) are one of the three classes of financial instruments that
must be classified outside of equity under ASC 480-10. ASC 480-10-20 defines
a mandatorily redeemable financial instrument as “[a]ny of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.” The characteristics of such an instrument are consistent with those in the FASB’s definition of a liability in FASB Concepts Statement 6 because they (1) embody an obligation to transfer
assets, (2) leave the issuer no discretion to avoid the future transfer of
assets, and (3) result from a past event (the issuance of the
instrument).
Chapter
5 discusses the second of the three classes: financial instruments, other than outstanding shares, that embody an obligation to repurchase shares (or an obligation that is indexed to such an obligation) in exchange for cash or other assets (e.g., a physically settled forward purchase or written put option on the issuer’s equity shares). These instruments embody obligations that have all the characteristics of a liability as defined in FASB Concepts Statement 6 because they conditionally
or unconditionally require the issuer to transfer assets, they give the
issuer no discretion to avoid the future transfer of assets, and they result
from a past event (i.e., the issuance of the instrument).
Chapter
6 discusses the third of the three classes: certain obligations to deliver a variable number of equity shares. As noted in paragraph B17 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board concluded that some financial instruments
“that embody obligations to issue shares place the holder of the instrument
in a position fundamentally different from the position of a holder of the
issuer’s equity shares, that such obligations do not result in an ownership
relationship, and that an instrument that embodies an obligation that does
not establish an ownership relationship should be a liability.” For example,
the economic payoff profile of an obligation to issue equity shares worth a
fixed monetary amount resemble that of a debt obligation. Even though it is
share settled, such an obligation could adversely affect the economic
interests of current holders of the entity’s equity shares by diluting their
ownership interest.
Under FASB Concepts Statement 6, an obligation to issue
equity shares is not a liability. Nevertheless, an entity should apply ASC
480-10 in evaluating whether a share-settled obligation within the scope of
ASC 480-10 should be classified as a liability since FASB concepts
statements are not an authoritative source of U.S. GAAP (see ASC
105-10-05-3). When the FASB developed the requirements that are now in ASC
480-10, its plan was to amend the definition of a liability in Concepts Statement 6 to include certain share-settled obligations, but the Board has not yet done so. Paragraphs B12 through B14 of the Background Information and Basis for Conclusions of FASB Statement 150 state:
As part of its deliberations on this Statement, the Board discussed the accounting for financial instruments that embody obligations that require (or permit at the issuer’s discretion) settlement by issuance of the issuer’s equity shares. Those obligations do not require a transfer of assets and, thus, do not meet the current definition of liabilities in Concepts Statement 6.
Therefore, those financial instruments have been classified as
equity.
However, not all such obligations establish the type
of relationship that exists between an entity and its owners. For
example, a financial instrument that requires settlement by issuance
of $100,000 worth of equity shares establishes something more akin
to a debtor-creditor relationship than to an ownership relationship,
because it requires that the issuer convey a fixed amount of value
to the holder that does not vary with the issuer’s equity shares. A
share-settled put option on the issuer’s equity shares establishes
the opposite (inverse) of an ownership relationship, because it
requires the issuer to convey value to the holder that
increases as the value of other owners’ interests
decreases.
The Board considered and rejected the alternative of resolving the accounting issues raised by those financial instruments by applying the original definitions of liabilities and equity in Concepts Statement 6. The Board decided that it would be
preferable to reconsider the distinction between liabilities and
equity. Otherwise, classification by issuers of financial
instruments that embody obligations would be based solely on whether
the obligation requires settlement by a transfer of assets or by an
issuance of equity instruments. As a result, certain instruments
would be classified as equity even though those instruments do not
establish the type of relationship that exists between an entity and
its owners. Instead, the Board decided that the relevance and
representational faithfulness of the reporting of those obligations
would be improved if classification were based on the type of
relationship established between the issuer and the holder of the
instrument as well as the form of settlement.
An obligation can be either unconditional or conditional. An
obligation is unconditional if no condition needs to be satisfied (other
than the passage of time) to trigger a duty or responsibility for the
obligated party to perform. Examples of unconditional obligations
include:
An obligation is conditional if the obligated party only has
a duty or responsibility to perform if a specified condition is met (e.g.,
the occurrence or nonoccurrence of an uncertain future event or the
counterparty’s election to exercise an option). Examples of conditional
obligations include:
- Physically settled written put options that, if exercised, could require the issuer to purchase equity shares and transfer assets (see Chapter 5).
- Physically settled forward contracts that require the issuer to purchase equity shares upon the occurrence or nonoccurrence of an event that is outside the issuer’s control (see Chapter 5).
- Net-settled forward contracts to purchase equity shares that could require the issuer to transfer cash or a variable number of equity shares to settle the contracts’ fair value if they are in a loss position (see Sections 5.2.3 and 6.2.5).
- Net-settled written options that require the issuer to transfer assets or shares if the counterparty elects to exercise the options (see Sections 5.2.3 and 6.2.6).
ASC 480-10 does not address the accounting for financial
instruments that do not embody any obligation of the issuer. Examples of
such instruments include:
- Outstanding equity shares that do not have any redemption or conversion provisions.
- Purchased call options that permit but do not require the issuer to purchase equity shares for cash (see ASC 480-10-55-35).
- Purchased put options that permit but do not require the issuer to sell equity shares for cash.
An obligation to provide services does not meet the
definition of a financial instrument and is therefore outside the scope of
ASC 480-10 (see Section
2.2.2).
2.2.1.2 Economic Compulsion
An instrument would not necessarily be classified outside of
equity even if its terms have been designed to economically compel the
issuer to redeem it. For example, a perpetual preferred share without any
contractual redemption requirements may have an increasing, discretionary
dividend designed to incentivize the issuer to redeem the instrument by a
certain date. That instrument would not be within the scope of ASC 480-10
because it embodies no obligation.
In developing the guidance in ASC 480-10, the FASB
considered whether an instrument in the form of a share should be viewed to
embody an obligation to redeem the share if the issuer could be economically
compelled to redeem the share but is not legally required to do so. However, the Board decided not to establish any such requirement. Paragraph B24 of the Background Information and Basis for Conclusions of FASB Statement 150
states, in part:
Some types of
preferred stock pay no, or low, dividends during the first few years
they are outstanding and then pay dividends at an increasing rate.
The Board considered whether an issuer of such “increasing-rate
preferred stock” should be deemed to have an obligation to redeem
the shares even though it is not legally obligated to do so. The
Exposure Draft proposed that to the extent the shares are not
mandatorily redeemable and no enforceable obligation to pay
dividends exists, increasing-rate preferred stock does not embody an
obligation on the part of the issuer and, therefore, should not be
classified as a liability. Some commentators proposed that
increasing-rate preferred stock be classified as a liability on the
grounds that the increasing rate made redemption economically
compelling or created an implied mandatory redemption date. The
Board reconsidered that issue during its redeliberations but did not
resolve it. The Board deferred until the next phase of the project a
decision about whether an increasing-rate dividend provision, as
well as other forms of economic compulsion, imposes an obligation on
the issuer that causes the instrument to be a
liability.
While the existence of economic compulsion itself is not
sufficient to cause an instrument to be classified as a liability under ASC
480-10, it may be a factor in the evaluation of whether a feature is
substantive. Further, note that the SEC staff has issued guidance on the
accounting for increasing-rate preferred stock (see ASC 505-10-S99-7).
Example 2-1
Increasing-Rate Preferred Stock
A
perpetual preferred share has the following
terms:
- A fixed par amount ($100).
- A stated dividend rate (5 percent per annum) for an initial period (five years).
- An increasing dividend-rate. As of a specified date in the future, the dividend rate will have increased to an interest rate that is likely to be significantly in excess of market rates (20 percent per annum).
- Discretionary dividends. The issuer has discretion over whether to declare a dividend (i.e., the issuer has no legally enforceable obligation to pay the dividend).
- A call option. The issuer has the right to repurchase the preferred share at its par amount if it also pays all unpaid and accumulated dividends on the preferred share.
- A dividend stopper. The issuer is not permitted to declare and pay any dividends on common shares before it pays all accumulated and unpaid dividends on the preferred share.
In these circumstances,
the issuer may be expected to have a strong economic
incentive to call the preferred stock before the
cumulative undeclared dividends become too large. If
it does not call the instrument, the issuer will
either pay significantly above-market dividends to
the preferred shareholders or be unable to pay
dividends on common stock (potentially resulting in
the loss of much of the value of its common stock).
Nevertheless, the preferred stock is outside the
scope of ASC 480-10 because it does not meet the
definition of a mandatorily redeemable financial
instrument and does not contain an unconditional
obligation to deliver a variable number of shares.
(Note also that the issuer’s incentive to redeem the
instrument would weaken if the market’s required
return on similar instruments approached or exceeded
20 percent per annum, for example, because the
issuer’s financial situation deteriorated
sufficiently or market interest rates
increased.)
2.2.1.3 Issuer Discretion to Avoid a Transfer of Assets or Equity Shares
In a manner consistent with the FASB’s definition of a liability in Concepts Statement 6, an issuer does not have an obligation
under ASC 480-10 if it has complete discretion to avoid the transfer of
assets or equity shares. ASC 480-10 does not address the accounting for a
financial instrument that does not embody any obligation of the issuer.
Therefore, the following are examples of instruments that are outside the
scope of ASC 480-10:
-
An agreement to repurchase an entity's own stock by transferring assets, or to issue equity shares, that permits the issuer to cancel the agreement at any time at its sole discretion without penalty.
-
An agreement that requires the issuer to transfer assets or issue equity shares upon the occurrence of an event that is solely within its control. In this case, the entity has no obligation before the event occurs since the entity could not be forced to transfer assets or issue shares unless it decides to proceed with the event or allows it to occur.
The table in Section 9.4.2 lists examples of events
and circumstances that may be considered solely and not solely within the
issuer’s control when their occurrence triggers a duty or responsibility for
the issuer to transfer assets or issue shares. Note, however, that the
determination of whether a specific event is within the issuer’s control
could differ depending on the specific facts and circumstances. For example,
an event that would ordinarily be considered to be solely within the
issuer’s control may not qualify as such if either (1) the counterparty
controls the issuer’s decision to cause the event to occur through board
representation or other rights or (2) the issuer is firmly committed to
undertake an action that will cause the event to occur.
Example 2-2
Callable and Puttable Warrant
A
warrant:
- Permits Holder H to purchase a fixed number of Entity E’s perpetual common shares for a fixed amount of cash.
- Contains:
- A call option that permits E to repurchase the warrant for a fixed price in cash at any time.
- A put option that permits H to put the warrant to E for a fixed price in cash 30 days after giving notice of its intent to exercise the put. If H gives notice of its intent to exercise the put, E has the right to exercise its call option before the put option becomes exercisable. Accordingly, E can prevent the put option from ever becoming exercised.
In evaluating whether
the warrant embodies one or more obligations that
cause it to fall within the scope of ASC 480-10, E
must consider all of the warrant’s terms and
features.
The warrant
contains two conditional requirements: (1) delivery
of a fixed number of shares for cash if H elects to
exercise the warrant and (2) delivery of a fixed
amount of cash if H elects to put the warrant.
The first conditional
requirement represents an obligation of E, because E
has no discretion to avoid it. To be within the
scope of ASC 480-10, however, an obligation to
deliver shares must be for the delivery of a
variable number of shares (see Chapter
6). Since this conditional obligation
is to deliver a fixed number of equity shares, it
does not cause the instrument to be classified as an
asset or a liability under ASC 480-10.
In assessing the second conditional
requirement, E notes that it is able to prevent the
exercise of the put option by exercising its call
option after the counterparty has notified E of its
intent to exercise the put in 30 days.
Despite E’s ability to prevent exercise of the put option, E has a conditional
obligation to transfer assets (pay cash) since it
(1) it cannot prevent H from giving notice of its
intent to exercise the put option and (2) is
required to pay cash irrespective of whether it
exercises its call option or allows the put option
to be exercised (i.e., it has no discretion to avoid
the requirement to pay cash). Under ASC 480-10-25-8,
E classifies the warrant as a liability because it
(1) is not an outstanding share, (2) embodies an
obligation that is indexed to an obligation to
repurchase E’s equity shares, and (3) may require E
to settle the obligation by transferring assets;
that is, it contains a conditional obligation to
deliver cash (see Section 5.1). If
the put option was removed, however, ASC 480-10
would not require E to classify the warrant as an
asset or a liability because the conditional
obligation to deliver a fixed number of equity
shares is not within the scope of ASC 480-10 and the
call option does not represent an obligation.
Instead, E would apply other GAAP (e.g., ASC 815-40)
to determine how to account for the warrant.
2.2.1.4 Asset-Classified Instruments Embodying Obligations
ASC 480-10
25-12 Certain financial
instruments that embody obligations that are
liabilities within the scope of this Subtopic also
may contain characteristics of assets but be
reported as single items. Some examples include the
following:
- Net-cash-settled or net-share-settled forward purchase contracts
- Certain combined options to repurchase the issuer’s shares.
Those instruments are
classified as assets or liabilities initially or
subsequently depending on the instrument’s fair
value on the reporting date.
Although ASC 480-10 applies only to instruments that embody
obligations of the issuer, not all instruments within its scope are
liabilities. For example, an issuer may pay a net premium to purchase a
single freestanding financial instrument, such as a collar that includes
both a purchased call option and a written put option on the issuer’s
shares. Because of the written option component, that instrument embodies an
obligation that is within the scope of ASC 480-10. If the fair value of the
purchased option component (a valuable right) exceeds the fair value of the
written option component, however, the collar is an asset rather than a
liability. Similarly, a net-settled forward contract to purchase the
entity’s equity shares embodies a conditional obligation to transfer assets
or equity shares if the stock price is less than the contracted forward
price on the forward settlement date, but it is an asset if the contract is
in a gain position for the issuer on that date.
2.2.1.5 Prepaid Obligations
ASC 480-10 does not apply to a contract that embodies an
obligation to repurchase equity shares (or a contract indexed to such an
obligation) if the issuer prepays its obligation and therefore has no
remaining obligation to transfer assets or issue equity shares. For example,
a prepaid written put option does not meet the criteria to be accounted for
as an asset or a liability under ASC 480-10-25-8 or ASC 480-10-25-14 because
it does not represent an obligation of the issuing entity (i.e., the option
writer) to transfer assets or issue equity shares. (Prepaid written put
option strategies and economically equivalent arrangements have been
marketed under names such as Dragons, Caesars, or ZCalls.)
Although such an instrument is not within the scope of ASC
480-10, the issuing entity (i.e., the option writer) will need to consider
the applicability of other relevant GAAP. For example, the issuing entity
should consider whether the prepaid contract represents a hybrid financial
instrument that includes an embedded derivative that should be bifurcated in
accordance with ASC 815-15-25-1. The issuing entity should also consider the
guidance in ASC 815-40 on contracts related to an entity’s own equity (see
Deloitte’s Roadmap Contracts on an Entity’s
Own Equity) and in ASC 505-10-45-2 on receivables for
the issuance of equity.
In accordance with a 2004 speech by Scott Taub, then deputy chief accountant in
the SEC’s Office of the Chief Accountant, the issuing entity should also
provide transparent disclosures about the transaction and the related
accounting considerations.
Example 2-3
Prepaid Written Put Option
As part of its share repurchase strategy, Entity Y
issues a prepaid written put option on its own
common shares to Bank B. The relevant facts and
circumstances are as follows:
- The notional amount of the option is 100,000 common shares of Y.
- The strike price of the option is $20 per share, which also represents the fair value of Y’s common shares on the option issuance date.
- The option premium is $4 per share.
- On the option issuance date, Y pays B $16 per share (or $1.6 million = $16 per share × 100,000), which represents the prepayment of the option strike price less the amount of the option premium due from B ($16 = $20 – $4).
- The prepaid written put option is a European-style option; it can be exercised (and will also expire) one year after the option issuance date (the exercise date).
- If the fair value of Y’s common shares on the exercise date is equal to or greater than the option strike price, B will pay Y $20 per share (or $2 million = $20 per share × 100,000).
- If the fair value of Y’s common shares on the exercise date is less than the option strike price, B will deliver 100,000 of Y’s common shares to Y.
The effect of Y’s
issuance of the prepaid written put option to B is
as follows:
Possible Outcome | Economic Result |
---|---|
The fair value of Y’s common
shares on the exercise date is greater than the
option strike price. | Entity Y receives a return on the
written option equal to the difference between the
strike price ($2 million = $20 per share × 100,000
shares) and the prepayment amount ($1.6 million =
$16 per share × 100,000 shares), or $400,000: an
annual return of 25 percent. |
The fair value of Y’s common
shares on the exercise date is equal to or less
than the option strike price. | Entity Y reacquires 100,000 of
its common shares for $16 per share (the
prepayment amount) under more favorable terms than
the fair value of the shares on the option
issuance date ($20 per share). |
As an alternative to
the written put option strategy, Y and B could have
entered into an economically equivalent arrangement
(i.e., one that has the same payoff profile)
involving a purchased call option with a strike
price of $0 per share and a written call option with
a strike price of $20 per share. Under this
alternative approach, the prepayment amount of $16
per share represents the premium due on the
in-the-money purchased call option ($20), reduced by
the premium received from the written call option
($4).
Under either approach,
Y would not apply ASC 480-10-25-8 through 25-13 to
the contract. It would, however, consider other
relevant GAAP to determine the appropriate
accounting for its share repurchase
strategy.
2.2.2 Financial Instruments
ASC
480-10 — Glossary
Financial Instrument
Cash, evidence of an ownership interest
in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term
financial instrument in this definition is recursive
(because the term financial instrument is included in
it), though it is not circular. The definition requires
a chain of contractual obligations that ends with the
delivery of cash or an ownership interest in an entity.
Any number of obligations to deliver financial
instruments can be links in a chain that qualifies a
particular contract as a financial instrument.
Contractual rights and contractual
obligations encompass both those that are conditioned on
the occurrence of a specified event and those that are
not. All contractual rights (contractual obligations)
that are financial instruments meet the definition of
asset (liability) set forth in FASB Concepts Statement
No. 6, Elements of Financial Statements, although some
may not be recognized as assets (liabilities) in
financial statements — that is, they may be
off-balance-sheet — because they fail to meet some other
criterion for recognition.
For
some financial instruments, the right is held by or the
obligation is due from (or the obligation is owed to or
by) a group of entities rather than a single entity.
The scope of ASC 480-10 is limited to financial instruments,
which include:
- Ownership interests (e.g., common or preferred shares or interests in a partnership or limited liability company).
- Contracts to deliver cash (e.g., net-cash-settled options or forward contracts).
- Contracts to deliver shares (e.g., share-settled debt or net-share-settled options or forward contracts).
- Contracts to exchange financial instruments (e.g., physically settled written options or forward contracts that involve the exchange of equity shares for cash or another financial asset).
An obligation to provide services does not meet the definition of a financial instrument and is thus outside the scope of ASC 480-10. In paragraph B34 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board notes that the “to provide services” language in the description of a liability in FASB Concepts Statement 6 was omitted from the
definition of an obligation now in ASC 480-10-20:
This Statement [i.e., the guidance that is now in ASC
480-10] omits the Concepts Statement’s phrase to provide
services, because this Statement [i.e., ASC 480-10] applies only to
financial instruments.
However, a financial instrument (e.g., an outstanding share) may
contain embedded features (e.g., an obligation to deliver gold) that would not
have met the definition of a financial instrument on a stand-alone basis. ASC
480-10 applies to such a hybrid financial instrument. ASC 815-15-55-110 and
55-111 contain an example of “mandatorily redeemable preferred stock whose
preferred dividends are payable in cash but that requires redemption at the end
of 1 year for a payment of 312 ounces of gold.” That example implies that ASC
480 applies to the preferred stock and further suggests that the preferred stock
contains an embedded derivative whose underlying is the price of gold, which is
not clearly and closely related to the host preferred stock contract.
2.2.3 Freestanding Financial Instruments
ASC
480-10 — Glossary
Freestanding Financial
Instrument
A financial
instrument that meets either of the following
conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
ASC
480-10
25-1 The guidance in this
Section shall be applied to a freestanding financial
instrument in its entirety. . . .
ASC 480-10 applies only to financial instruments that are
freestanding in accordance with the definition of a freestanding financial
instrument in ASC 480-10-20. Accordingly, an entity does not apply ASC 480-10
separately to a feature that is embedded in a financial instrument (see
Section
2.3.2).
For example, if an outstanding share that is not mandatorily
redeemable contains an embedded put option feature that permits the holder to
require the issuer to repurchase the share for a fixed amount of cash, that
option would not be analyzed separately from the share under ASC 480-10 unless
the share is minimal (see Section 3.2). ASC 480-10 does not require classification of that
outstanding share as a liability even though the share contains a component
(i.e., the embedded written put) for which liability classification would have
been required if the component had been issued as a freestanding financial
instrument that was separate from the share (see Chapters 4 and 6).
The definition of a freestanding financial instrument helps not
only in the identification of whether an item is within the scope of ASC 480-10
but also in the determination of the appropriate units of account; that is,
whether an item should be aggregated or disaggregated for accounting purposes
(see Section 3.3).
2.2.4 Legal Form of Share or Involves Equity Shares
ASC
480-10
05-6 For purposes of this
Subtopic, three related terms — shares, equity shares,
and issuer’s equity shares — are used in the particular
ways defined in the glossary.
The instruments in each of the three classes of freestanding
financial instruments that must be classified outside of equity under ASC 480-10
either (1) have the legal form of a share (see Section 2.2.4.1) or could result in the
receipt or delivery of the issuer’s equity shares (see Sections 2.2.4.2 and
2.2.4.3) or (2)
are indexed to an obligation to repurchase its equity shares:
- Mandatorily redeemable financial instruments (the first class; see Chapter 4) applies only to “instruments issued in the form of shares” (emphasis added).
- The second class (see Chapter 5) applies only to financial instruments that embody “an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation” (emphasis added).
- The third class (see Chapter 6) applies only to obligations that “the issuer must or may settle by issuing a variable number of its equity shares” (emphasis added).
If a contract is not in the legal form of a share and does not
involve the potential receipt or delivery of the issuer’s equity shares or is
not indexed to an obligation to repurchase the issuer’s equity shares, it would
be outside the scope of ASC 480-10. Accordingly, financial instruments that are
in the legal form of debt are outside the scope of ASC 480-10. For example, a
note in the legal form of debt that has a stated maturity, stated coupon rate,
and creditor rights is outside the scope of ASC 480-10 even if it is mandatorily
exchangeable into a specified number of common shares on a future date (e.g.,
certain premium income-exchangeable securities). The issuer should present such
a security as a liability on the basis of its legal form.
An instrument that represents a legal-form debt obligation
should be classified as a liability even if it has certain economic
characteristics that are similar to an equity instrument. For example, an
instrument that represents a legal-form debt obligation in the jurisdiction in
which it is issued and carries creditor rights (e.g., an ability to seek
recourse in a bankruptcy court) should be classified as a liability even if the
issuer only has a de minimis amount of common equity capital and the instrument
is described as an “equity certificate,” has a long maturity (e.g., 40 years),
is subordinated to all other creditors, contains conversion rights into common
equity, and provides dividend rights that are similar to those of a holder of
common equity (e.g., payable only if declared). If it is not readily apparent
whether a claim on the entity legally represents debt or equity, an entity may
need to seek an opinion from legal counsel.
In this Roadmap, the term “share-settled debt” is used to
describe a share-settled obligation that is not in the legal form of debt but
has the same economic payoff profile as debt (see Chapter 6).
2.2.4.1 Shares
ASC 480-10 — Glossary
Shares
Shares includes various forms of
ownership that may not take the legal form of
securities (for example, partnership interests), as
well as other interests, including those that are
liabilities in substance but not in form. (Business
entities have interest holders that are commonly
known by specialized names, such as stockholders,
partners, and proprietors, and by more general
names, such as investors, but all are encompassed by
the descriptive term owners. Equity of business
entities is, thus, commonly known by several names,
such as owners’ equity, stockholders’ equity,
ownership, equity capital, partners’ capital, and
proprietorship. Some entities [for example, mutual
organizations] do not have stockholders, partners,
or proprietors in the usual sense of those terms but
do have participants whose interests are essentially
ownership interests, residual interests, or
both.)
In ASC 480-10, the term “share” is not limited to a
financial instrument in the form of equity securities but broadly applies to
any financial instrument that takes the form of an ownership interest. For
example, shares include common and preferred shares, partnership interests
(e.g., participating securities in the form of preferred limited partnership
interests issued by investment funds licensed as SBICs), membership
interests in limited liability companies or cooperative entities, and
policyholder interests in mutual insurance companies.
The following table lists
examples of instruments that, unless a legal analysis of their form suggests
otherwise, would and would not be considered shares under ASC 480-10:
Share | Not a Share |
---|---|
|
|
Under U.S. GAAP, instruments that are in the legal form of
shares (i.e., instruments that evidence a claim to the net assets of the
issuer and do not provide the holder with creditor rights) generally are
classified in the stockholders’ equity section of the balance sheet (either
permanent or temporary equity) unless they meet the criteria for liability
classification in ASC 480-10. Thus, a preferred stock instrument that is not
classified as a liability under ASC 480-10 generally would be presented in
equity even if it has a stated liquidation preference, a stated dividend,
redemption features, and a claim to net assets that is senior to that of
common stockholders.
2.2.4.2 Equity Shares
ASC 480-10 — Glossary
Equity Shares
Equity shares refers only to shares
that are accounted for as equity.
ASC 480-10-20 suggests that the term “equity share” is
limited to shares that qualify, and are classified, as equity (including
both permanent and temporary equity) in the reporting entity’s financial
statements. The term does not apply to shares that are classified as
liabilities. Nevertheless, ASC 480-10-25-8 applies to financial instruments,
such as warrants, options, or forwards, that involve the issuance of
mandatorily redeemable shares that would be accounted for as liabilities
when they are issued; see ASC 480-10-25-13(b) and ASC 480-10-55-33 and
Sections
5.1.3 and 5.2.1.
Surplus notes, which are defined in ASC 944-470-20 as
“financial instruments issued by insurance entities that are includable in
surplus for statutory accounting purposes as prescribed or permitted by
state laws and regulations,” do not qualify as equity shares under ASC
944-470-25-1 but are reported as debt instruments. ASC 944-470-05-1
indicates that such notes are also known as “certificates of contribution,
surplus debentures, or capital notes.”
2.2.4.3 Issuer’s Equity Shares
ASC 480-10 — Glossary
Issuer’s Equity
Shares
The equity shares
of any entity whose financial statements are
included in the consolidated financial statements.
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
15-6 Paragraphs 480-10-55-53
through 55-58 apply to the specific circumstances
described by those paragraphs in which a majority
owner enters into a transaction in the shares of a
consolidated subsidiary and a derivative instrument
indexed to the noncontrolling interest in that
subsidiary.
References in ASC 480-10 to the “issuer’s equity shares”
include equity shares issued by any consolidated subsidiary. For example, if
a parent writes a freestanding put option on a noncontrolling interest in a
subsidiary, the put option might fall within the scope of ASC 480-10 in the
parent’s consolidated financial statements even if it is not recognized in
the subsidiary’s financial statements. Similarly, an entity should evaluate
a put option written by a subsidiary on its own or its parent’s equity
shares to determine whether the option falls within the scope of ASC 480-10
in the consolidated financial statements. ASC 480-10-55-53 through 55-58
contain special accounting guidance on transactions involving noncontrolling
interests (see Section
7.1).
Conversely, shares issued by entities that are not
consolidated in the reporting entity’s financial statements are not the
issuer’s equity shares. For example, if a subsidiary enters into a contract
to purchase the parent’s equity shares for cash, that contract would be
within the scope of ASC 480-10 in the parent’s consolidated financial
statements but not in the subsidiary’s separate financial statements.1 Further, shares issued by an equity method investee or a third party
are not considered the issuer’s equity shares and are therefore outside the
scope of ASC 480-10. Accordingly, an entity that enters into a contract to
purchase or deliver shares of an equity method investee or a third party
would apply other GAAP in accounting for the contract (e.g., ASC 815-10, ASC
321, or ASC 323).
Footnotes
1
See Section 4.2.2 of Deloitte’s
Roadmap Noncontrolling Interests for further
discussion of the accounting for a subsidiary that owns shares of
its parent.
2.3 Derivatives
2.3.1 Interaction With Derivative Accounting Requirements in ASC 815-10
ASC 480-10
35-1 Financial instruments within the scope of Topic 815 shall be measured subsequently as required by the provisions of that Topic.
ASC 815-10
15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic: . . .
d. Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares (forward purchase contracts for the reporting entity’s shares that require physical settlement) that are accounted for under paragraphs 480-10-30-3 through 30-5, 480-10-35-3, and 480-10-45-3.
15-83 A
derivative instrument is a financial instrument or other
contract with all of the following characteristics:
-
Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both.
-
-
Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
-
Net settlement. The contract can be settled net by any of the following means:
-
Its terms implicitly or explicitly require or permit net settlement.
-
It can readily be settled net by a means outside the contract.
-
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
-
Some instruments that must be classified as assets or liabilities under ASC 480-10 have all of the characteristics of a derivative instrument in ASC 815-10-15-83. In accordance with ASC 815-10-15-74(d), if such instruments are physically settled forward contracts to repurchase equity shares for cash, they are exempt from the scope of the derivative accounting requirements in ASC 815-10. Instead, the accounting guidance in ASC 480-10 applies (see Chapter 5). Other instruments within the scope of ASC 480-10 that have all the characteristics of derivative instruments fall within the scope of both ASC 480-10 and ASC 815-10 unless one of the scope exceptions in ASC 815 applies. Practically, this means that an entity may be required to apply the disclosure requirements of both ASC 480 and ASC 815 to such instruments. Further, in accordance with ASC 815-10, such instruments are measured subsequently at fair value, with changes in fair value recognized in earnings, unless they qualify as hedging instruments in a cash flow or net investment hedge, in which case all or a portion of the change in fair value is recognized in other comprehensive income.
An option or forward that is outside the scope of the derivative accounting
requirements in ASC 815-10 (e.g., because it does
not meet the net settlement characteristic in the
FASB’s definition of a derivative) would
nevertheless be accounted for at fair value, with
changes in fair value recognized in earnings, if
it is within the scope of ASC 480-10 unless it is
a forward contract that requires physical
settlement by repurchase of a fixed number of the
issuer’s equity shares in exchange for cash (see
Section 5.3).
2.3.2 Interaction With Embedded Derivative Requirements in ASC 815-15
ASC 480-10
15-5 Because paragraph 480-10-15-3 limits the scope of this Topic to freestanding instruments, this Topic does not apply to a feature embedded in a financial instrument that is not a derivative instrument in its entirety.
25-2 For purposes of applying paragraph 815-10-15-74(a) in analyzing an embedded feature as though it were a separate instrument, paragraphs 480-10-25-4 through 25-14 shall not be applied to the embedded feature. Embedded features shall be analyzed by applying other applicable guidance.
ASC 480-10 does not apply in an entity’s evaluation of whether an embedded feature should be bifurcated as an embedded derivative under ASC 815-15. For example, in determining whether an embedded feature qualifies for the scope exception in ASC 815-10-15-74(a) for certain contracts that are both indexed to, and classified in, stockholders’ equity (e.g., a written put option embedded in a share), an entity disregards the classification guidance in ASC 480-10. Instead, the entity assesses whether the feature qualifies for that scope exception by applying the indexation and classification guidance in ASC 815-40 (see Section 2.3.3) and any other relevant guidance other than ASC 480-10 to the embedded put feature.
A financial instrument within the scope of ASC 480-10 could potentially contain
a feature that must be bifurcated as an embedded
derivative under ASC 815-15-25-1. For example, the
redemption amount of a mandatorily redeemable
financial instrument that is classified as a
liability under ASC 480-10 might be indexed to the
price of gold. If so, the issuer should assess
whether the indexation to gold must be separated
as an embedded derivative under ASC 815-15. ASC
815-15-55-110 through 55-113 illustrate the
application of the “clearly and closely related”
criterion in an entity’s bifurcation analysis to
mandatorily redeemable preferred stock for which
the redemption amount is indexed to the price of
gold or a fixed amount of a specified foreign
currency. The host contract that remains after an
embedded feature has been bifurcated as an
embedded derivative under ASC 815-15 should be
analyzed separately from the embedded derivative
in the measurement under ASC 480-10-35 (see
Section 4.2.1).
2.3.3 Interaction With Accounting Requirements for Own-Equity Contracts in ASC 815-40
ASC 815-40
15-3 The guidance in this Subtopic does not apply to any of the following: . . .
e. Financial instruments that are within the scope of Topic 480 (see paragraph 815-40-15-12).
15-12 Paragraph 480-10-15-5 explains that Topic 480 does not apply to a feature embedded in a financial instrument that is not a derivative instrument in its entirety (for example, a written put option embedded in a nonderivative host contract) in analyzing the embedded feature as though it were a separate instrument as required by paragraph 815-15-25-1(c). Therefore, this Subtopic applies in evaluating those embedded features under Subtopic 815-15.
ASC 815-40 addresses the accounting for contracts indexed to, and potentially
settled in, the issuer’s equity shares (e.g.,
purchased put or call options, written call
options, and forward sale contracts). ASC
815-40-15-3(e) specifies that freestanding
financial instruments within the scope of ASC
480-10 are exempt from ASC 815-40. Accordingly,
ASC 815-40 does not apply to freestanding
contracts indexed to, and potentially settled in,
the issuer’s equity shares if they are required to
be classified as assets or liabilities under ASC
480-10 (e.g., freestanding written put options and
freestanding forward purchase contracts on own
equity). This implies that an entity needs to
assess whether a contract is within the scope of
ASC 480-10 before it can determine whether to
apply ASC 815-40 to the contract. See Deloitte’s
Roadmap Contracts
on an Entity’s Own Equity for a
comprehensive discussion of the application of ASC
815-40.
2.3.4 Application of ASC 480-10 to Freestanding Written Puts and Forward Purchase Contracts
ASC 480-10
55-63
The following table addresses classification of
freestanding written put options and forward purchase
contracts within the scope of this Subtopic.
Note: In all cases above, the contracts must be reassessed at each reporting period in order to determine whether or not the contract must be reclassified.
The table in ASC 480-10-55-63 illustrates how an entity would classify, in accordance with ASC 480-10, freestanding written put options and forward purchase contracts under which the issuer has agreed to buy shares at a specified price on a future date. Irrespective of whether such an instrument requires physical settlement, net cash settlement, or net share settlement, or whether it gives the issuer or the counterparty a choice of settlement methods, the instrument is classified as an asset or a liability under ASC 480-10.
If a forward contract requires physical settlement by repurchase of a fixed number of the issuer’s equity shares for cash, it is classified as a liability under ASC 480-10-25-8 and accounted for in accordance with ASC 480-10-30-3 and ASC 480-10-35-3 in a manner similar to a treasury stock repurchase with borrowed funds (see Section 5.3.1). Other forward purchase contracts and written put options that require or may require the issuer to settle its obligation under the contract by transferring assets are classified as assets or liabilities under ASC 480-10-25-8 and accounted for at fair value under ASC 480-10-30-7, ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5 (see Sections 5.1 and 5.3.2). Such contracts include those that require net cash settlement, permit the issuer to choose between net cash or physical settlement (but not net share settlement), and give the counterparty a settlement choice if at least one of the options is physical settlement or net cash settlement. Forward purchase contracts and written put options that require or permit the issuer to settle its obligation under the contract net in shares are classified as assets or liabilities under ASC 480-10-25-14(c) and accounted for at fair value in accordance with ASC 480-10-30-7 as well as ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5 (see Sections 6.1.4 and 6.3).
2.4 Share-Based Payments
ASC Master Glossary
Share-Based Payment Arrangements
An arrangement under which either of the following conditions
is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet
either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest
that may not take the legal form of securities (for example,
partnership interests), as well as other interests,
including those that are liabilities in substance but not in
form. Equity shares refers only to shares that are accounted
for as equity.
Also called share-based compensation arrangements.
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
15-8 The
guidance in the Distinguishing Liabilities from Equity Topic
does not apply to an obligation under share-based
compensation arrangements if that obligation is accounted
for under Topic 718. For example, employee stock ownership
plan shares or freestanding agreements to repurchase those
shares are not within the scope of this Topic because those
shares are accounted for under Subtopic 718-40 through the
point of redemption. However, this Topic does apply to a
freestanding financial instrument that was issued under a
share-based compensation arrangement but is no longer
subject to Topic 718. For example, this Topic applies to a
mandatorily redeemable share issued upon a grantee’s
exercise of a share option. (Topic 718 provides accounting
guidance for dividends on allocated shares, redemption of
shares, recognition of expense, and computing earnings per
share [EPS].) However, employee stock ownership plan shares
that are mandatorily redeemable or freestanding agreements
to repurchase those shares continue to be subject to other
applicable guidance related to Subtopic 718-40.
ASC 718-10
25-7
Topic 480 excludes from its scope instruments that are
accounted for under this Topic. Nevertheless, unless
paragraphs 718-10-25-8 through 25-19A require otherwise, an
entity shall apply the classification criteria in Section
480-10-25 and paragraphs 480-10-15-3 through 15-4 in
determining whether to classify as a liability a
freestanding financial instrument given to a grantee in a
share-based payment transaction. Paragraphs 718-10-35-9
through 35-14 provide criteria for determining when
instruments subject to this Topic subsequently become
subject to Topic 480 or to other applicable GAAP.
25-8
In determining the classification of an instrument, an
entity shall take into account the classification
requirements as established by Topic 480. In addition, a
call option written on an instrument that is not classified
as a liability under those classification requirements (for
example, a call option on a mandatorily redeemable share for
which liability classification is not required for the
specific entity under the requirements) also shall be
classified as equity so long as those equity classification
requirements for the entity continue to be met, unless
liability classification is required under the provisions of
paragraphs 718-10-25-11 through 25-12.
Awards May Become Subject to Other Guidance
35-9 Paragraphs 718-10-35-10
through 35-14 are intended to apply to those instruments
issued in share-based payment transactions with employees
and nonemployees accounted for under this Topic, and to
instruments exchanged in a business combination for
share-based payment awards of the acquired business that
were originally granted to grantees of the acquired business
and are outstanding as of the date of the business
combination.
35-9A
A convertible instrument award granted to a nonemployee in
exchange for goods or services to be used or consumed in a
grantor’s own operations is subject to recognition and
measurement guidance in this Topic until the award is fully
vested. Once vested, a convertible instrument award that is
equity in form, or debt in form, that can be converted into
equity instruments of the grantor, shall follow recognition
and measurement through reference to other applicable
generally accepted accounting principles (GAAP), including
Subtopic 470-20 on debt with conversion and other
options.
Pending Content (Transition Guidance: ASC
815-40-65-1)
35-9A
Paragraph superseded by Accounting Standards
Update No. 2020-06.
35-10 A freestanding financial
instrument issued to a grantee that is subject to initial
recognition and measurement guidance within this Topic shall
continue to be subject to the recognition and measurement
provisions of this Topic throughout the life of the
instrument, unless its terms are modified after any of the
following:
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- Subparagraph superseded by Accounting Standards Update No. 2019-08.
- A grantee vests in the award and is no longer providing goods or services.
- A grantee vests in the award and is no longer a customer.
- A grantee is no longer an employee.
Pending Content (Transition Guidance: ASC
815-40-65-1)
35-10 A freestanding financial
instrument or a convertible security issued to a
grantee that is subject to initial recognition and
measurement guidance within this Topic shall
continue to be subject to the recognition and
measurement provisions of this Topic throughout
the life of the instrument, unless its terms are
modified after any of the following:
-
Subparagraph superseded by Accounting Standards Update No. 2019-08.
-
Subparagraph superseded by Accounting Standards Update No. 2019-08.
-
A grantee vests in the award and is no longer providing goods or services.
-
A grantee vests in the award and is no longer a customer.
-
A grantee is no longer an employee.
35-10A Only for purposes of paragraph
718-10-35-10, a modification does not include a change to
the terms of an award if that change is made solely to
reflect an equity restructuring provided that both of the
following conditions are met:
- There is no increase in fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved, that is, the holder is made whole) or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring.
- All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.
35-11 Other modifications of that
instrument that take place after a grantee vests in the
award and is no longer providing goods or services, is no
longer a customer, or is no longer an employee should be
subject to the modification guidance in paragraph
718-10-35-14. Following modification, recognition and
measurement of the instrument shall be determined through
reference to other applicable GAAP.
35-12
Once the classification of an instrument is determined, the
recognition and measurement provisions of this Topic shall
be applied until the instrument ceases to be subject to the
requirements discussed in paragraph 718-10-35-10. Topic 480
or other applicable GAAP, such as Topic 815, applies to a
freestanding financial instrument that was issued under a
share-based payment arrangement but that is no longer
subject to this Topic. This guidance is not intended to
suggest that all freestanding financial instruments shall be
accounted for as liabilities pursuant to Topic 480, but
rather that freestanding financial instruments issued in
share-based payment transactions may become subject to that
Topic or other applicable GAAP depending on their
substantive characteristics and when certain criteria are
met.
35-14
An entity may modify (including cancel and replace) or
settle a fully vested, freestanding financial instrument
after it becomes subject to Topic 480 or other applicable
GAAP. Such a modification or settlement shall be accounted
for under the provisions of this Topic unless it applies
equally to all financial instruments of the same class
regardless of the holder of the financial instrument.
Following the modification, the instrument continues to be
accounted for under that Topic or other applicable GAAP. A
modification or settlement of a class of financial
instrument that is designed exclusively for and held only by
grantees (or their beneficiaries) may stem from the
employment or vendor relationship depending on the terms of
the modification or settlement. Thus, such a modification or
settlement may be subject to the requirements of this Topic.
See paragraph 718-10-35-10 for a discussion of changes to
awards made solely to reflect an equity restructuring.
ASC 480-10 does not apply to a contract issued to a grantee that is subject to
ASC 718. This includes share-based payment awards granted to (1) an employee as
compensation for rendering service, (2) a nonemployee as compensation for the
acquisition of goods or services by the entity, or (3) a customer in conjunction
with the entity’s sale of goods or services that are within the scope of ASC 606.
ASC 480-10 also does not apply to shares of employee stock ownership plans (ESOPs).
An entity applies ASC 718 in determining (1) whether such contracts should be
classified as equity or as liabilities or assets and (2) how to account for them.
For example, ASC 718 applies to puttable employee stock options and shares of
ESOPs.
ESOP shares and freestanding contracts to repurchase such shares are
accounted for under ASC 718-40. FASB Staff Position FAS 150-4 (superseded as a
result of the Codification) contains the following commentary:
By law, employers with ESOPs must provide the employee with
a put option or other redemption feature if the shares are not readily
tradable; often, the plan requires that upon death, retirement, or the
employee’s reaching a certain age the shares must be sold back to the
employer at fair value. If the employer must redeem, then the shares
meet the definition of mandatorily redeemable shares under [ASC 480-10.
However,] ESOP shares or freestanding agreements to repurchase those shares
are not within the scope of [ASC 480-10], because those shares are accounted
for under [ASC 718-40] through the point of redemption.
Although share-based payment awards subject to ASC 718 are outside
the scope of ASC 480, ASC 718-10-25-7 requires entities to apply the classification
criteria in ASC 480-10-25 and in ASC 480-10-15-3 and 15-4 unless ASC 718-10-25
requires otherwise. For detailed guidance on the application of these requirements,
see Chapter 5 of
Deloitte’s Roadmap Share-Based
Payment Awards.
A contract originally issued to a grantee in a share-based payment
arrangement that is subject to ASC 718 may become subject to ASC 480-10 after the
contract’s issuance if its terms are modified. ASC 718 ceases to apply if the terms
of a share-based payment award originally subject to ASC 718 are modified and the
holder is no longer an employee or, for awards granted to nonemployees, a vested
award is modified and the grantee is no longer providing goods or services or is no
longer a customer. However, ASC 718 continues to apply if the modification is made
solely to reflect an equity restructuring and (1) there is no increase in the fair
value of the award (or the ratio of intrinsic value to the exercise price of the
award is preserved — that is, the holder is made whole) or the antidilution
provision is not added to the terms of the award in contemplation of an equity
restructuring and (2) all holders of the same class of equity instruments are
treated in the same manner. If a contract originally issued to a grantee in a
share-based payment arrangement subject to ASC 718 becomes subject to ASC 480-10,
the classification of the contract as equity or as an asset or a liability may
change as a result of the application of ASC 480-10.
Connecting the Dots
Although a contract originally granted in a share-based
payment arrangement that is subject to ASC 718 may become subject to other
GAAP, including ASC 480-10, as a result of a modification of its terms, the
modification should be accounted for under ASC 718. The classification and
subsequent accounting for the instrument under other applicable GAAP are
determined after the application of ASC 718’s guidance on accounting for
modifications.
ASC 480-10-15-8 indicates that if an employee exercises a stock
option within the scope of ASC 718 and receives mandatorily redeemable shares, those
shares would not be within the scope of ASC 718 but would need to be evaluated under
ASC 480.
ASC 718-10-15-5(b) exempts from the scope of ASC 718 transactions involving equity
instruments granted to a lender or investor that provides financing to the issuer.
For example, if an entity obtains a loan in exchange for issuing a contract on its
own equity, that contract would not be within the scope of ASC 718 but would be
evaluated under ASC 480-10 along with any other applicable literature (e.g., ASC
815-10 and ASC 815-40).
2.5 Convertible Preferred Shares With CCFs (Before the Adoption of ASU 2020-06)
ASC 470-20
15-4 The guidance in this Section shall be considered after consideration of the guidance in Subtopic 815-15 on bifurcation of embedded derivatives, as applicable (see paragraph 815-15-55-76A). The guidance in the Cash Conversion Subsections applies only to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement, unless the embedded conversion option is required to be separately accounted for as a derivative instrument under Subtopic 815-15. The guidance in the Cash Conversion Subsections does not affect an issuer’s determination under Subtopic 815-15 of whether an embedded feature shall be separately accounted for as a derivative instrument.
Pending Content (Transition Guidance: ASC
815-40-65-1)
15-4
Paragraph superseded by Accounting Standards
Update No. 2020-06.
15-6 For purposes of determining whether an instrument is within the scope of the Cash Conversion Subsections, a convertible preferred share shall be considered a convertible debt instrument if it has both of the following characteristics:
- It is a mandatorily redeemable financial instrument.
- It is classified as a liability under Subtopic 480-10.
For related implementation guidance, see paragraph 470-20-55-70.
Pending Content (Transition Guidance: ASC
815-40-65-1)
15-6
Paragraph superseded by Accounting Standards
Update No. 2020-06.
55-70 An
example of a convertible preferred share that paragraph
470-20-15-6 requires an entity consider as a convertible
debt instrument for purposes of the scope application of the
Cash Conversion Subsections is a convertible preferred share
that has a stated redemption date and also would require the
issuer to settle the face amount of the instrument in cash
upon exercise of the conversion option. Such a convertible
preferred share is a mandatorily redeemable financial
instrument and is classified as a liability under Subtopic
480-10 because it embodies an unconditional obligation to
redeem the instrument by transferring assets at a specified
or determinable date (or dates).
Pending Content (Transition Guidance: ASC
815-40-65-1)
55-70
Paragraph superseded by Accounting Standards
Update No. 2020-06.
Before the adoption of ASU 2020-06, an instrument that is within the scope of
ASC 480-10 because it meets the definition of a mandatorily redeemable financial
instrument in ASC 480-10-20 (see Chapter 4) may be subject also to the cash conversion guidance in
ASC 470-20. For example, the terms of a redeemable convertible preferred share with
a stated redemption date might state that, upon conversion of the instrument by the
holder, the issuer must settle the face value of the instrument in cash but may
choose to settle the conversion spread in either shares or cash. Such an issuer
should consider whether it is required to separate the instrument into liability and
equity components in accordance with the cash conversion guidance in ASC 470-20 (see
Sections 4.2.4 and
4.3.1.4).
The CCF guidance in ASC 470-20 applies to the issuer’s accounting for convertible preferred stock that meets all of the following four conditions:
- Upon conversion, it may be settled either fully or partially in cash or other assets in accordance with its stated terms.
- It meets the definition of a mandatorily redeemable financial instrument in ASC 480-10 (see Section 4.1.1).
- It is classified as a liability under ASC 480-10 (i.e., it is a mandatorily redeemable financial instrument that is not exempt from the scope of ASC 480-10; see Section 4.1.5).
- The CCF is not required to be separately accounted for as a derivative instrument under ASC 815-15 (see Section 2.3 of Deloitte’s Roadmap Convertible Debt (Before Adoption of ASU 2020-06)).
In the application of the CCF guidance in ASC 470-20, such convertible preferred stock is treated as convertible debt.
Changing Lanes
ASU 2020-06 removes the separation
model in ASC 470-20 for certain convertible instruments with a CCF.
Therefore, the above guidance on application of the CCF accounting model
does not apply to entities that have adopted ASU 2020-06. However, the ASU
does not affect whether convertible preferred shares are within the scope of
ASC 480-10-15-4. Further, convertible preferred shares that are classified
as liabilities under ASC 480-10-25-4 are subject to the requirements for
convertible debt in ASC 470-20, such as the disclosure requirements in ASC
470-20-50 (see ASC 470-20-15-2D). See Chapter 1 for additional details about
ASU 2020-06.
2.6 Contingent Consideration in a Business Combination
ASC 480-10
15-9 Subtopic 805-30 provides guidance on the recognition and initial measurement of consideration issued in a business combination, including contingent consideration.
15-10 However, when recognized, a financial instrument within the scope of this Topic that is issued as consideration (whether contingent or noncontingent) in a business combination shall be classified pursuant to the requirements of this Topic.
35-4A Contingent consideration issued in a business combination that is classified as a liability in accordance with the requirements of this Topic shall be subsequently measured at fair value in accordance with 805-30-35-1.
ASC 805-30 — Glossary
Contingent Consideration
Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
In business combinations, the parties often agree to contingent consideration (i.e., consideration that depends on future events or conditions). Contingent consideration arrangements permit the parties to proceed with a business combination without agreeing on the final purchase price. For example, the acquirer may agree to deliver a specified number of its own equity shares if the acquiree’s earnings exceed a specified target in the year after the combination. Other examples of events that may trigger contingent consideration payments include reaching a specified stock price or achieving a milestone in a research and development project.
In determining the appropriate classification of a contingent consideration
arrangement, the acquirer considers the classification guidance in ASC 480-10 and
any other applicable guidance (e.g., ASC 815-40). To measure the arrangement,
however, the acquirer applies ASC 805-30 instead of ASC 480-10. Contingent
consideration is part of the total consideration transferred for the acquiree and
must therefore be measured and recognized at fair value as of the acquisition date
under ASC 805-30. ASC 805-30-35-1 provides guidance on how to recognize changes in
the fair value of contingent consideration other than measurement-period
adjustments. Contingent consideration classified as equity is not remeasured, and
its settlement is recognized in equity. Contingent consideration classified as an
asset or liability is remeasured to fair value in each reporting period, with
changes in fair value recognized in earnings, unless it qualifies for recognition in
other comprehensive income under the hedge accounting guidance in ASC 815 (which
would be unusual).
Under ASC 805, the acquirer recognizes as revisions to goodwill those adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information stems from events that occurred after the acquisition date. For example, if earnings targets are met, share prices change, or FDA approvals are obtained after the acquisition date, resulting changes in fair value are recognized in earnings and not as adjustments to goodwill.
2.7 Registration Payment Arrangements
ASC 480-10
15-8A The guidance in this Topic does not apply to the following instruments:
- Registration payment arrangements within the scope of Subtopic 825-20.
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. (Subtopic 470-20 provides guidance on accounting for convertible instruments with contingently adjustable conversion ratios.)
- 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.
- 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).
Pending Content (Transition Guidance: ASC
815-40-65-1)
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, an issuer may agree to pay amounts if it is unable to deliver registered shares or maintain an effective registration. For example, a warrant or other equity-linked contract may require the issuer to:
- Use its “best efforts” to file a registration statement for the resale of shares and have the registration statement declared effective by the end of a specified grace period (e.g., within 90 to 180 days).
- Maintain the effectiveness of a registration statement for a specified period.
If the issuer fails to meet the conditions, the contract may require it to make cash payments to the counterparty unless or until a registration statement is declared effective. For example, the contract may require the entity to pay the investor 2 percent of the contract purchase price in each month after the end of a 180-day grace period during which there is no registration statement in effect covering the shares that will be delivered under the contract.
ASC 480-10 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).
ASC 825-20-15-4 implies that an arrangement does not qualify for the scope exception in ASC 480-10 for registration payment arrangements if any of the following criteria apply:
- 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 (e.g., a payment that is made upon the exercise of an option on own stock that is subject to the arrangement).
Accordingly, provisions of the types contemplated in ASC 825-20-15-4 would be considered in the analysis under ASC 480-10 of the financial instrument that contains them.
2.8 Guarantee Obligations
ASC 480-10
55-23 An
entity’s guarantee of the value of an asset, liability, or
equity security of another entity may require or permit
settlement in the entity’s equity shares. For example, an
entity may guarantee that the value of a counterparty’s
equity investment in another entity will not fall below a
specified level. The guarantee contract requires that the
guarantor stand ready to issue a variable number of its
shares whose fair value equals the deficiency, if any, on a
specified date between the guaranteed value of the
investment and its current fair value. Upon issuance, unless
the guarantee is accounted for as a derivative instrument,
the obligation to stand ready to perform is a liability
addressed by Topic 460. If, during the period the contract
is outstanding, the fair value of the guaranteed investment
falls below the specified level, absent an increase in
value, the guarantor will be required to issue its equity
shares. At that point in time, the liability recognized in
accordance with that Topic would be subject to the
requirements of Topic 450. This Subtopic establishes that,
even though the loss contingency is settleable in equity
shares, the obligation under that Topic is a liability under
paragraph 480-10-25-14(b) until the guarantor settles the
obligation by issuing its shares. That is because the
guarantor’s conditional obligation to issue shares is based
on the value of the counterparty’s equity investment in
another entity and not on changes in the fair value of the
guarantor’s equity instruments.
A guarantee obligation within the scope of ASC 460-10 might be subject to ASC 480-10 if it requires or permits the guarantor to settle its obligation in a variable number of its equity shares (e.g., the contract is a liability under ASC 480-10-25-14(b); see Sections 6.1.3, 6.2.2, and 6.2.3). For such a contract, an entity should consider the requirements of both ASC 480-10 and ASC 460-10 (e.g., the disclosure requirements in ASC 460-10-50).
ASC 460-10-15-4 states that ASC 460-10 applies, with certain exceptions, to the following types of guarantee contracts:
- Contracts that contingently require a guarantor to make payments [including cash, financial instruments, other assets, shares of its stock, or provision of services] to a guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party. . . .
- Contracts that contingently require a guarantor to make payments . . . to a guaranteed party based on another entity’s failure to perform under an obligating agreement (performance guarantees).
- Indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party.
- Indirect guarantees of the indebtedness of others, even though the payment to the guaranteed party may not be based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party.
Chapter 3 — Contract Analysis
Chapter 3 — Contract Analysis
As part of its accounting analysis under ASC 480-10, an issuer must carefully evaluate an instrument’s contractual terms (see Section 3.1). Any feature that is nonsubstantive or minimal is ignored (see Section 3.2). Further, the issuer must consider how to appropriately identify units of account (see Section 3.3).
3.1 Identifying and Evaluating Contractual Terms
In determining the appropriate accounting for a contract or transaction under ASC 480-10, an entity is well advised to devote adequate time to reading the underlying legal documents. Terms that are significant to the accounting analysis may be buried deep within the fine print of the contract. All of the contractual terms as well as the legal and regulatory framework and surrounding facts and circumstances need to be carefully evaluated in light of the applicable accounting requirements.
In forming a view on the appropriate accounting, an entity cannot necessarily
rely on the name given to a transaction (e.g.,
mandatorily redeemable equity security,
convertible preferred equity certificate, hybrid
equity unit, warrant, or equity option) or how it
is described in summary term sheets, slideshow
presentations, and marketing materials. Products
with similar economics and legal characteristics
sometimes go by different names in the marketplace
(e.g., products marketed by different banks),
while products subject to different accounting may
go by the same or similar names (e.g., the
accounting analysis for a warrant on an entity’s
own stock might depend on whether it includes
redemption requirements, and for a convertible
preferred equity certificate, such analysis might
depend on whether the certificate is in the legal
form of debt or equity). Furthermore, the names
given to contractual provisions in legal documents
(e.g., conversion features or share settlement
provisions) do not necessarily reflect how they
would be identified and analyzed for accounting
purposes. Minor variations in how contractual
terms are defined can have major accounting
implications.
For example, a share described contractually as “redeemable” or “mandatorily redeemable” does not necessarily meet the definition of a mandatorily redeemable financial instrument under ASC 480-10. If a share with a mandatory redemption date contains, for instance, a substantive conversion feature that permits the investor to convert the share into a fixed number of common shares before the mandatory redemption date, the share would not be considered mandatorily redeemable under ASC 480-10 (see Section 4.1).
An individual contract may consist of multiple legal documents (e.g., a trade
confirmation that refers to a master agreement or a contract that is modified by a
side letter). The issuer should consider all such documents in identifying the terms
of the contract. To determine the appropriate accounting for a contract that
involves the receipt or delivery of equity shares, the issuer should also consider
whether the terms of the underlying shares could affect the accounting analysis of
the contract. For example, an entity may write a call option or warrant on its
equity shares under which the shares that would be delivered upon the option’s
exercise are redeemable by the shareholder in accordance with the issuer’s articles
of incorporation, a certificate of designation applicable to the shares, a separate
agreement, or another arrangement. Such a redemption provision may affect the
classification of the warrant even if the warrant contract does not mention any
redemption requirement (see Section 5.2.1.1).
3.2 Nonsubstantive or Minimal Features
3.2.1 Overview
ASC 480-10
25-1 . . . Any nonsubstantive or minimal features shall be disregarded in applying the classification provisions of this Section. Judgment, based on consideration of all the terms of an instrument and other relevant facts and circumstances, is necessary to distinguish substantive, nonminimal features from nonsubstantive or minimal features.
In its evaluation of whether a freestanding financial instrument should be
classified outside of equity under ASC 480-10, an entity is required to
disregard any nonsubstantive or minimal features contained in the instrument.
For example, if a conversion option in an otherwise mandatorily redeemable
preferred equity security is nonsubstantive, the entity ignores that conversion
option in determining whether the share should be classified as a liability
under ASC 480-10. Thus, as long as redemption is judged certain to occur because
the conversion option is nonsubstantive, a preferred equity security with a
stated redemption date might meet the definition of a mandatorily financial
instrument in ASC 480-10-20 (see Section 4.1) even if it contains an equity
conversion option.
To determine whether a feature is nonsubstantive or minimal, an entity applies judgment and considers “all the terms of [the] instrument and other relevant facts and circumstances.” The examples in ASC 480-10-55’s application guidance imply that it may be relevant for an entity to consider (1) whether the feature is very deeply out-of-the-money and (2) the value of the feature in relation to the other components of the instrument (e.g., whether its fair value is trivial relative to the fair value of the entire instrument):
- ASC 480-10-55-12 states that a conversion option embedded in a mandatorily redeemable preferred equity security would be judged nonsubstantive if the conversion price is “extremely high in relation to the current share price” (i.e., the conversion option is very deeply out-of-the-money; see Section 3.2.2.1). For classification purposes, such a security is analyzed as a mandatorily redeemable equity security without an embedded conversion option. (In the absence of the requirement to disregard nonsubstantive or minimal features, the entity could have circumvented the requirement to classify the preferred equity security as a liability by embedding the nonsubstantive conversion option in the security.)
- In accordance with ASC 480-10-55-41, an outstanding share of preferred stock with a par amount of $100 and paying a small dividend would be judged minimal if the share contains an embedded written option that permits the counterparty to put both (1) the share and (2) 100,000 shares of common stock for an aggregate exercise price of $4.5 million when the current stock market value of those shares is $5 million (see Section 3.2.2.2). For classification purposes, such a financial instrument is analyzed as a freestanding written put option on common stock without a preferred stock host. (In the absence of the requirement to disregard nonsubstantive or minimal features, the entity could have circumvented the requirement to classify the written put as a liability by embedding it in the minimal preferred stock host.)
A feature may be substantive or nonminimal irrespective of whether it is
expected or not expected to be exercised or
triggered. ASC 480-10-55-40 suggests that a share
that contains mirror-image put and call options
that permit the issuer to call the instrument and
the holder to put the instrument on the same
exercise date and at the same strike price is not
a mandatorily redeemable financial instrument.
Even though there may be a significant likelihood
that either the put option or the call option will
be exercised, the share is not a mandatorily
redeemable financial instrument since there is a
reasonable possibility that both options will
expire at-the-money. Accordingly, the instrument
is analyzed as a share with a conditional
redemption requirement rather than as a share that
is certain to be redeemed (see Section
4.2.1). However, if the mirror price is
set at a level that makes it virtually impossible
for one option to expire unexercised (e.g., the
exercise price of the put option is set so high
that the option is virtually certain to be
exercised), the share should be considered
mandatorily redeemable.
In the evaluation of whether a feature is nonsubstantive or minimal, it may be relevant to consider whether it was designed to avoid the classification requirements in ASC 480-10. The FASB’s purpose in developing the requirements related to nonsubstantive or minimal features was to prevent entities from incorporating such features into instruments to circumvent the classification requirements in ASC 480-10. Paragraph B54 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
In reaching its conclusion to limit this Statement’s classification requirements only to certain freestanding financial instruments, the Board became concerned that a nonsubstantive or minimal feature might be inserted into a financial instrument, which otherwise would be a freestanding financial instrument subject to this Statement, to circumvent the provisions of this Statement. The Board decided to prevent that possibility by providing that any nonsubstantive or minimal features should be disregarded in applying the classification provisions of this Statement.
If a feature was included in a contract in good faith for substantive business
reasons, and the parties believed at the inception
of the contract that it was reasonably possible
that the feature would become operable, the
feature should not be considered nonsubstantive.
Conversely, the feature may lack substance if the
outcome of a condition in the contract’s terms is
predetermined. For instance, an obligation that is
conditional in form may, in substance, be
unconditional if the condition is certain to be
met in the absence of a violation of other legal
obligations (e.g., if the holder of an embedded
redemption option is legally required to exercise
it under the terms of the same contract, a
separate agreement, or its articles of
incorporation).
The evaluation of whether a feature is nonsubstantive or minimal should be
performed only at contract inception and should
focus exclusively on those features that, if
disregarded, would result in an instrument’s
classification as a liability (or as an asset in
some circumstances). That is, an issuer does not
reassess its conclusion regarding whether a
feature is nonsubstantive or minimal even if
circumstances change so that the feature becomes
substantive, nonsubstantive, minimal, or
nonminimal. This view is supported by the guidance
in ASC 480-10-55-12, which suggests that an entity
does not subsequently reassess its determination
that a conversion feature embedded in a preferred
share with a stated redemption date is
nonsubstantive. In addition, this view is
consistent with paragraph B54 of the Background
Information and Basis for Conclusions of FASB
Statement 150 (quoted above), which implies that
the purpose of the guidance is to prevent entities
from circumventing the classification provisions
of ASC 480-10 by inserting a nonsubstantive or
minimal feature into a contract at its inception.
If, however, the contract is modified, a
reassessment of whether a feature is
nonsubstantive is required.
3.2.2 Examples
3.2.2.1 Mandatorily Redeemable Preferred Shares With a Nonsubstantive Conversion Option
ASC 480-10
55-11
For another example of a conditionally redeemable
instrument, an entity may issue preferred shares
with a stated redemption date 30 years hence that
also are convertible at the option of the holders
into a fixed number of common shares during the
first 10 years. Those instruments are not
mandatorily redeemable for the first 10 years
because the redemption is conditional, contingent
upon the holder’s not exercising its option to
convert into common shares. However, when the
conversion option (the condition) expires, the
shares would become mandatorily redeemable and
would be reclassified as liabilities, measured
initially at fair value.
55-12 If
the conversion option were nonsubstantive, for
example, because the conversion price is extremely
high in relation to the current share price, it
would be disregarded as provided in paragraph
480-10-25-1. If that were the case at inception,
those preferred shares would be considered
mandatorily redeemable and classified as
liabilities with no subsequent reassessment of the
nonsubstantive feature.
Usually, an instrument that contains both a mandatory redemption requirement and an equity conversion option does not meet the definition in ASC 480-10 of a mandatorily redeemable financial instrument. The possibility of a conversion into equity shares suggests that redemption in cash or other assets is not certain to occur (see Section 4.1). If the conversion option is nonsubstantive, however, it would be disregarded in the evaluation of whether the instrument is a mandatorily redeemable financial instrument. A conversion option is nonsubstantive if the conversion price is “extremely high” relative to the share price (i.e., significantly deep out-of-the-money) at inception. That a conversion option is contingent (e.g., upon the payment of a dividend or the sale of a subsidiary) does not necessarily make it nonsubstantive as long as it is reasonably possible that the contingency will be met.
3.2.2.2 Option to Redeem Shares Embedded in a Minimal Host
ASC 480-10
55-41 An
entity issues one share of preferred stock (with a
par amount of $100), paying a small dividend, and
embeds in it an option allowing the holder to put
the preferred share along with 100,000 shares of
the issuer’s common stock (currently trading at
$50) for a fixed price of $45 per share in cash.
The preferred stock host is judged at inception to
be minimal and would be disregarded under
paragraph 480-10-25-1 in applying the
classification provisions of this Subtopic.
Therefore, under either paragraphs 480-10-25-8
through 25-12 or 480-10-25-14(c) (depending on the
form of settlement), that instrument would be
analyzed as a written put option in its entirety,
classified as a liability, and measured at fair
value.
Usually, an outstanding share that includes in its terms a written option that permits the holder to put the share to the issuer in exchange for cash is outside the scope of ASC 480-10 because it does not contain an unconditional obligation to deliver either assets or shares. Further, the embedded put option is not separately evaluated under ASC 480-10. If a written put option on own equity shares is embedded in a minimal share host, however, the host is disregarded in the application of the classification requirements of ASC 480-10. In such a case, the put option is evaluated as a freestanding financial instrument and classified as a liability under ASC 480-10-25-8 (see Section 5.1).
3.3 Unit of Account
ASC
Master Glossary
Unit of Account
The level at which an asset or a liability
is aggregated or disaggregated in a Topic for recognition
purposes.
In applying ASC 480-10, an issuer should consider how to
appropriately identify units of account (i.e., “the level at which an asset or a
liability is aggregated or disaggregated” for accounting purposes). Determining the
appropriate units of account is important because the application of ASC 480-10 and
other GAAP depend on how units of account are identified. For example, if an issuer
writes a freestanding put option on an equity share, the put option is analyzed as a
unit of account that is separate from the share. Under ASC 480-10, the written put
option would be classified as a liability and measured at fair value, with changes
in fair value recognized in earnings. If the issuer instead were to embed the same
put option in the equity share, however, the put option would not be separately
evaluated under ASC 480-10 because the scope of ASC 480-10 is limited to
freestanding financial instruments (see Sections 2.2.3 and 2.3.2). In this circumstance, the combination
of the share and the embedded put option potentially would represent a single unit
of account that qualifies for equity classification depending on the application of
other GAAP (including ASC 815-10 and ASC 815-15).
3.3.1 Concept of a “Freestanding Financial Instrument”
ASC
480-10 — Glossary
Freestanding Financial
Instrument
A financial
instrument that meets either of the following
conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Because ASC 480-10 applies only to freestanding financial
instruments and not to features embedded in such instruments, the definition of
a freestanding financial instrument helps an issuer determine whether an item is
within the scope of ASC 480-10 (see Section 2.2.3). A single contract often
represents a freestanding financial instrument. However, sometimes a single
legal agreement consists of more than one component that individually meets the
definition of a freestanding financial instrument, such as components that are
legally detachable and separately exercisable (e.g., debt with a detachable
warrant). Conversely, two separate agreements might, for accounting purposes,
have to be combined and treated as a single freestanding financial instrument
(e.g., debt issued with a warrant that is not legally detachable and separately
exercisable).
ASC 480-10-20 defines a freestanding financial instrument as one
that is entered into either “separately and apart from any of the entity’s other
financial instruments or equity transactions” or “in conjunction with some other
transaction and is legally detachable and separately exercisable.” Therefore, an
entity should consider the following questions in identifying freestanding
financial instruments:
-
Was the transaction entered into contemporaneously with and in contemplation of another transaction, or was it entered into separately and apart from other transactions?The fact that a transaction was entered into separately and apart from any other transaction suggests that it is a freestanding financial instrument that is separate from any other transaction. If the transaction was entered into contemporaneously and in contemplation of another transaction, the entity should assess whether the two transactions represent a single freestanding financial instrument. For example, if warrants are issued in conjunction with a debt issuance of the same issuer, the issuer should consider whether to treat them as being embedded in the debt even if they are subject to a separate contractual agreement.A transaction’s having been entered into contemporaneously or in conjunction with some other transaction, however, would not necessarily result in a conclusion that the two transactions should be viewed on a combined basis as a single freestanding financial instrument. The entity should also consider whether the transactions are legally detachable and separately exercisable (see below) and whether the combination guidance in ASC 815-10 applies (see Section 3.3.2).A one-week period between transactions may be good evidence that the transactions are not contemporaneous if the entity is exposed to market fluctuations during this time. Even when transactions occur at different times, however, entities should consider all available evidence to ensure that no side agreements or other contracts were entered into that suggest the transactions were entered into in contemplation of one another.Options written by the acquired entity on its stock as of the date of a business combination are often viewed as effectively modifying previously existing shares. Such options are not considered to have been entered into separately and apart from the shares.
-
Is the item legally detachable?Neither ASC 480 nor other GAAP provide guidance on the meaning of “legally detachable.” In practice, an item is considered legally detachable from another item if it is (1) separately transferable from that item or (2) otherwise capable of being separated from that item. If an item is separately exercisable but not considered legally detachable, it would not be a separate freestanding financial instrument under item (b) of the definition of a freestanding financial instrument. However, in some cases, the separate exercisability of an item results in a conclusion that an item is legally detachable.An item is always considered “legally detachable” if it can be transferred separately from another item in a single contractual agreement (or from another item in multiple contracts entered into at the same time) at the holder’s discretion (i.e., without limitations imposed by the counterparty). The fact that an item can be transferred independently from another item indicates that it is a separate unit of account even if the two items were entered into contemporaneously and have the same counterparty. This view is supported by the guidance in ASC 815-10-25-9, which states, in part:Derivative instruments that are transferable are, by their nature, separate and distinct contracts.Similarly, ASC 815-10-15-5 states, in part:The notion of an embedded derivative . . . does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.However, a scenario in which two items cannot be transferred independently of one another suggests that each item is not a freestanding financial instrument under (b) in the definition of a freestanding financial instrument in ASC 480-10-20. For example, if a warrant “travels with” a bond and cannot be transferred separately from the bond, it may be an embedded feature in the bond.A contract may be entered into in conjunction with some other item. For such a contract to be considered a freestanding instrument, an assessment must be performed of both the form and substance of the transaction, including the substance of the independent transferability of the item. In some circumstances, an item is unconditionally separately transferable by the holder but would have no economic value if the related item were not held, which would suggest that the separate transferability has no substance and the item is embedded in the related item (see further discussion in question 3). Similarly, the holder of shares not readily obtainable in the market may have a separately transferable put option that it can exercise only by delivering the same specific shares. In this case, the shares and the put option may represent a single, combined unit of account on the basis of an assessment of the substance of the transaction.In other circumstances, an item may be separately transferred only with the consent of the counterparty. If an item may be separated from a related contract without any modification to the contractual terms (e.g., the contract specifically permits the item to be transferred if the issuer gives its consent and such consent cannot be unreasonably withheld), the legally detachable condition is, in substance, generally met since the counterparty has agreed to not withhold its consent. If, however, the counterparty can always prevent the separate transfer of the item at its discretion, the legally detachable condition is, in substance, most likely not met and therefore the item is not a freestanding financial instrument.The SEC staff has indicated in informal discussions that it is possible for two items that have been entered into contemporaneously with the same counterparty to be considered freestanding financial instruments solely on the basis of the items’ ability to be separately exercised (i.e., even though the contractual terms prevent the items from being transferred separately). This would generally be the case when a reasonable conclusion can be reached that the separate exercisability of one item is sufficient to establish that it is legally detachable from the related item. However, when determining whether an item can be transferred separately, an entity must use significant judgment and consider the transaction’s form and substance. We therefore strongly recommend that an entity consult with its independent accounting advisers when performing this assessment.
-
Can the item be exercised separately, or does exercise result in the termination, redemption, or automatic exercise of a specifically identified item?If an item can be freely exercised without terminating the other item (e.g., through redemption, automatic exercise, or expiration), it is considered to be “separately exercisable.” The fact that a warrant remains outstanding if a bond to which it is attached is redeemed, for example, suggests that the warrant is a freestanding financial instrument that is separate from the bond. Similarly, if a bond may remain outstanding after a net-share-settled conversion feature included in the bond is exercised, the conversion feature may be a freestanding financial instrument.Conversely, if the exercise of an item results in the termination of a specifically identified item, the first item would not be considered separately exercisable from the other item. For example, if a warrant can be exercised only by the tendering of a specific bond in a physical settlement, it may be a feature embedded in the bond rather than a freestanding financial instrument. ASC 470-20-25-3 states, in part:[I]f stock purchase warrants are not detachable from [a] debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument.Similarly, if a specifically identified share is subject to a redemption requirement, the share and the redemption requirement may represent one single freestanding financial instrument even if they are documented in separate agreements. ASC 480-10-15-7C states, in part:Some entities have issued shares that are required to be redeemed under related agreements. If the shares are issued with a redemption agreement and the required redemption relates to those specific underlying shares, the shares are mandatorily redeemable.
-
Does the transaction involve multiple counterparties?Contracts with different counterparties are treated as separate freestanding financial instruments even if they were issued contemporaneously or are transacted as a package. Thus, ASC 815-10-15-6 suggests that an option added or attached to an existing debt instrument by another party is not an embedded derivative because it does not have the same counterparty. Similarly, ASC 815-15-25-2 indicates that the notion of an embedded derivative in a hybrid instrument does not refer to provisions in separate contracts between separate counterparties.Example 3-1Issuance of a Bond With a WarrantAn entity delivers a bond and a warrant on its own equity to an underwriter for cash. The underwriter is a party to the warrant but holds the bond merely as an agent for a third-party investor. The terms and pricing of the bond sold to the third-party investor are not affected by the sale of the warrant to the underwriter. Because they involve different counterparties, the bond and the warrant are two separate freestanding financial instruments.
Under ASC 815-10-25-10, transactions that are entered into with
a single party are treated as having the same counterparty even if some of them
are structured through an intermediary. In consolidated financial statements,
the reporting entity is the consolidated group. Therefore, the parent and its
subsidiary would not be considered different parties in the consolidated
financial statements. For example, if a parent entity writes a put option on
subsidiary shares to the holder of those shares, it is acceptable to view the
option as being embedded in the shares in the consolidated financial statements
even though the subsidiary technically is not a party to the option.
3.3.2 Combination Guidance
ASC
480-10
25-15 A freestanding financial
instrument that is within the scope of this Subtopic
shall not be combined with another freestanding
financial instrument in applying paragraphs 480-10-25-4
through 25-14 unless combination is required under the
provisions of Topic 815. For example, a freestanding
written put option that is classified as a liability
under this Subtopic shall not be combined with an
outstanding equity share.
ASC 480-10 precludes an entity from treating two or more
freestanding financial instruments as a single unit of account unless
combination is required under the derivative accounting requirements in ASC 815.
Thus, the entity is prevented from circumventing the requirements of ASC 480-10
by analyzing freestanding instruments on a combined basis as a synthetic
instrument. For example, the entity could not combine a written put option on
the entity’s shares with an outstanding share and analyze them in combination as
a puttable share if the option and the share are separate freestanding financial
instruments. If the entity had been permitted to combine the option and the
share, it might have been able to avoid the liability classification
requirements in ASC 480-10 for the option since those requirements do not apply
to (1) puttable shares that are not certain to be redeemed or (2) embedded put
features.
Paragraph B51 of the Background Information and Basis for Conclusions of FASB Statement 150 explains the Board’s reasoning and states, in
part:
[T]he Board prohibited the
combining of instruments within the scope of [ASC 480-10] to avoid
comparability and representational faithfulness problems from
inadvertent or planned circumvention of [its] requirements . . . . The
Board saw no justification for combining an instrument that in itself is
a liability within the scope of this Statement with another freestanding
instrument, because that combination might (a) cause a freestanding
instrument to be considered to be outside the scope of this Statement,
(b) change the reported amount of the liability, or (c) change the
required measurement method.
Under a narrow exception in ASC 480-10, two or more items must be combined if combination would be required in accordance with the derivative accounting requirements in ASC 815. Paragraph B50 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
The Board noted that there are certain
circumstances in which [ASC 815] and related guidance require separate
transactions to be viewed in combination. Those circumstances arise if
it is determined that one or more transactions were entered into
separately to circumvent the requirements of [ASC 815]. The Board
decided that, in those circumstances, it would be appropriate to retain
that guidance.
Accordingly:
- If two or more transactions are required to be combined under ASC 815-10, they would be combined under ASC 480-10 as well.
- If two or more transactions are not required to be combined under ASC 815-10, they would not be combined under ASC 480-10 either.
ASC 815-10-15-8 states, in part:
In some circumstances, an entity could enter into two
or more legally separate transactions that, if combined, would generate
a result that is economically similar to entering into a single
transaction that would be accounted for as a derivative instrument under
this Subtopic.
Nevertheless, ASC 815 ordinarily does not permit an entity to
treat two or more freestanding financial instruments as a single combined unit
of account. Derivatives Implementation Group Issue F6 (not codified) notes the
following:
[ASC 815] is a
transaction-based standard.
Similarly, ASC 815-10-25-6 states, in part:
This Subtopic generally does not provide for the
combination of separate financial instruments to be evaluated as a
unit.
However, if two or more freestanding financial instruments have
characteristics suggesting that they were structured to circumvent GAAP, they
may need to be combined and treated as a single unit of account. Specifically,
ASC 815-10 requires two or more separate transactions to be combined and viewed
in combination as a single unit of account for accounting purposes if they were
entered into in an attempt to circumvent that subtopic’s accounting requirements
for derivatives (i.e., measured at fair value, with subsequent changes in fair
value recognized in earnings except for qualifying hedging instruments in cash
flow or net investment hedges). ASC 815-10-15-9 states that such combination is
required if the transactions have all of the following characteristics:
- They “were entered into contemporaneously and in contemplation of one another.”
- They “were executed with the same counterparty (or structured through an intermediary).”
- They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
- “There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those
listed above from ASC 815-10-15-9 and adds the following commentary:
If separate derivative instruments have
all of [these] characteristics, judgment shall be applied to determine
whether the separate derivative instruments have been entered into in
lieu of a structured transaction in an effort to circumvent GAAP: . . .
If such a determination is made, the derivative instruments shall be
viewed as a unit.
Note that the SEC staff has indicated that it will challenge the accounting for transactions that have been structured to circumvent GAAP. EITF Issue 02-2 (not codified) states, in part:
The SEC Observer encouraged the [FASB] to examine the
broader issue of when to combine transactions and noted that, in the
interim, the SEC staff will continue to challenge the accounting for
transactions for which it appears that multiple contracts have been used
to circumvent generally accepted accounting principles.
3.3.3 Application Issues and Examples
3.3.3.1 Issuance of Warrants and Put Options
Example 3-2
Issuance of Warrants and Put Options
An entity issues stock purchase warrants on its
stock to third-party investors. In conjunction with
that transaction, the entity enters into a
warrant-holder rights agreement with each warrant
holder giving it a put right that allows it to
require the entity to purchase for cash any or all
of the shares issued or issuable to the holders
under the warrants. The put right cannot be sold
separately from the shares issued or issuable, and
those shares cannot be sold separately from the put
rights. In other words, the put rights are directly
linked to the shares that are issued or issuable
under each warrant and accompany the shares if sold
or transferred to another party. The put rights
cannot be used to put back shares other than those
issued or issuable under the warrants.
In this scenario, the warrants and put rights are combined and viewed as one
single freestanding financial instrument (unit of
account) even though they are documented in two
separate legal documents. The combined instrument
would be classified as a liability under ASC 480-10
because it is not an outstanding share, it embodies
an obligation of the issuer (see Section
2.2.1), and the entity could be
required under the put option to repurchase shares
by transferring assets (see Chapter
5). If the warrants are exercised, the
put rights would be considered embedded in the
shares. As a result, those redeemable shares would
be outside the scope of ASC 480-10 because they do
not meet the definition of a mandatorily redeemable
financial instrument (see Chapter 4), they
represent outstanding shares (see Chapter 5), and they
do not embody an unconditional obligation to issue a
variable number of shares (see Chapter
6).
3.3.3.2 Put Option on Noncontrolling Interest
Example 3-3
Put Option on Noncontrolling Interest
An entity holds 70 percent of the equity shares of
another entity and consolidates that entity (i.e.,
the entities have a parent-subsidiary relationship).
The remaining 30 percent of the shares (the
noncontrolling interest) are held by a third party.
After the parent acquires its 70 percent of the
shares and the third party acquires its 30 percent,
the parent entity writes a put option that permits
the third party to sell all of its shares to the
parent for a fixed price on or before a specified
date. Unlike the put option, the shares have no
expiration date. Upon exercise, the put option is
physically settled. There is no mechanism to net
cash or net share settle the option. Given the
nature of its terms, the put option cannot be
transferred separately from the noncontrolling
interest, and the exercise of the put option results
in the termination of the noncontrolling
interest.
Because it is not legally detachable and separately exercisable, the put option
should be considered embedded in the noncontrolling
interest rather than a freestanding financial
instrument. Because redemption is not certain to
occur, the entity would not classify the instrument
(the combination of the noncontrolling interest and
the put option) as a liability under ASC 480-10 (see
Chapter 4). In the parent’s
consolidated financial statements, the put option
may be considered embedded in the noncontrolling
interest irrespective of whether the option issuer
is the parent or the subsidiary.
3.3.3.3 Issuance of Shares and Put Options
Example 3-4
Issuance of Shares and Put Options
An entity issues equity shares along with put
options that give the counterparty the right to
require the entity to redeem the same number of
shares for cash. The options can only be physically
settled through the exchange of shares for cash. The
put options do not require delivery of any
specifically identified shares, and because the
shares issued with the put options are publicly
traded, they are not the only shares available to
settle the put option. Therefore, the put options
would not be considered embedded in the shares.
Instead, they would be classified as liabilities
under ASC 480-10 (see Chapter
5).
3.3.3.4 Put Right That Expires Upon Share Transfer
Example 3-5
Put Right That Expires Upon Share Transfer
An entity enters into an agreement to sell a share
along with a put right to a specific investor. The
put right is solely for the benefit of that specific
investor with regard to the specific share it has
purchased. If the investor transfers the share to a
third party, the put right irrevocably terminates
upon the transfer. Even if the investor subsequently
repurchases the share, it cannot regain its put
right.
In these
circumstances, the agreement effectively prohibits
separation of the put right from the share.
Therefore, the put right would not be considered
legally detachable from the share and would not be a
freestanding financial instrument. Instead, the
entity would analyze the share and the put right on
a combined basis in determining whether ASC 480-10
applies. The redeemable shares would be outside the
scope of ASC 480-10 because they do not meet the
definition of a mandatorily redeemable financial
instrument (see Chapter 4), they
represent outstanding shares (see Chapter
5), and they do not embody an
unconditional obligation to issue a variable number
of shares (see Chapter
6).
3.3.3.5 Tranche Preferred Stock Agreement
Example 3-6
Tranche
Preferred Stock Agreement
Entity X enters into a preferred
stock purchase agreement with unrelated investors to
sell two tranches of convertible redeemable
preferred stock (the “preferred stock”). The
purchase agreement stipulates the following:
-
On the first closing date, which is the date of the purchase agreement, the investors will acquire 50,000 shares of preferred stock for $50 million.
-
On the second closing date, the investors will acquire 25,000 additional shares of preferred stock for $25 million subject to a specified condition. The second closing will occur only if (1) a specific milestone related to X’s operations is achieved two years from the first closing date or (2) the specific milestone related to X’s operations is not achieved two years from the first closing date but the holders waive the milestone requirement and elect to purchase the additional shares of preferred stock (the “contingent purchase option”).
The purchase agreement stipulates
that the holders of preferred stock issued in the
first closing cannot transfer their contingent
purchase options separately from the preferred
shares acquired in the first closing (or vice
versa). However, such holders have the right to
convert those preferred shares into common stock
before the date that is two years from the first
closing date. The purchase agreement does not
restrict the holders that convert preferred shares
into common stock from selling those common shares.
The only restrictions on selling common stock stem
from restrictions under U.S. securities laws.
In this example, the contingent
purchase option would be considered a freestanding
financial instrument because it meets the “legally
detachable and separately exercisable” condition.
The holders can “detach” the two instruments because
they can convert the preferred stock into common
stock and sell those shares while retaining the
contingent purchase option (i.e., the two
instruments are capable of being separated). This
would be the case even if the contingent purchase
option may not be separately transferred after the
conversion into common stock of the preferred shares
obtained in the first closing. It would not be
appropriate to consider the preferred shares and the
contingent purchase option a single combined
financial instrument, because the contingent
purchase option would not become embedded in the
common shares received upon conversion of the
preferred stock purchased in the first closing.
Note that the conclusion in this example would not
change even if:
- The holders could not sell the common shares received upon conversion of the preferred stock purchased in the first closing before satisfaction or expiration of the contingent purchase option. At the inception of the arrangement, the two instruments still meet the legally detachable and separately exercisable condition because the contingent purchase option (1) cannot become embedded in the common shares received upon conversion of the preferred stock purchased in the first closing and (2) does not become freestanding only if the preferred stock purchased in the first closing is converted into common stock (instead, the ability to convert the preferred stock purchased in the first closing is evidence that the contingent purchase option is capable of being separated at the inception of the arrangement).
- The preferred stock purchased on the first closing date cannot be transferred or converted before the contingent purchase option is satisfied or expires and the holders have the right to acquire the additional shares related to the contingent purchase option at their option at any time before two years from the closing date. The two instruments still meet the legally detachable and separately exercisable condition because the investor can separate the two components by early exercising the contingent purchase option while retaining the preferred shares acquired on the first closing date.
As this example illustrates, and in a manner
consistent with practice, an option or commitment to
issue additional preferred shares is almost always a
freestanding financial instrument because the
separate exercisability of the option or commitment
is sufficient to demonstrate that the feature is
capable of being separated.
3.3.4 Allocation of Proceeds and Issuance Costs
3.3.4.1 Allocation of Proceeds
The amount of proceeds attributable to a financial
instrument affects the determination of its initial carrying amount.
Generally, one of the following two approaches applies to the issuer’s
allocation of proceeds received among freestanding financial instruments
that are part of the same transaction:
- A with-and-without method (also known as a residual method; see Section 3.3.4.2).
- A relative fair value method (see Section 3.3.4.3).
The appropriate allocation method depends on the accounting
that applies to each freestanding financial instrument issued as part of the
transaction. The issuer should also consider whether it is necessary to
allocate an amount to any other rights or privileges included in the
transaction (see, for example, ASC 470-20-25-24 and ASC 835-30-25-6).
3.3.4.2 With-and-Without Method
If one or more, but not all, of the freestanding financial
instruments issued as part of a single transaction must be recognized as
assets or liabilities measured at fair value on a recurring basis (e.g., one
of the instruments is accounted for at fair value on a recurring basis under
ASC 480-10, as a derivative instrument under ASC 815, or at fair value under
the fair value option in ASC 825-10), the with-and-without method should be
applied in the allocation of proceeds among the freestanding financial
instruments. This approach is analogous to the allocation method for
bifurcated embedded derivatives in ASC 815-15-30-2 and 30-3.
Under the with-and-without method, a portion of the proceeds
equal to the fair value of the instrument (or instruments) measured at fair
value on a recurring basis is first allocated to that instrument (or
instruments) on the basis of its fair value as of the initial measurement
date. The remaining proceeds are then allocated to the other instrument (or
instruments) issued in the same transaction either on a residual basis, if
there is only one remaining instrument, or by using a relative fair value
approach, if there are multiple remaining instruments. The with-and-without
allocation approach avoids the recognition of a “day 1” gain or loss in
earnings that is not associated with a change in the fair value of the
instrument (or instruments) that is subsequently measured at its fair value.
Under this approach, if there is only one freestanding financial instrument
to which the residual proceeds are allocated, the issuer is not required to
estimate that instrument’s fair value.
Example 3-7
Debt Issued With a Detachable Warrant
Company C issues debt to Company B, together with a
detachable and separately transferable warrant, for
total proceeds of $10,000, which is also the par
amount of the debt. The warrant gives the holder the
right to purchase shares issued by C, which are
redeemable for cash at the holder’s option. Company
C determines that the debt and the warrant represent
separate freestanding financial instruments.
Rather than electing to account for
the debt by using the fair value option in ASC
825-10, C will account for it by using the interest
method in ASC 835-30. In evaluating whether the
warrant is within the scope of ASC 480-10, C
determines that the warrant is a freestanding
financial instrument that embodies an obligation to
repurchase the issuer’s equity shares and may
require the issuer to settle the obligation by
transferring assets. In a manner consistent with the
guidance in ASC 480-10, C will account for the
warrant as a liability that is measured both
initially and subsequently at fair value, with
changes in fair value recognized in earnings (see
Chapter 5). Company C estimates that
the initial fair value of the warrant is $2,000.
In determining the initial
carrying amounts, C allocates the proceeds received
between the debt and the warrant. Because the
warrant, but not the debt, will be measured at fair
value, with changes in fair value recognized in
earnings, C should first measure the fair value of
the warrant ($2,000) and allocate that amount to the
warrant liability. The amount of proceeds allocated
to the debt is the difference between the total
proceeds received ($10,000) and the fair value of
the warrant ($2,000). The resulting discount from
the par amount of the debt ($2,000) is accreted to
par by using the effective-interest method in ASC
835-30.
3.3.4.2.1 Estimated Fair Values Exceed Proceeds Received
In some circumstances, the initial fair value of the
items that must be subsequently measured at fair value exceeds the
proceeds received. At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting Fellow Hillary Salo
addressed the allocation of proceeds related to the
issuance of a hybrid instrument in situations in which the initial fair
value of the financial liabilities that must be measured at fair value
(such as embedded derivatives) exceeds the net proceeds received. Ms.
Salo provided the following example:
[A] reporting entity that wants to align itself
with a specific investor issues $10 million of convertible debt
at par and is required to bifurcate an in the money conversion
option with a fair value of $12 million.
Her remarks also apply by analogy to freestanding
financial instruments (e.g., debt issued with detachable warrants) when
(1) one or both are measured at fair value with changes in fair value
recognized in earnings and (2) the initial fair value of items that must
be remeasured at fair value exceeds the amount of the proceeds received.
In addition, her remarks are relevant to an issuer’s determination of
the appropriate accounting for a repurchase of an outstanding financial
instrument at an amount in excess of its fair value (see Section 6.1.3 of Deloitte’s Roadmap
Contracts on an Entity’s Own
Equity).
Example 3-8
Fair Value of Instruments Exceeds Purchase
Price
Entity Y issues debt and
detachable warrants on preferred shares that are
redeemable by the holder upon a change of control
for $100 million of cash proceeds. The entity
elects to account for the debt at fair value under
the fair value option in ASC 825-10. In accordance
with ASC 480-10-25-8 (see Chapter
5), Y must account for the warrants as
liabilities at fair value. The total estimated
fair value of the debt and the warrants is $120
million as of the issuance date.
Ms. Salo made the following remarks:
[T]he staff believes that when reporting
entities analyze these types of unique fact patterns, they
should first, and most importantly, verify that the fair values
of the financial liabilities required to be measured at fair
value are appropriate under Topic 820. [Footnote omitted] If
appropriate, then the reporting entity should evaluate whether
the transaction was conducted on an arm’s length basis,
including an assessment as to whether the parties involved are
related parties under Topic 850. [Footnote omitted] Lastly, if
at arm’s length between unrelated parties, a reporting entity
should evaluate all elements of the transaction to determine if
there are any other rights or privileges received that meet the
definition of an asset under other applicable guidance.
In the fact patterns analyzed by the staff, we
concluded that if no other rights or privileges that require
separate accounting recognition as an asset could be identified,
the financial liabilities that are required to be measured at
fair value (for example, embedded derivatives) should be
recorded at fair value with the excess of the fair value over
the net proceeds received recognized as a loss in earnings.
Furthermore, given the unique nature of these transactions, we
would expect reporting entities to provide clear and robust
disclosure of the nature of the transaction, including reasons
why the entity entered into the transaction and the benefits
received.
Additionally, some people may wonder whether the
staff would reach a similar conclusion if a transaction was not
at arm’s length or was entered into with a related party. We
believe those fact patterns require significant judgment;
therefore, we would encourage consultation with OCA in those
circumstances.
Accordingly, an entity should perform the following
steps in determining the appropriate accounting (quoted text is from Ms.
Salo’s speech):
-
Step 1 — “[V]erify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.”If the entity has not complied with the fair value measurement requirements in ASC 820 regarding its estimated values, it should adjust those values to ensure its compliance. For a detailed discussion of the requirements in ASC 820, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
-
Step 2 — “[E]valuate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under Topic 850.”As noted in ASC 820-10-35-3, a “fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.” ASC 820-10-20 defines market participants, in part, as parties that “are independent of each other, that is, they are not related parties.” Circumstances in which a transaction price may not represent fair value include those in which (1) the transaction was between related parties and took place under duress or (2) the entity was forced to accept the transaction price because of financial difficulties.In practice, a pro rata distribution to equity owners is recognized as an equity transaction (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account), whereas a non-pro-rata distribution is recognized as a charge to earnings in the period in which the distribution is declared. Thus, if a wholly owned subsidiary issues debt to its parent, any excess of the fair value of the instruments issued over the proceeds received might represent a deemed dividend from the subsidiary to the parent. If a related-party transaction represents a non-pro-rata distribution, however, expense recognition may be appropriate.
-
Step 3 — “[E]valuate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.”If the transaction was conducted at arm’s length and the total fair value of the liabilities measured at fair value exceeds the proceeds received, an entity should carefully evaluate whether the difference is attributable to some other transaction element that qualifies for accounting recognition (e.g., separate freestanding financial instruments or other rights or privileges). If so, those elements should be recognized separately (e.g., as an asset or expense in accordance with other applicable GAAP). By analogy, under paragraph 3 of FASB Technical Bulletin 85-6 (partially codified in ASC 505-30), it is presumed that a purchase of shares at a price significantly in excess of the open market price includes amounts attributable to other items:A purchase of shares at a price significantly in excess of the current market price creates a presumption that the purchase price includes amounts attributable to items other than the shares purchased. For example, the selling shareholder may agree to abandon certain acquisition plans, forego other planned transactions, settle litigation, settle employment contracts, or restrict voluntarily the ability to purchase shares of the company or its affiliates within a stated time period.
If, after performing these steps, an entity determines
that no other transaction elements can be identified, the excess of the
fair value over the proceeds is recognized as an expense (an up-front
loss). In this circumstance, the SEC staff expects the entity to provide
“clear and robust disclosure of the nature of the transaction, including
reasons why the entity entered into the transaction and the benefits
received.”
3.3.4.3 Relative Fair Value Method
The relative fair value method is appropriate if either of
the following applies: (1) none of the freestanding financial instruments
issued as part of a single transaction are measured at fair value, with
changes in fair value recognized in earnings on a recurring basis, or (2)
after the entity measures freestanding financial instruments at fair value
under the with-and-without method, more than one freestanding financial
instrument is not subsequently measured at fair value on a recurring basis.
To apply this method, the entity allocates the proceeds (or remaining
proceeds after application of the with-and-without method) on the basis of
the fair values of each freestanding financial instrument at the time of
issuance. ASC 470-20-25-2 requires an entity to use the relative fair value
allocation approach to allocate proceeds in certain transactions involving
debt and detachable warrants. The approach is also appropriate for other
transactions that involve freestanding financial instruments that are not
measured at fair value on a recurring basis.
Under the relative fair value method, the issuer makes
separate estimates of the fair value of each freestanding financial
instrument and then allocates the proceeds in proportion to those fair value
amounts (e.g., if the estimated fair value of one of the instruments is 20
percent of the sum of the estimated fair values of each of the instruments
issued in the transaction, 20 percent of the proceeds would be allocated to
that instrument). Because an issuer needs to independently measure each
freestanding financial instrument issued as part of the transaction, more
fair value estimates are required under the relative fair value method than
under the with-and-without method.
In some transactions involving the issuance of more than two
freestanding financial instruments, both the with-and-without method and the
relative fair value method will apply. For example, if one freestanding
financial instrument is measured at fair value on a recurring basis and
others are not, the freestanding financial instrument that is subsequently
measured at fair value on a recurring basis should be initially measured at
its fair value, and the remaining amount of proceeds should be allocated
among the freestanding financial instruments not subsequently measured at
fair value on the basis of their relative fair values.
3.3.4.4 Allocation of Issuance Costs
Issuance costs are specific incremental costs that are (1)
paid to third parties and (2) directly attributable to the issuance of a
debt or equity instrument. Thus, issuance costs represent costs incurred
with third parties that result directly from and are essential to the
financing transaction and would not have been incurred by the issuer had the
financing transaction not occurred. Examples of costs that may qualify as
issuance costs include underwriting fees, professional fees paid to
attorneys and accountants, printing and other document preparation costs,
travel costs, and registration and listing fees directly related to the
issuance of the instrument. Amounts paid to the investor upon issuance, such
as commitment fees, origination fees, and other amounts paid to the investor
(e.g., reimbursement of the investor’s expenses) represent a reduction in
the proceeds received, not issuance costs.1
Costs that would have been incurred irrespective of whether
there is a proposed or actual offering do not qualify as issuance costs. For
example, in accordance with SAB Topic 5.A (reproduced in ASC 340-10-S99-1),
allocated management salaries and other general and administrative expenses
do not represent an issuance cost. Similarly, legal and accounting fees that
would have been incurred irrespective of whether the instrument was issued
are not issuance costs (see AICPA Technical Q&As Section 4110.01).
Further, the SEC staff believes that if a proposed offering
is aborted (including the postponement of an offering for more than 90
days), its associated costs do not represent issuance costs of a subsequent
offering.
Unless a debt instrument is subsequently measured at fair
value on a recurring basis, any issuance costs attributable to the initial
sale of the instrument should be offset against the associated proceeds in
the determination of the instrument’s initial net carrying amount (see ASC
835-30-45-1A). Similarly, issuance costs attributable to the initial sale of
an equity instrument should be deducted from the related proceeds (see SAB
Topic 5.A and AICPA Technical Q&As Section 4110.01).
However, as indicated in ASC 825-10-25-3, if the fair value
option has been elected, “[u]pfront costs and fees [are] recognized in
earnings as incurred and not deferred.” Any issuance costs allocated to
other instruments that are subsequently measured at fair value, with changes
in fair value recognized in earnings (e.g., derivative instruments), also
are recognized in the period incurred since they are not a characteristic of
the asset or liability (see ASC 820-10-35-9B).
Entities should consistently apply a systematic and rational
method for allocating issuance costs among freestanding financial
instruments that form part of the same transaction. In limited
circumstances, U.S. GAAP prescribe a specific allocation method for such
costs. Otherwise, the allocation method is based on the specific facts and
circumstances. In the remaining discussion, it is assumed that an amount of
proceeds is allocated to each freestanding financial instrument. If few or
no proceeds are allocated to such an instrument issued as part of a group
(e.g., a loan commitment entered into with a term loan), an entity may
allocate issuance costs on the basis of the relative amount of costs that
would have been incurred if each freestanding financial instrument had been
entered into separately. Otherwise, if the proceeds are allocated solely on
the basis of the relative fair value method, issuance costs should also be
allocated on that basis, which is consistent with the guidance in SAB Topic
2.A.6 (reproduced in ASC 340-10-S99-2). If an entity uses the
with-and-without method (including allocation to a freestanding financial
instrument that contains an embedded derivative that must be bifurcated from
its host contract), one of the following two methods is generally considered
appropriate:
-
The relative fair value method — The issuer would allocate issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to the allocation of proceeds to debt instruments with detachable warrants in ASC 470-20-25-2. SAB Topic 2.A.6 (reproduced in ASC 340-10-S99-2) states that this method should be applied in the allocation of costs between services received “[w]hen an investment banker provides services in connection with a business combination or asset acquisition and also provides underwriting services associated with the issuance of debt or equity securities.” However, if no proceeds are allocated to the debt under the with-and-without method, any issuance costs allocated to the debt under the relative-fair value method should be expensed as incurred because it would be inappropriate to present a debt liability as an asset.
-
An approach that is consistent with the allocation of proceeds — The issuer would allocate issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments. ASC 470-20-30-31 requires entities to use this approach when allocating issuance costs between the liability and equity components of convertible instruments within the scope of the CCF guidance in ASC 470-20.
The method used should be applied consistently to similar
transactions. Any issuance costs allocated to a freestanding or an embedded
financial instrument that is subsequently measured at fair value through
earnings must be expensed as of the issuance date (see, e.g., ASC
825-10-25-3).
3.3.5 Accelerated Share Repurchase Programs
ASC
505-30
25-5 An accelerated share
repurchase program is a combination of transactions that
permits an entity to repurchase a targeted number of
shares immediately with the final repurchase price of
those shares determined by an average market price over
a fixed period of time. An accelerated share repurchase
program is intended to combine the immediate share
retirement benefits of a tender offer with the market
impact and pricing benefits of a disciplined daily open
market stock repurchase program.
25-6 An entity shall account
for such an accelerated share repurchase program as the
following two separate transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date
- As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock.
Example 1 (see paragraph
505-30-55-1) provides an illustration of an accelerated
share repurchase program that is addressed by this
guidance.
ASC 505-30 contains unit-of-account guidance that applies to
accelerated share repurchase programs. Under ASC 505-30-25-6, an entity accounts
for an accelerated share repurchase as two separate units of account: a treasury
stock repurchase and a separate forward contract on the entity’s shares. An
entity should analyze the treasury stock repurchase and forward contract
separately to determine whether ASC 480-10 applies.
The terms of accelerated share repurchases vary. In a
traditional accelerated share repurchase, an entity (1) repurchases a targeted
number of its own shares at the current stock price up front for cash and (2)
simultaneously enters into a net-settled forward sale of the same number of
shares. Economically, the forward serves as a true-up mechanism to adjust the
price ultimately paid for the shares purchased. The purpose is to reduce the
number of outstanding shares immediately at a repurchase price that reflects the
average stock market price over an extended period (e.g., the volume-weighted
average price on each trading day during the contract period). On a combined
basis, the initial share repurchase and the forward sale put the issuer in an
economic position similar to that of having conducted a series of open market
purchases of its own stock over a specified period.
In practice, the settlement of the treasury stock repurchase
often takes place one or a few days after the execution of the accelerated share
repurchase (e.g., the initial share delivery date may be three business days
after the transaction date), at which time the issuer pays cash and receives an
initial number of shares. If so, the obligation to repurchase shares in exchange
for cash is classified as a liability under ASC 480-10-25-8 (see Chapter 5) during the
period between the accelerated share repurchase transaction date and the
settlement date of the treasury stock repurchase (sometimes described as the
“initial share delivery date” or the “prepayment date”). Note that in some
accelerated share repurchase transactions, the payment of cash in the treasury
stock repurchase occurs before the receipt of the initial shares, in which case
ASC 480-10 may cease to apply once the obligation to pay cash has been
settled.
In evaluating whether the forward component of an accelerated
share repurchase is within the scope of ASC 480-10, the issuer should consider
whether it embodies an obligation to transfer assets or a variable number of
shares that meet the criteria in ASC 480-10-25-8 or ASC 480-10-25-14 (see
Chapters 5 and
6,
respectively). Usually, an issuer is not required to classify as a liability
under ASC 480-10 the forward contract component in a traditional accelerated
share repurchase because it does not embody an obligation to repurchase shares
for assets and does not involve an obligation to deliver a variable number of
shares with a monetary value that moves inversely with — or is based on
something other than — the price of the issuer’s stock. However, an issuer
cannot assume that the forward contract component of an accelerated share
repurchase is outside the scope of ASC 480-10 without analyzing its specific
terms and features.
In some accelerated share repurchase transactions, a portion of
the prepayment amount on the initial share delivery date represents a premium
paid by the issuer to increase the forward sale price that the issuer will
receive in the forward component of the transaction (relative to an at-market
forward) rather than a payment for the shares to be received in the initial
treasury stock repurchase. For example, the issuer may apply 20 percent of the
prepayment amount to the forward component to reduce the likelihood that the
forward component will ever dilute EPS. In this case, the issuer may be required
to account for the forward component as an asset or liability under ASC
480-10-25-8 in the period between the transaction date and the prepayment date
(which may be the initial share delivery date) if the forward component permits
net share settlement, because the forward component embodies an obligation to
pay cash (on the initial share delivery date) to repurchase shares (the issuer
will receive shares at the forward settlement date if the stock price is less
than the forward price).
If the forward component is outside the scope of ASC 480-10, the
issuer should evaluate it under other literature (e.g., ASC 815-40) to determine
whether it must be accounted for as an asset or a liability (see Section 3.2.5 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
ASC
505-30
Example 1: Accelerated Share
Repurchase Program
55-1 This Example illustrates
the guidance in paragraph 505-30-25-5 by identifying the
two separate transactions, namely a treasury stock
purchase and a forward contract, that are present in
what is sometimes described as an accelerated share
repurchase program.
55-2 The treasury stock
purchase is as follows.
55-3 Investment Banker, an
unrelated third party, borrows 1,000,000 shares of
Company A common stock from investors, becomes the owner
of record of those shares, and sells the shares short to
Company A on July 1, 1999, at the fair value of $50 per
share. Company A pays $50,000,000 in cash to Investment
Banker on July 1, 1999, to settle the purchase
transaction. The shares are held in treasury. Company A
has legal title to the shares, and no other party has
the right to vote those shares.
55-4 The forward contract is as
follows.
55-5 Company A simultaneously
enters into a forward contract with Investment Banker on
1,000,000 shares of its own common stock. On the October
1, 1999, settlement date, if the volume-weighted average
daily market price of Company A’s common stock during
the contract period (July 1, 1999, to October 1, 1999)
exceeds the $50 initial purchase price (net of a
commission fee to Investment Banker), Company A will
deliver to Investment Banker cash or shares of common
stock (at Company A’s option) equal to the price
difference multiplied by 1,000,000. If the
volume-weighted average daily market price of Company
A’s common stock during the contract period is less than
the $50 initial purchase price (net of a commission fee
to Investment Banker), Investment Banker will deliver to
Company A cash equal to the price difference multiplied
by 1,000,000.
55-6 Under the guidance in
paragraph 505-30-25-5, an entity would account for this
accelerated share repurchase program as two separate
transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the July 1, 1999, acquisition date
- As a forward contract indexed to its own common stock.
ASC 505-30-55-1 through 55-6 illustrate how accelerated share
repurchase transactions are analyzed as two separate units of account (i.e., a
treasury stock repurchase and a forward contract). The issuer would need to
evaluate whether ASC 480-10 applies to the treasury stock repurchase, the
forward contract, or both.
Example 3-9
Accelerated Share Repurchase Transaction
An issuer enters into an accelerated share repurchase transaction on December 30
under which it is obligated to transfer a fixed amount
of cash (a prepayment amount of $500 million) in
exchange for a fixed number of its common shares (10
million initial shares) on the initial share delivery
date (January 2). On the transaction’s final settlement
date (March 31), the issuer will either deliver or
receive shares. If the volume-weighted average price
(VWAP) of the issuer’s common shares exceeds $50, the
issuer will deliver shares; if the VWAP is less than
$50, the issuer will receive shares. The number of
shares that will be received or delivered is calculated
as the prepayment amount ($500 million) divided by the
VWAP over the contract period less the initial shares
(10 million) already delivered.
In these
circumstances, the treasury stock repurchase is required
to be accounted for as a liability under ASC
480-10-25-8. In accordance with ASC 480-10-30-3, the
issuer recognizes the liability on the accelerated share
repurchase transaction date initially measured “at the
fair value of the shares at inception, adjusted for any
consideration or unstated rights or privileges.”
Simultaneously, in accordance with ASC 480-10-30-5,
equity is “reduced by an amount equal to the fair value
of the shares at inception.” Because under ASC
480-10-35-3(a) both the amount to be paid — $500 million
— and the settlement date — January 2 — are fixed, the
liability is measured at the present value of the amount
to be paid at settlement — $500 million — with interest
cost accruing at the rate implicit at inception during
the period from the transaction date to the initial
share delivery date. (Further, if any part of the
prepayment amount represents a premium payment for the
forward component of the accelerated share repurchase
transaction, that portion would be accounted for
separately as a liability measured at fair value under
ASC 480-10-35-1, ASC 480-10-35-4A, or ASC 480-10-35-5,
between the transaction date and the initial share
delivery date, as discussed above.)
On the initial share delivery date, the liability for the treasury stock
repurchase is extinguished by delivery of the prepayment
amount. After the initial share delivery date, the
transaction is outside the scope of ASC 480-10 and is
therefore evaluated under other GAAP (including ASC
815-10 and ASC 815-40; see Section 3.2.5 of
Deloitte’s Roadmap Contracts on an Entity’s
Own Equity).
Footnotes
1
Depending on the relationship between the issuer and
the investor, amounts paid to the investor could represent a
dividend or other distribution as opposed to an issuance cost. An
entity should use judgment and consider the particular facts and
circumstances when determining what these amounts represent.
Chapter 4 — Mandatorily Redeemable Financial Instruments
Chapter 4 — Mandatorily Redeemable Financial Instruments
This chapter discusses the requirements in ASC 480-10 related to mandatorily redeemable financial instruments, including the scope of this classification category (see Section 4.1); certain application issues (see Section 4.2); accounting (see Section 4.3); reclassifications (see Section 4.4); and equity-for-debt exchanges (see Section 4.5).
4.1 Classification
4.1.1 Overview
ASC
480-10 — Glossary
Mandatorily Redeemable Financial
Instrument
Any of various
financial instruments issued in the form of shares that
embody an unconditional obligation requiring the issuer
to redeem the instrument by transferring its assets at a
specified or determinable date (or dates) or upon an
event that is certain to occur.
ASC
480-10
25-4 A mandatorily redeemable
financial instrument shall be classified as a liability
unless the redemption is required to occur only upon the
liquidation or termination of the reporting
entity.
25-6 In determining if an
instrument is mandatorily redeemable, all terms within a
redeemable instrument shall be considered. The following
items do not affect the classification of a mandatorily
redeemable financial instrument as a liability:
- A term extension option
- A provision that defers redemption until a specified liquidity level is reached
- A similar provision that may delay or accelerate the timing of a mandatory redemption.
25-7 If a financial
instrument will be redeemed only upon the occurrence of
a conditional event, redemption of that instrument is
conditional and, therefore, the instrument does not meet
the definition of mandatorily redeemable financial
instrument in this Subtopic. . . .
55-3
Various financial instruments issued in the form of
shares embody unconditional obligations of the issuer to
redeem the instruments by transferring its assets at a
specified or determinable date or dates or upon an event
that is certain to occur.
55-4 This Section presents two
examples of mandatorily redeemable financial
instruments:
- Certain forms of trust-preferred securities (those that are required to be redeemed at specified or determinable dates)
- Stock that must be redeemed upon the death or termination of the individual who holds it, which is an event that is certain to occur.
55-5 Although some mandatorily
redeemable instruments are issued in the form of shares,
those instruments are classified as liabilities under
this Subtopic because of the embodied obligation on the
part of the issuer to transfer its assets.
To meet ASC 480-10’s definition of a mandatorily redeemable
financial instrument, the instrument must have all of the following
characteristics:
- Its legal form must be a share (see Section 4.1.2).
- It must embody an unconditional obligation of the issuer to redeem the instrument at a specified or determinable date (or dates) or upon an event that is certain to occur (i.e., redemption is certain to occur in the absence of a breach of the instrument’s contractual terms — see Section 4.1.3).
- The issuer must be required to satisfy the obligation by transferring its assets (see Section 4.1.4).
Paragraph B20 of the Background Information and Basis for Conclusions of FASB Statement 150 notes that mandatorily redeemable financial instruments have all the characteristics of a liability as described in FASB Concepts Statement 6 because they:
(a)
embody a present duty that entails settlement by future transfer of
assets at a specified or determinable date or on occurrence of a
specified event, (b) leave the issuer no discretion to avoid the future
sacrifice of assets, and (c) result from a transaction — the issuance of
the instrument — that has already happened.
There are several exceptions in ASC 480-10 to the requirement to
classify instruments that meet the definition of a mandatorily redeemable
financial instrument as liabilities. See the discussion in Section 4.1.5.
4.1.2 Legal Form of a Share
ASC
480-10 — Glossary
Shares
Shares includes various forms of ownership that may not
take the legal form of securities (for example,
partnership interests), as well as other interests,
including those that are liabilities in substance but
not in form. (Business entities have interest holders
that are commonly known by specialized names, such as
stockholders, partners, and proprietors, and by more
general names, such as investors, but all are
encompassed by the descriptive term owners. Equity of
business entities is, thus, commonly known by several
names, such as owners’ equity, stockholders’ equity,
ownership, equity capital, partners’ capital, and
proprietorship. Some entities [for example, mutual
organizations] do not have stockholders, partners, or
proprietors in the usual sense of those terms but do
have participants whose interests are essentially
ownership interests, residual interests, or
both.)
The term “mandatorily redeemable financial instrument” is
limited to financial instruments “in the form of shares.” In this context,
shares include not just equity securities (including both common and preferred
stock). Rather, the term applies broadly to ownership interests in various
forms, including shares of stock not in the form of securities, partnership
interests (including general partnership interests and limited partnership
interests), membership interests (or units) in limited liability companies or
cooperative entities, and policyholder interests in mutual insurance companies.
However, financial instruments in the legal form of debt are outside the scope
of ASC 480-10 (see Section
2.2.4).
The following table lists
examples of instruments that, unless a legal analysis of their form suggests
otherwise, would and would not be considered shares under ASC 480-10:
Share | Not a
Share |
---|---|
|
|
4.1.3 Unconditional Redemption Obligation
To meet the definition of a mandatorily redeemable financial
instrument, the instrument must embody an unconditional redemption obligation.
An obligation involves a duty or responsibility to perform (see Section 2.2.1). A
redemption obligation is unconditional if redemption is certain to occur in the
absence of a violation of the contractual terms. Neither the issuer nor the
holder can have the unilateral discretion to avoid redemption except by both
parties’ consent (i.e., they mutually agree to modify the terms). Accordingly, a
share that is redeemable at the option of either the issuer or the holder, or
whose redemption is contingent upon the occurrence or nonoccurrence of an
uncertain future event, does not meet the definition of a mandatorily redeemable
financial instrument before the option is exercised or the event occurs, because
such an obligation is conditional.
Paragraph B25 of the Background Information and Basis for Conclusions of FASB Statement 150, states, in part:
[T]he Board considered whether to include within the
scope of this Statement shares that could be redeemed —
mandatorily, at the option of the holder, or upon some contingent event
that is outside the control of the issuer and the holder. However, this
Statement limits the meaning of mandatorily redeemable to unconditional
obligations to redeem the instrument by transferring assets at a
specified or determinable date (or dates) or upon an event certain to
occur.
As discussed in Section 6.2.6, an outstanding share that
embodies an unconditional obligation should be evaluated as a variable-share
obligation under ASC 480-10-25-14 rather than as a mandatorily redeemable
financial instrument under ASC 480-10-25-4 if the issuer has a choice of
settling the obligation by either transferring assets or delivering a variable
number of nonredeemable shares of equal value.
If an instrument with a mandatory redemption date contains
contractual features that have the effect of making redemption conditional, the
instrument would not meet the definition of a mandatorily redeemable financial
instrument in ASC 480-10-20 because redemption is not certain to occur.
Example 4-1
Mandatorily Redeemable Convertible Shares
An equity share with a fixed redemption date includes an embedded option that
permits the holder to convert the entire instrument into
a fixed number of equity shares before the stated
redemption date. The conversion feature is substantive.
Because the holder may elect to convert the instrument
into equity shares rather than hold it until redemption,
redemption is conditional on the holder’s not
converting.
Accordingly, a fixed-term instrument that is convertible into
the issuer’s shares of stock would not meet the definition of a mandatorily
redeemable financial instrument in ASC 480-10-20 unless (1) the conversion
option has expired, (2) the conversion option is nonsubstantive (see Section 3.2), (3) the
shares that would be delivered upon conversion contain an unconditional
redemption obligation, or (4) the issuer is required to settle all or part of
the instrument in cash or other assets upon conversion (e.g., it must settle the
stated amount, or par, in cash).
In evaluating whether an instrument meets the definition of a
mandatorily redeemable financial instrument, the issuer does not consider
redemption obligations accounted for as freestanding instruments that are
separate from the instrument being evaluated. For example, a perpetual share
that is issued along with a forward contract that requires the issuer to
repurchase a similar share for cash on a specified date would not be viewed as
embodying a redemption obligation as long as the contracts are two separate
freestanding financial instruments (see Section 3.3).
A redemption obligation does not have to be for a fixed amount
to qualify as unconditional. For example, the amount of the redemption
obligation might be for the current fair value of the share or a participating
interest in the issuer’s net assets, or it may vary on the basis of a specified
underlying (e.g., the S&P 500). Further, the timing of redemption does not
have to be fixed if redemption is certain to occur at some point (e.g., upon an
event that is certain to occur at an unknown time).
In determining whether a redemption obligation is unconditional,
an entity does not consider the likelihood of redemption (although the
likelihood that a term will be triggered might affect an evaluation of whether
the term is substantive; see Section 3.2). For example, a high probability that the issuer
will be unable to satisfy a contractually unconditional redemption obligation
(e.g., because of a lack of funds) does not make that obligation conditional.
Conversely, a high probability that an instrument will be redeemed (e.g.,
because of an economic incentive to redeem the instrument) does not make a
conditional redemption obligation unconditional (see Section 2.2.1).
The following table contains
examples of terms and conditions that would be considered unconditional
redemption obligations and those that would not:
Unconditional Redemption Obligations | Not
Unconditional Redemption Obligations |
---|---|
|
|
If the redemption obligation in an outstanding share is
conditional, an issuer that applies SEC guidance should consider whether it must
classify the instrument in temporary equity (see Chapter 9).
4.1.4 Transfer of Cash or Other Assets
As defined, mandatorily redeemable financial instruments are
limited to instruments that the issuer must settle in its assets (e.g., cash or
investments in debt or equity securities issued by third parties). An instrument
that does not involve a future transfer of assets (e.g., a prepaid obligation)
does not meet this definition. Further, an instrument that the issuer must
settle by providing services (e.g., an obligation to repurchase shares in
exchange for services) would not meet the definition and would be outside the
scope of ASC 480-10 (see Section 2.2.2).
Although the issuer’s equity shares are assets of its
shareholders, they are not the issuer’s assets. Accordingly, an instrument that
the issuer must or may settle in its equity shares would not qualify as a
mandatorily redeemable financial instrument. However, an entity should evaluate
whether ASC 480-20-25-14 requires such an instrument to be classified outside of
equity (see Chapter
6). For example, under that guidance, an issuer would classify as
a liability a share that it must settle in a variable number of its equity
shares worth a fixed monetary amount known at inception (e.g., a preferred share
that is mandatorily convertible in a variable number of common shares worth a
fixed monetary amount). A share that the issuer must “redeem” on a specified
date by delivering a fixed number of the issuer’s equity shares would not meet
the definition of a mandatorily redeemable financial instrument because the
transfer of cash or other assets is not involved. Further, because the delivery
of a variable number of shares is not involved, the issuer would not be required
to classify the share as a liability under ASC 480-10-25-14.
Regardless of their classification in the subsidiary’s separate
financial statements, shares issued by a parent and held by its subsidiary would
be considered assets in the evaluation of whether ASC 480-10 applies in the
subsidiary’s separate financial statements.
Example 4-2
Shares Issued by a Subsidiary That Are Mandatorily
Convertible Into Parent Shares
Subsidiary S issues a preferred share that is mandatorily convertible into a
fixed number of common shares issued by its parent on a
specified date. In its separate financial statements, S
would treat any held shares issued by Parent P as assets
when applying ASC 480-10. Therefore, in S’s separate
financial statements, the mandatorily convertible
preferred shares may meet the definition of a
mandatorily redeemable financial instrument. In P’s
consolidated financial statements, however, common
shares issued by P are not assets but are considered the
issuer’s equity shares. Therefore, in P’s consolidated
financial statements, the mandatorily convertible
preferred share issued by S is outside the scope of ASC
480-10.
Although the guidance in ASC 480-10-S99-3A on temporary equity
classification contains an exception for certain contracts for which redemption
will be funded by an insurance policy (see Section 9.4.3), there is no similar
exception from the liability classification guidance in ASC 480-10 for such
contracts. An instrument that must be redeemed for cash or other assets upon the
death of the holder must be classified as a liability even if the issuer has an
insurance contract to cover the cost of redemption (see ASC 480-10-55-64).
The following table contains
examples of obligations to transfer cash or other assets:
Future Transfer of Cash or Other Assets | Not a
Future Transfer of Cash or Other Assets |
---|---|
|
|
4.1.5 Exceptions
4.1.5.1 Overview
There are several exceptions to the liability classification
requirement for instruments that meet the definition of a mandatorily
redeemable financial instrument. Those exceptions apply to:
- Shares that are mandatorily redeemable only upon the liquidation or termination of the reporting entity (see Section 4.1.5.2).
- Mandatorily redeemable noncontrolling interests that are redeemable only upon the liquidation or termination of the subsidiary (see Section 4.1.5.3). (For other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, the classification provisions in ASC 480-10 apply, but not the measurement provisions.)
- Mandatorily redeemable financial instruments of nonpublic entities that are not SEC registrants unless they are mandatorily redeemable on fixed dates for amounts that are either fixed or are determined by reference to an external index (e.g., an interest rate index or currency index) (see Section 4.1.5.4).
The table below summarizes
the various exceptions to the requirement to apply the guidance in ASC
480-10 to instruments that meet the definition of a mandatorily redeemable
financial instrument:
Affected Entities
|
Affected Instruments
|
Guidance in ASC 480-10 That Does Not
Apply
|
Guidance in ASC 480-10 That
Applies
|
---|---|---|---|
All entities | Shares that are mandatorily redeemable only upon
the liquidation or termination of the reporting
entity |
|
|
Parents preparing consolidated
financial statements | Mandatorily redeemable noncontrolling interests
that are redeemable only upon the liquidation or
termination of the subsidiary |
|
|
Other mandatorily redeemable noncontrolling
interests that were issued before November 5,
2003 |
|
| |
Subsidiaries preparing stand-alone financial
statements | Mandatorily redeemable noncontrolling interests
that were issued before November 5, 2003 |
|
|
Nonpublic entities that are not SEC
registrants | Mandatorily redeemable financial instruments other
than those that are mandatorily redeemable on fixed
dates for amounts that are either fixed or
determined by reference to an interest rate index,
currency index, or another external
index |
|
|
If a mandatorily redeemable financial instrument qualifies
for one of the exceptions in ASC 480-10, the issuer should consider the
applicability of ASC 480-10-S99-3A to that instrument. That guidance
requires SEC registrants to classify certain redeemable securities in
temporary equity (see Chapter 9). In prepared remarks at the 2003 AICPA Conference on Current SEC
Developments, then SEC Professional Accounting Fellow Gregory Faucette
stated the following:
Entities with instruments that qualify for [the scope exceptions in ASC
480-10-15-7A through 15-15F] 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 480-10]. In other words, if
both the classification and measurement guidance in [ASC 480-10 is
inapplicable] for an instrument, look to [ASC 480-10-S99-3A] for
both classification and measurement guidance. If only the
measurement guidance in [ASC 480-10 is inapplicable] for an
instrument, look to [ASC 480-10-S99-3A] for continued measurement
guidance.
4.1.5.2 Only-Upon-Liquidation Exception
ASC 480-10
25-4 A mandatorily redeemable
financial instrument shall be classified as a
liability unless the redemption is required to occur
only upon the liquidation or termination of the
reporting entity.
Certain entities such as partnerships, limited liability
companies, or trusts that are set up for a specific project or purpose may
have a finite life. Their governing documents (e.g., partnership agreement
or articles of organization) may specify a date (e.g., December 31, 2199) on
which they will be terminated and on which their assets will be liquidated,
their liabilities will be settled, and any remaining cash will be
distributed to holders of their equity interests. When such entities issue
equity interests, redemption is certain to occur. Therefore, those interests
meet the definition in ASC 480-10-20 of a mandatorily redeemable financial instrument. Nevertheless, in developing the guidance in ASC 480-10, the FASB concluded that entities should not be required to classify such an interest as a liability under ASC 480-10. Paragraph B21 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
One commentator noted that “. . .
if the issuing entity must be liquidated and ceases to exist when
the mandatory redemption of its shares occurs, then the holders of
those shares appear to have an ownership interest similar to the
equity owners of the company.” The Board agreed and drafted [ASC
480-10-25-4] so that if redemption of an equity instrument is
required on liquidation or termination of the reporting entity, the
instrument is classified as equity.
In consolidated financial statements, a similar exception
applies to instruments that are mandatorily redeemable upon the liquidation
or termination of a subsidiary. In accordance with ASC 480-10-15-7E, such
instruments are not classified as liabilities under ASC 480-10 even if they
meet the definition of a mandatorily redeemable financial instrument.
If a finite-life entity issues an instrument that is
mandatorily redeemable either upon the scheduled liquidation or termination
of the reporting entity or upon an event that is certain to occur (e.g., the
holder’s death), the only-upon-liquidation exception to liability
classification is available if the event that would trigger redemption is
not certain to occur before the entity’s scheduled liquidation or
termination. In such a scenario, the potential requirement to redeem before
the entity’s liquidation or dissolution represents a conditional obligation
because the event that triggers it is not certain to occur before the
entity’s scheduled liquidation or dissolution. Even though the instrument is
certain to be redeemed, it is possible that redemption will be required only
upon the entity’s liquidation or dissolution, in which case the
only-upon-liquidation exception is available.
4.1.5.3 Noncontrolling Interest Exception
ASC 480-10
15-7E The guidance in this
Subtopic does not apply to mandatorily redeemable
noncontrolling interests (of all entities, public
and nonpublic) as follows:
- The classification and measurement provisions of this Subtopic do not apply to mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities by the subsidiary, under the only upon liquidation exception in paragraphs 480-10-25-4 and 480-10-25-6, but would be classified as liabilities by the parent in consolidated financial statements.
- The measurement provisions of this Subtopic do not apply to other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, both for the parent in consolidated financial statements and for the subsidiary that issued the instruments that result in the mandatorily redeemable noncontrolling interest. For those instruments, the measurement guidance for redeemable shares and noncontrolling interests in other predecessor literature (for example, in paragraph 480-10-S99-3A) continues to apply.
15-7F All public entities as
well as nonpublic entities that are SEC registrants
with mandatorily redeemable noncontrolling interests
subject to the classification and measurement scope
exception in paragraph 480-10-15-7E are required to
follow the disclosure requirements in paragraphs
480-10-50-1 through 50-3 as well as disclosures
required by other applicable guidance.
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.
In consolidated financial statements, instruments that are
mandatorily redeemable only upon the liquidation or termination of a
subsidiary (e.g., noncontrolling interests in limited-life subsidiaries) are
not required to be classified as liabilities, even if they meet the
definition of a mandatorily redeemable financial instrument. Further, such
instruments are exempt from the measurement guidance in ASC 480-10, although
its disclosure requirements apply. In evaluating whether the scope exception
in ASC 480-10-15-7E applies to situations in which the subsidiary does not
meet the definition of a business, an entity should carefully consider the
substance of the arrangement. If the subsidiary is not a substantive entity,
the scope exception does not apply. This conclusion is consistent with
analogous guidance in ASC 815-40-15-5C (see Section 2.6.1 of Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity) as well as ASC 810-10-40-3A. For
example, a subsidiary would not be considered a substantive entity if it was
structured to circumvent the mandatorily redeemable guidance in ASC 480.
If a noncontrolling interest in an entity that does not have
a limited life qualifies as a mandatorily redeemable financial instrument
under ASC 480-10, the entity is subject to all of the requirements of ASC
480-10 unless the nonpublic entity exception applies or the interest is
grandfathered. Under ASC 480-10-15-7E(b), mandatorily redeemable
noncontrolling interests are grandfathered out of ASC 480-10’s measurement
provisions if the interests were issued before November 5, 2003. This
applies both in the parent’s consolidated financial statements and in the
financial statements of the subsidiary that issued the instrument. The
classification and disclosure provisions of ASC 480-10 apply to such
instruments.
4.1.5.4 Exception for Certain Instruments of Certain Nonpublic Entities
ASC 480-10
15-7A The classification,
measurement, and disclosure guidance in this
Subtopic does not apply to mandatorily redeemable
financial instruments that meet both of the
following:
- They are issued by nonpublic entities that are not Securities and Exchange Commission (SEC) registrants.
- They are mandatorily redeemable, but not on fixed dates or not for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index.
15-7B Mandatorily redeemable
financial instruments issued by an SEC registrant
are not eligible for the scope exception in
paragraph 480-10-15-7A, even if the entity meets the
definition of a nonpublic entity.
15-7C Some entities have
issued shares that are required to be redeemed under
related agreements. If the shares are issued with a
redemption agreement and the required redemption
relates to those specific underlying shares, the
shares are mandatorily redeemable. If an entity with
such shares and redemption agreement is a nonpublic
entity that is not an SEC registrant, those
mandatorily redeemable shares meet the scope
exception in paragraph 480-10-15-7A if they meet the
conditions specified in that paragraph.
15-7D Although the disclosure
requirements of this Subtopic do not apply for those
mandatorily redeemable instruments of certain
nonpublic companies that meet the scope exception in
paragraph 480-10-15-7A, the requirements of Subtopic
505-10 still apply. In particular, paragraph
505-10-50-3 requires information about the pertinent
rights and privileges of the various securities
outstanding, which includes mandatory redemption
requirements. Paragraph 505-10-50-11 also requires
disclosure of the amount of redemption requirements
for all issues of stock that are redeemable at fixed
or determinable prices on fixed or determinable
dates in each of the next five years.
ASC 480-10 — Glossary
Securities and Exchange
Commission Registrant
An entity (or an entity that is controlled by an
entity) that meets any of the following criteria:
- It has issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
- It is required to file financial statements with the Securities and Exchange Commission (SEC).
- It provides financial statements for the purpose of issuing any class of securities in a public market.
ASC Master Glossary
Nonpublic Entity
Any entity other than one that
meets any of the following criteria:
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria.
An entity that has only
debt securities trading in a public market (or that
has made a filing with a regulatory agency in
preparation to trade only debt securities) is a
nonpublic entity.
For nonpublic entities that are not SEC registrants, ASC
480-10 does not apply to mandatorily redeemable financial instruments other
than those that are mandatorily redeemable on fixed dates for amounts that
either are fixed or are determined by reference to an interest rate index,
currency index, or another external index. For example, if a nonpublic
entity has outstanding shares that are mandatorily redeemable for cash upon
the death of the holder, those shares would not be accounted for as
liabilities under ASC 480-10, even if they meet the definition of a
mandatorily redeemable financial instrument, because the redemption date is
not fixed. Similarly, if the shares of a nonpublic entity are mandatorily
redeemable at the appraised value or fair value of the holder’s interest in
the net assets of the entity, those shares would not be classified as
liabilities under ASC 480, because the redemption amount is neither fixed
nor determined on the basis of an external index.
The following table
illustrates whether ASC 480 does or does not apply to a mandatorily
redeemable financial instrument issued by a nonpublic entity that is not an
SEC registrant:
Redemption Terms | Fixed Date | Variable Date |
---|---|---|
Fixed amount | Yes | No |
Amount determined by reference to an interest rate
index, currency index, or another external
index | Yes | No |
Other variable amounts | No | No |
ASC 480-10-15-7D notes that in accordance with ASC
505-10-50-3 and ASC 505-10-50-11, a nonpublic entity that is not an SEC
registrant that has issued securities to which the exception applies is
required to disclose (1) “information about the pertinent rights and
privileges of the various securities outstanding, which includes mandatory
redemption requirements” and (2) “the amount of redemption requirements for
all issues of stock that are redeemable at fixed or determinable prices on
fixed or determinable dates in each of the next five years.”
To be eligible for the exception in ASC 480-10-15-7A, the
issuer must be a nonpublic entity that is not an SEC registrant. In the
application of ASC 480-10, a nonpublic entity is an “entity that has only
debt securities trading in a public market (or that has made a filing with a
regulatory agency in preparation to trade only debt securities).” However,
according to ASC 480-10-20, an entity is an SEC registrant if it has debt
securities trading in a public market (or will issue such securities).
Therefore, an entity that has issued either debt or equity securities
trading in a public market, or is in the process of issuing such securities,
is not eligible for the exception.
Broker-dealers that are required to file financial
statements with the SEC are not eligible for the exception for nonpublic
entities that are not SEC registrants, even if they do not issue publicly
traded stock or debt. In prepared remarks at the 2003 AICPA Conference on Current SEC
Developments, Mr. Faucette stated the following:
[S]ome broker-dealers have asserted that they
should be eligible for the [exceptions] for mandatorily redeemable
financial instruments of certain nonpublic entities . . . . However,
certain nonpublic entities are defined as entities other than SEC
registrants. The definition of an SEC registrant . . . includes
entities that are required to file financial statements with the
SEC. Thus, the definition of an SEC registrant includes any
broker-dealer that is required to file financial statements with the
SEC, even if they do not issue publicly-traded stock or debt.
Therefore, we believe that any broker-dealer that files statements
with the SEC is not eligible for the additional
[exceptions].
If a nonpublic entity that is not an SEC registrant
subsequently becomes an SEC registrant, the entity applies ASC 480-10 as if
it were an SEC registrant for all periods presented. In such a scenario, the
exception to some of the requirements in ASC 480-10 for nonpublic entities
is not available for any period presented. The SEC staff communicated its
view on this matter at the AICPA SEC Regulations Committee meeting on April
8, 2004, which is described in the highlights of that meeting:
An entity is generally no longer eligible for the
nonpublic company treatment alternatives when it is in the process
of becoming a public entity. Such entities must comply with public
company treatment alternatives in the standard as of the date that
all public companies were required to adopt the standard, even if
that requires a company that is in the process of filing an IPO to
restate prior period financial statements.
4.2 Application Issues
4.2.1 Share That Is Both Puttable and Callable
ASC 480-10
55-38 An entity issues a share of stock that is not mandatorily redeemable. However, under its terms the stock is both of the following:
- Puttable by the holder any time after five years or upon a change in control
- Callable by the issuer any time after five years.
55-39 That instrument is outside the scope of this Subtopic. The instrument as a whole is not mandatorily redeemable under paragraphs 480-10-25-4 and 480-10-25-6 because of both of the following conditions:
- The redemption is optional (conditional).
- A written put option and a purchased call option issued together with the same terms differ from a forward purchase contract under this Subtopic.
55-40 That combination of embedded features does not render the stock mandatorily redeemable because the options could expire at the money, unexercised, and, thus, the redemption is not unconditional. Because the instrument as a whole is an outstanding share, it is not subject to paragraphs 480-10-25-8 through 25-12, nor, because the embedded obligation is conditional, is it subject to paragraph 480-10-25-14. As a financial instrument that is not a derivative instrument in its entirety, it is subject to analysis under Subtopic 815-15 to determine whether the issuer must account for any embedded feature separately as a derivative instrument. Because of the guidance in paragraph 480-10-25-2, paragraphs 480-10-25-4 through 25-14 shall not be applied to any embedded feature for the purposes of that analysis. In applying paragraph 815-15-25-1, the embedded written put option is evaluated under the guidance in Subtopic 815-40 and would generally be classified in equity. If so, the embedded written put option meets the criterion for exclusion in paragraph 815-10-15-74(a) and, therefore, is not separated from its host contract. If the written put option was not embedded in the share, but was issued as a freestanding instrument, it would be a liability under this Subtopic.
ASC 480-10-55-38 through 55-40 illustrate that a share whose terms contain both an embedded issuer call option and an embedded investor put option would not be classified as a liability under ASC 480-10 even if the options have mirroring terms (e.g., the same strike price). If a redemption option in an outstanding share can be exercised by either party at the same exercise price over a specified period, it may be unlikely that both parties will elect not to exercise the option. Nevertheless, such a redemption option is analyzed as conditional under ASC 480-10 because redemption is not certain to occur (e.g., it is possible the options could expire at-the-money). (Although not explicitly stated in ASC 480-10-55-38, the discussion in ASC 480-10-55-40 implies that the options have an expiration date. See also Section 3.2.1.) An outstanding share is not classified as a liability under ASC 480-10 if redemption is conditional.
The accounting analysis for embedded option combinations in ASC 480-10 differs from that in ASC 815. Under ASC 815-10-25-10, “an embedded (nontransferable) purchased call (put) option and an embedded (nontransferable) written put (call) option [that are combined] in a single hybrid instrument” are “considered as a single forward contract” when they have the same strike price and meet certain other criteria (i.e., such an option combination is treated as an unconditional obligation under ASC 815; see ASC 815-10-25-10 through 25-13). Under ASC 480-10, the same option combination is analyzed as a conditional obligation.
If an option combination is embedded in the shares issued by a subsidiary, the parent should consider whether it is required to apply the special accounting guidance in ASC 480-10-55-55 and ASC 480-10- 55-59 when preparing its consolidated financial statements. That guidance provides a limited exception to the guidance in ASC 480-10-55-38 through 55-40 by requiring such embedded option combinations and the noncontrolling interest to be accounted for on a combined basis as a financing of the parent’s purchase of the noncontrolling interest (see Section 7.1).
4.2.2 Exchangeable Share
Under ASC 480-10-25-4, an exchangeable share would be classified as a liability
if it (1) is mandatorily redeemable for cash on a stated redemption date and (2)
contains an option that permits the holder to require the issuer to exchange the
share for the shares of a third party. Such an instrument meets the definition
of a mandatorily redeemable financial instrument because delivery by the issuer
of either cash or assets in the form of third-party shares is certain.
Similarly, an exchangeable share would be classified as a liability in the
separate financial statements of a subsidiary if it (1) is mandatorily
redeemable for cash on a stated redemption date and (2) contains an option for
the holder to require the issuer (the subsidiary) to exchange it for
nonredeemable shares of its parent. The instrument would meet the definition of
a mandatorily redeemable financial instrument in the subsidiary’s separate
financial statements because delivery by the subsidiary of either cash or assets
is certain. (Note that shares issued by a parent would be treated as assets
rather than as equity in the separate financial statements of the subsidiary
regardless of how they are classified in the subsidiary’s separate financial
statements.)
Example 4-3
Exchangeable Shares
Entity X has issued shares that are exchangeable, at the option of Holder H, into trust units of Parent P. The trust units are traded in an active market. The key terms and rights of the exchangeable shares are as follows:
- Initially, each share is exchangeable into one trust unit. The exchangeable shares do not have any voting rights, and H cannot obligate X to pay cash instead of trust units at redemption. As P makes distributions to its unit holders, the exchange ratio increases, thereby increasing the number of trust units to be received when the exchangeable shares are redeemed for trust units.
- The shares can be exchanged by H for trust units at any time for 10 years after the date of issuance. However, X must redeem the shares at the end of year 10, in which case X may elect to deliver either trust units or an equivalent amount of cash.
- In the event of liquidation, dissolution, or the winding up of X, or any other distribution among X’s shareholders, exchangeable shares are entitled to a preference over X’s common shares with respect to the payment of dividends. The holders of exchangeable shares are entitled to a cumulative preferred-cash dividend.
In its separate financial statements, X should classify the exchangeable shares
as liabilities. The exchangeable shares meet the
definition of a mandatorily redeemable financial
instrument since they are mandatorily redeemable on the
10th anniversary of their issuance and will require
payment, at X’s option, in either trust units or cash,
both of which represent assets of X in the application
of ASC 480-10.
4.2.3 Redemption Requirement That Is Contingent on the Issuer’s Liquidity
A redemption obligation that is unconditional (e.g., it has a mandatory redemption date and no terms that make redemption uncertain) except for a condition that a specified liquidity level must be reached (i.e., the term is extended in case of insufficient liquidity) is treated as an unconditional redemption obligation under ASC 480-10. In developing the guidance in ASC 480-10, the FASB concluded that a share with a provision that makes the share mandatorily redeemable for cash or other assets when a specified liquidity level is reached meets the definition of a mandatorily redeemable financial instrument and should be classified as a liability (see ASC 480-10-25-6). Paragraph B22 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
Some commentators inquired about certain shares that allow the issuer to extend their term, defer redemption until a specified liquidity level is reached, or have similar provisions that may delay or accelerate the timing of a required redemption. The Board concluded that such shares meet the definition of mandatorily redeemable financial instruments and should be classified as liabilities because those kinds of provisions may affect the timing of but do not remove the unconditional requirement for redemption.
Similarly, statutory requirements (e.g., corporate state law) may limit an
entity’s ability to redeem its own stock in cash or other assets if the entity
lacks the wherewithal to pay (i.e., if a lack of sufficient net assets would
result in the impairment of the entity’s capital). In these circumstances, the
payment of cash or other assets to satisfy a redemption obligation might result
in personal liability for directors and potential liability for stockholders. To
protect the entity from the risk of breaching the terms of a mandatorily
redeemable share, the share may include a provision that defers redemption by
the entity if such redemption would be illegal under the applicable state law
because of a lack of legally available funds. Such limitation on an entity’s
ability to redeem shares should not cause an otherwise unconditionally
redeemable instrument to be considered conditionally redeemable. This kind of
limitation is similar to a provision that prevents an entity from redeeming an
instrument unless a specified liquidity level is reached. However, that guidance
should not be applied by analogy to redemption requirements that are contingent
upon uncertain future circumstances or events other than the entity’s liquidity
(e.g., future revenue).
If an outstanding share must be redeemed only to the extent that the issuer has
a sufficient amount of available cash or meets another similar liquidity
measure, the issuer should consider whether the redemption requirement
represents an unconditional obligation under the above guidance. That is, the
issuer should consider whether (1) the lack of sufficient liquidity to redeem
the instrument is akin to a default, in which case an unconditional obligation
exists, or (2) the issuer controls the ability to determine whether the
instrument is redeemed, in which case an unconditional obligation does not
exist. A redemption feature that is contingent on a measure of available
liquidity that is determined by the entity on the basis of the application of
significant judgment or discretion should be viewed as conditional under ASC
480. Only if the entity controls the ability to avoid redemption is the
obligation deemed conditional.
Example 4-4
Shares Redeemable With Available Cash
Company A has issued perpetual preferred stock that must be redeemed to the extent that A has available cash. Available cash is defined in the preferred stock terms in a manner that permits subjective adjustments at A’s discretion, as follows:
Available Cash means, as of any date, (1) the amount of cash on hand, less (2) all amounts due and payable as of such date, and less (3) working capital and other amounts, which the Company deems necessary for the Company’s business in its commercially reasonable discretion.
The stock does not meet the definition of a mandatory redeemable financial
instrument under ASC 480-10 because (1) it has no stated
redemption date and (2) the determination of whether
available cash exists is subject to A’s significant
judgment and discretion (i.e., it is within A’s
control).
4.2.4 Preferred Stock
For a convertible preferred share to meet the definition of a mandatorily
redeemable financial instrument and be classified as a liability under ASC
480-10, it must embody an unconditional obligation to transfer assets. A
convertible preferred share that the issuer must settle fully or partially in
cash irrespective of whether it is converted embodies such an obligation, since
a transfer of cash or other assets is certain to occur unless there is a
violation of the contractual terms. For example, a fixed-term (i.e., mandatorily
redeemable) convertible preferred share meets the definition of a mandatorily
redeemable financial instrument and must be classified as a liability under ASC
480-10 if, upon conversion, it requires the issuer to pay the stated amount
(i.e., the liquidation preference, or par amount) in cash and allows the issuer
to settle the excess conversion value in cash or shares. Before the adoption of
ASU 2020-06, such an instrument would also be within the scope of the CCF
guidance in ASC 470-20 unless the CCF must be bifurcated as a derivative
instrument under ASC 815-15.
Example 4-5
Cash-Settleable Convertible, Mandatorily Redeemable
Preferred Stock
A convertible preferred share has (1) a fixed redemption date on which the
issuer will settle its stated par amount in cash and (2)
a substantive conversion option that, if exercised by
the counterparty, requires the issuer to settle the par
amount in cash but permits it to settle the excess of
the conversion value over the par amount (the conversion
spread) in either cash or shares. The convertible
preferred share meets the definition of a mandatorily
redeemable financial instrument and is classified as a
liability under ASC 480-10 since the issuer has an
unconditional obligation to transfer cash or other
assets in exchange for the par amount. Because the
issuer has the option to settle the conversion spread in
either cash or shares upon conversion, the instrument is
within the scope of the CCF guidance in ASC 470-20
before the adoption of ASU 2020-06 unless the issuer
concludes that the conversion feature must be bifurcated
as an embedded derivative under ASC 815-15.
A convertible preferred share that has a stated redemption date and permits the
issuer to elect settlement of the entire instrument in either cash or shares or
a combination thereof does not contain an unconditional obligation to transfer
assets because the issuer has the right to settle the entire conversion value in
shares. Accordingly, before the adoption of ASU 2020-06, these types of
preferred stock would not meet the definition of a mandatorily redeemable
financial instrument in ASC 480-10 and therefore are not within the scope of the
CCF guidance in ASC 470-20.
A requirement to transfer assets that is contingent on the counterparty’s election of a cash settlement or the occurrence (or nonoccurrence) of an uncertain future event represents a conditional, rather than an unconditional, obligation to transfer assets. Thus, convertible preferred stock that has such a requirement is not a mandatorily redeemable financial instrument under ASC 480-10. For example, a perpetual convertible preferred share that must be settled in cash or other assets upon the counterparty’s election to convert does not meet the definition of a mandatorily redeemable financial instrument in ASC 480-10 because the obligation to transfer cash or other assets is contingent on such an election.
Changing Lanes
ASU 2020-06 removes the separation model in ASC
470-20 for certain convertible instruments with a CCF. Therefore, the
guidance discussed above on the CCF accounting model does not apply to
entities that have adopted ASU 2020-06. However, the ASU does not affect
the above discussion of when convertible preferred shares are within the
scope of ASC 480-10-15-4. See Chapter 1 for additional details
about ASU 2020-06.
4.3 Accounting
4.3.1 Measurement
4.3.1.1 Initial Measurement
ASC 480-10
30-1 Mandatorily redeemable financial instruments shall be measured initially at fair value.
On initial recognition, mandatorily redeemable financial instruments must be measured at their fair value. An entity applies ASC 820-10 to determine fair value. See Section 4.3.3 for a discussion of the accounting for issuance costs.
4.3.1.2 Subsequent Measurement
ASC 480-10
35-3 Forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares in exchange for cash and mandatorily redeemable financial instruments shall be measured subsequently in either of the following ways:
- If both the amount to be paid and the settlement date are fixed, those instruments shall be measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception.
- If either the amount to be paid or the settlement date varies based on specified conditions, those instruments shall be measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost.
Unless the entity elects to account for the
instrument at fair value, with changes in fair
value recognized in earnings under ASC 825-10, a
mandatorily redeemable financial instrument is
measured subsequently in one of two ways depending
on whether the redemption amount or the redemption
date varies on the basis of specified
conditions:
Redemption Amount
|
Redemption Date
|
Subsequent Measurement
|
---|---|---|
Fixed | Fixed | Present value of the amount to be paid at settlement, discounted by using the implicit rate at inception (i.e., effective interest method) |
Fixed Varies Varies | Varies Fixed Varies | Amount of cash that would be paid under the conditions specified in the contract if settlement occurred as of the reporting date (settlement value) |
4.3.1.2.1 Fixed Date and Fixed Amount
If the redemption date and the redemption amount are both fixed, the instrument is subsequently measured at the present value of the amount to be paid at settlement, discounted by using the implicit rate at inception. The implicit rate is calculated by using the effective interest method (i.e., the implicit rate is the rate that makes the present value of the instrument’s cash flows equal to the initial measurement amount).
If the redemption consists of a stated amount along with accrued and unpaid
dividends, whether or not declared, the present
value as of each measurement date is calculated by
using an effective interest rate that is
determined on the basis of the total redemption
amount (i.e., including both the stated redemption
amount and cumulative dividends, whether or not
declared). For example, if a liquidation
preference is payable at redemption of a
mandatorily redeemable financial instrument, and
the instrument accrues dividends at a per annum
rate of 8 percent (whether or not declared), the
calculation of the effective interest rate would
take into account not just the liquidation
preference but also the dividends at the per annum
rate of 8 percent. Any dividends paid before the
redemption date would reduce the carrying amount
of the instrument.
4.3.1.2.2 Variable Date or Redemption Amount
If the redemption date, the redemption amount, or both vary, the instrument is subsequently measured at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred on the reporting date. Examples of mandatorily redeemable financial instruments with a varying redemption amount include those for which the redemption amount varies on the basis of the instrument’s current fair value or a formula (e.g., one that is dependent on the issuer’s most recent financial year’s EBIT or EBITDA). Examples of instruments for which the redemption date varies include those that are mandatorily redeemable upon an event that is certain to occur but whose timing is uncertain (e.g., the holder’s death).
In estimating the amount of cash that would be paid under the conditions specified in the contract if settlement occurred on the reporting date, an issuer should not incorporate projected changes in the factors that affect a variable redemption price (e.g., forward projections of EBITDA if the redemption price is a function of EBITDA). Instead, the redemption amount is calculated on the basis of the conditions that exist as of the balance sheet date (e.g., the most recent EBITDA measure if the redemption price is a function of EBITDA). This view is consistent with the guidance on redeemable equity securities classified in temporary equity under ASC 480-10-S99-3A (see Chapter 9). In paragraph 14 of ASC 480-10-S99-3A, the SEC staff states that if “the maximum redemption amount is contingent on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure).”
If the redemption amount varies (e.g., as a function of EBITDA), an entity
should not reduce the carrying amount of the
liability below the initially recorded amount. ASC
480-10-45-3 implies that the amount of reported
interest cost cannot be less than zero on a
cumulative basis from the date of initial
recognition (see Section 4.3.2).
This is consistent with the view that an entity
cannot recognize interest income on a liability as
well as with the guidance on redeemable securities
classified in temporary equity under ASC
480-10-S99-3A (see Section 9.5). In
paragraph 16(e) of ASC 480-10-S99-3A, the SEC
staff states that “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
. . . are appropriate only to the extent that the
registrant has previously recorded increases in
the carrying amount of the redeemable equity
instrument.” If the instrument is redeemed for an
amount less than the net carrying amount, the
issuer recognizes the difference as an
extinguishment gain.
4.3.1.3 Embedded Features
If a feature must be separated as an embedded derivative under ASC 815-15, an
entity should analyze the host contract separately from the embedded
derivative in determining the appropriate measurement under ASC 480-10-35-3
(e.g., in estimating the redemption amount). This is consistent with ASC
815-15-25-54, which requires an entity to account for a host contract that
remains after separation of an embedded derivative on the basis of GAAP
applicable to instruments of that type that do not contain embedded
derivatives.
Example 4-6
Mandatorily Redeemable Preferred Stock
Indexed to the Price of Gold
A mandatorily redeemable preferred share has a fixed redemption date and a
redemption price that is indexed to the price of
gold (i.e., $100,000 plus the cumulative change in
the price of 100 ounces of gold, if positive).
Entity X determines that (1) the initial fair
value of the entire instrument is $100,000, (2)
the indexation to gold should be separated as an
embedded derivative under ASC 815-15, (3) the
derivative has an initial fair value of $5,000,
and (4) the host contract that remains after
separation of the embedded derivative has a fixed
redemption amount of $100,000.
Entity X measures the host contract as a mandatorily redeemable financial instrument with an initial carrying amount of $95,000 (determined by using a with-and-without method in accordance with ASC 815-15-30-2), a fixed redemption amount of $100,000, and a fixed redemption date. It would subsequently measure the host contract at the present value of the assumed fixed redemption amount of $100,000 discounted by using the implicit rate at inception (i.e., a rate determined on the basis of an initial carrying amount of $95,000) in accordance with ASC 480-10-35-3(a).
Example 4-7
Mandatorily Redeemable Financial Instrument
With a Put Option
A mandatorily redeemable financial instrument contains a feature that could accelerate an otherwise fixed redemption date if uncertain future events occur (e.g., a put option contingent on a change in control). If the acceleration feature is separated as an embedded derivative, the host contract is analyzed as a mandatorily redeemable financial instrument with a fixed settlement date.
A mandatorily redeemable financial instrument with a fixed redemption amount at
maturity may contain a put or call feature that
permits the holder or the issuer to settle the
instrument early at an amount other than the fixed
redemption amount. For example, the issuer may
have an option to call the instrument before the
stated redemption date at a premium to its fixed
redemption amount, or the holder may have an
option to put the instrument early at a discount
to its fixed redemption amount. Although such an
instrument could be viewed as having a variable
redemption amount and a variable redemption date,
it is generally appropriate for an entity to treat
the instrument as having a fixed redemption amount
at maturity under ASC 480-10-35-3 and to analyze
the put or call feature separately in determining
whether the feature must be bifurcated as an
embedded derivative under ASC 815-15. In the
application of the interest method (see Section
4.3.1.2), any discount from the amount
payable on the first noncontingent put date would
be amortized to that date.
4.3.1.4 Preferred Stock With CCF (Before the Adoption of ASU 2020-06)
Before the adoption of ASU 2020-06, if a convertible preferred share meets the
definition of a mandatorily redeemable financial instrument in ASC 480-10
because (1) it specifies the date on which it will be redeemed for cash (or
other assets) and (2) the issuer is required to settle it either fully or
partially in cash (or other assets) upon conversion (see Sections 2.5 and
4.2.4), the
issuer should consider whether the instrument is subject to the guidance on
convertible debt with CCFs in ASC 470-20.
The issuer of an instrument within the scope of the cash conversion guidance in ASC 470-20 is required to separate the instrument into its liability and equity components by allocating the issuance proceeds and any direct transaction costs between the two components. Under the cash conversion guidance, the issuer determines the measurement of the liability and equity components by using a “liability-first” allocation approach as follows:
- The issuer first determines the carrying amount of the liability component before considering any allocation of transaction costs. It determines the carrying amount on the basis of a hypothetical nonconvertible debt instrument that includes any or all features embedded in the convertible debt except for the conversion feature and any feature that is nonsubstantive at inception. The measurement attribute for the liability component at initial recognition is its fair value.
- Then, the issuer determines the carrying amount of the equity component before considering any allocation of transaction costs. The issuer measures the equity component by using a residual approach under which the amount of issuance proceeds that remains after allocation to the liability component is allocated to the equity component.
- Finally, the issuer allocates qualifying transaction costs between the liability and equity components in proportion to the allocation of proceeds between each component in the first two steps.
After initial recognition, the issuer measures the liability component at amortized cost by applying the interest method in ASC 835 and treats as a debt discount the excess of the principal amount to be repaid at the end of the expected life of similar hypothetical nonconvertible debt over the initial carrying amount of the liability component. The debt discount and any transaction costs allocated to the liability component (i.e., the debt issuance costs) are amortized over the expected life of similar nonconvertible debt by using the interest method.
In accordance with ASC 825-10-15-5(f), the issuer is not permitted to elect the fair value option in ASC 825-10 for an instrument within the scope of the cash conversion guidance in ASC 470-20 since such an instrument contains a separated equity component.
Changing Lanes
ASU
2020-06 removes the separation model in ASC
470-20 for certain convertible instruments with a CCF. Therefore,
the guidance discussed above on the CCF accounting model does not
apply to entities that have adopted ASU 2020-06. However, the ASU
does not affect the above discussion of when convertible preferred
shares are within the scope of ASC 480-10-15-4. See Chapter 1 for
additional details about ASU 2020-06.
4.3.2 Interest Cost
ASC 480-10
45-2B Depending on the settlement terms, this Subtopic requires that mandatorily redeemable shares that are not subject to the deferral in paragraphs 480-10-15-7A through 15-7F be measured at either the present value of the amount to be paid at settlement or the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount as interest cost (change in redemption amount).
45-3 Any amounts paid or to be paid to holders of the contracts discussed in paragraph 480-10-35-3 in excess of the initial measurement amount shall be reflected in interest cost.
For a mandatorily redeemable financial instrument, the following items are reported as interest cost:
- Changes in its carrying amount, including the amortization of any discount if the contract is measured at the present value of the amount to be paid at settlement.
- Any amounts paid or to be paid to the holder in excess of the initial measurement amount, including the payment or declaration of dividends and the accrual of cumulative dividends.
Accrued cumulative dividends are recognized as interest cost, even if not
declared, if the holder is entitled to such
dividends during the life of the contract or at
settlement. Conversely, undeclared noncumulative
dividends are not recognized as interest cost if
the holder is not entitled to them before they are
declared (i.e., the undeclared dividends are not
paid at settlement).
4.3.3 Issuance Costs
Unless the issuer elects to account for the mandatorily redeemable financial
instrument at fair value with changes in fair value recognized in earnings under
ASC 825-10, an entity should treat any issuance costs as a direct deduction from
the amount reported for the liability on the face of the balance sheet in a
manner similar to its treatment of debt issuance costs under ASC 835-30-45-1A.
Subsequently, the entity reports the amortization of the issuance costs as
interest cost in a manner similar to its amortization of a debt discount. If the
entity elects to measure the instrument at fair value with changes in fair value
recognized in earnings under ASC 825-10, any up-front costs and fees are
expensed at inception under ASC 825-10-25-3. For a discussion of what qualifies
as an issuance cost, see Section 3.3.4.4.
4.4 Reclassifications
4.4.1 Ongoing Reassessment
ASC 480-10
25-5 A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.
25-7 If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.
55-10 The guidance that follows discusses the requirement in paragraph 480-10-25-7 for reclassification of stock that becomes mandatorily redeemable. For example, an entity may issue equity shares on January 2, 2004, that must be redeemed (not at the option of the holder) six months after a change in control. When issued, the shares are conditionally redeemable and, therefore, do not meet the definition of mandatorily redeemable. On December 30, 2008, there is a change in control, requiring the shares to be redeemed on June 30, 2009. On December 31, 2008, the issuer would treat the shares as mandatorily redeemable and reclassify the shares as liabilities, measured initially at fair value. Additionally, the issuer would reduce equity by the amount of that initial measure, recognizing no gain or loss.
55-11 For another example of a conditionally redeemable instrument, an entity may issue preferred shares with a stated redemption date 30 years hence that also are convertible at the option of the holders into a fixed number of common shares during the first 10 years. Those instruments are not mandatorily redeemable for the first 10 years because the redemption is conditional, contingent upon the holder’s not exercising its option to convert into common shares. However, when the conversion option (the condition) expires, the shares would become mandatorily redeemable and would be reclassified as liabilities, measured initially at fair value.
55-12 If the conversion option were nonsubstantive, for example, because the conversion price is extremely high in relation to the current share price, it would be disregarded as provided in paragraph 480-10-25-1. If that were the case at inception, those preferred shares would be considered mandatorily redeemable and classified as liabilities with no subsequent reassessment of the nonsubstantive feature.
An entity should reassess in each reporting period whether any of its equity-classified shares have become mandatorily redeemable financial instruments. If circumstances change, a share that previously did not meet the definition of a mandatorily redeemable financial instrument may subsequently meet it. For example, a perpetual share that is required to be redeemed in cash upon the occurrence of an event that is not certain to occur (e.g., a deemed liquidation event) would not initially meet the definition of a mandatorily redeemable financial instrument, because redemption is conditional. If the event subsequently becomes certain to occur so that redemption becomes unconditional, the share would begin to meet the definition of a mandatorily redeemable financial instrument and should be reclassified as a liability unless a specific exception from liability classification applies.
Examples include:
- The expiration of a substantive conversion option in a preferred share with a stated redemption date on which the issuer is required to redeem the share for cash (see ASC 480-10-55-11). The share would be reclassified as a liability on the expiration date of the conversion option.
- The holder’s exercise of a physically settled put or redemption option in a perpetual preferred share that makes redemption certain to occur. That share would be reclassified as a liability on the option exercise date and remain a liability until the redemption date. (Redemption would continue to be considered conditional, however, if the issuer has the right to reject the redemption request under the redemption option without penalty.)
- The issuer’s exercise of a physically settled call or redemption option embedded in a perpetual preferred share that makes redemption certain to occur. The share would be reclassified as a liability on the option exercise date.
- The occurrence of an event (e.g., an IPO or change of control) that triggers the mandatory redemption of a perpetual preferred share for cash (see ASC 480-10-55-10 for an example). The share would be reclassified as a liability upon the occurrence of the event.
Reclassification is also required if the terms of a share are modified so that it begins to meet or ceases to meet the definition of a mandatorily redeemable financial instrument. However, the modification must be legally binding. An agreement in principle to change the contractual terms of an instrument may not be legally binding (e.g., if it allows either party to walk away without recourse).
A share might have to be reclassified as a liability even if the period until the required redemption date is short. For example, when an entity gives an irrevocable notice to purchase an outstanding redeemable share, it should consider whether the share must be reclassified as a mandatorily redeemable financial instrument.
An instrument for which redemption is not certain to occur does not meet the
definition of a mandatorily redeemable financial instrument.
For instance, a preferred share might contain an option for
the issuer to redeem the preferred share for cash and an
option for the holder to convert the share into common
stock. In such a scenario, even if the issuer notifies the
holder of its intent to exercise the redemption option, the
share would not meet the definition of a mandatorily
redeemable financial instrument if the holder has the
ability to convert the preferred stock into common stock
before the redemption date.
An instrument that previously did not meet the definition of a mandatorily redeemable financial instrument is reclassified as of the date it meets it. Thus, if a conditionally redeemable financial instrument in the form of a share became unconditionally redeemable after the balance sheet date, but before the financial statements were issued or available to be issued, an entity would not classify it as a liability as of the balance sheet date. However, the entity may be required to disclose the subsequent event in accordance with ASC 855-10-50-2 to keep the financial statements from being misleading.
4.4.2 Accounting for Reclassifications
ASC 480-10
30-2 If a conditionally redeemable instrument becomes mandatorily redeemable, upon reclassification the issuer shall measure that liability initially at fair value and reduce equity by the amount of that initial measure, recognizing no gain or loss.
When a conditionally redeemable financial instrument becomes a mandatorily
redeemable financial instrument (see Section
4.1), the issuer reclassifies it from the
equity to liabilities category at its current fair value as
of the date of the reclassification. No gain or loss should
be recognized in the income statement upon reclassification
because the reclassification is considered a distribution to
an owner. However, under the SEC guidance in ASC
260-10-S99-2, the reclassification of an equity-classified
preferred security as a liability (e.g., a preferred share
becomes mandatorily redeemable) is treated as a redemption
of equity by issuance of a debt instrument in the
calculation of EPS. In accordance with ASC 260-10-S99-2,
because the reclassification is accounted for as the
issuance of a new debt instrument to redeem the old equity
instrument (see Section 9.7.1),
previously recognized equity issuance costs would not be
expensed through the income statement but rather recognized
as part of the adjustment to EPS for the redemption of the
preferred stock.
If the instrument was previously classified in temporary equity under ASC 480-10-S99-3A, the issuer may need to adjust its method of measuring the instrument, because ASC 480-10-25-30-2 requires the instrument to be initially measured at fair value as of the reclassification date, and ASC 480-10-S99-3A permits certain accounting policies that are not available under ASC 480-10-35. Unlike paragraph 15 of ASC 480-10-S99-3A, for example, ASC 480-10-35 does not permit an entity to apply an accounting policy of measuring the instrument at the amount of cash that would be paid if settlement occurred as of the reporting date if the redemption date and the redemption amount are both fixed.
Example 4-8
Reclassification of Preferred Stock From Equity to a
Liability
Company D has outstanding preferred stock with the following terms:
- The preferred stock is automatically converted into common stock at a conversion price of $25 per share in the event that D effects a qualified IPO within the next five years.
- If D does not effect a qualified IPO by the end of the fifth year from the issuance date, the preferred stock becomes mandatorily redeemable in five years.
Company D should not classify the preferred stock as a liability under ASC 480 before the fifth year from the
issuance date if it concludes that the conversion upon a qualified IPO is a substantive feature. Furthermore,
while D is required to classify the preferred stock within temporary equity under ASC 480-10-S99-3A, it should
not remeasure the preferred stock to its redemption amount as long as the occurrence of a qualified IPO by
the end of year five is more than remote (see Section 9.5.4.3).
However, if a qualified IPO does not happen by the end of year five, the
preferred stock becomes a mandatorily redeemable
financial instrument for which reclassification as a
liability is required under ASC 480. In this
circumstance, in accordance with ASC 480-10-30-2, D
should reflect the reclassification by measuring the
liability initially at fair value and reducing equity by
the same amount without recognizing a gain or loss. This
reclassification is treated in the same manner as any
other extinguishment of preferred stock under ASC
260-10-S99-2. Therefore, the difference between the
initial fair value amount recognized for the preferred
stock upon reclassification as a liability and the net
carrying amount of the preferred stock (which should be
adjusted under other applicable GAAP, including ASC
480-10-S99-3A if applicable, immediately before such
reclassification) reflects a charge (or credit) to net
income in arriving at income available to common
stockholders.
For further discussion of the EPS impact of a
reclassification, see Sections 3.2.2,
3.2.3.5, and 3.2.4.4 of Deloitte’s Roadmap
Earnings per Share.
4.5 Equity-for-Debt Exchange
Entities sometimes enter into transactions involving the exchange of redeemable
securities classified in equity (or in temporary equity by SEC
registrants, as discussed in ASC 480-10-S99-3A) for mandatorily
redeemable securities classified as liabilities pursuant to ASC
480-10-25-4 (an “equity-for-debt exchange”). For example, an entity
that seeks to defer redemption of outstanding preference shares that
are currently redeemable at their holders’ option for cash may offer
those holders an exchange of existing preference shares for new
preference shares that are mandatorily redeemable at a later
date.
Assuming that the exchange is not akin to a troubled-debt restructuring, the
issuer should account for such an equity-for-debt
exchange as a reacquisition (extinguishment) of
the equity-classified securities and an issuance
of new liability-classified securities. The
redemption of the equity-classified securities
should be accounted for as a treasury stock
transaction under ASC 505, with no gain or loss
recognized in net income. The liability-classified
securities should be initially recognized and
measured at fair value in accordance with ASC
480-10-30-1. To the extent that the initial fair
value of the liability differs from the carrying
amount of the extinguished equity-classified
securities and the extinguished securities
represent preferred shares, the difference should
be deducted from or added to income available to
common stockholders in the calculation of EPS. ASC
260-10-S99-2 provides SEC registrants with
guidance on how redemptions of equity-classified
preferred securities affect the calculation of
EPS.
In some situations, entities analyze modifications or exchanges of
equity-classified redeemable securities by
analogizing to ASC 470-50 or other accounting
literature (see Section 3.2.6 of
Deloitte’s Roadmap Earnings per
Share). However, such analogies are
typically applied when the redeemable securities
both before and after the modification or exchange
are classified in equity (including temporary
equity); they do not apply to equity-for-debt
exchanges.
Example 4-9
Exchange of Preferred Securities
Company R, an SEC registrant, has 1 million outstanding shares of Series A redeemable convertible preferred stock. Company R issued the Series A stock on January 1, 20X1, at its par value of $20 per share, or $20 million in issuance proceeds. The stock is convertible into 5 million shares of R’s common stock (conversion ratio of 5:1 or $4 per share) at the option of each holder at any time and is mandatorily redeemable on June 30, 20X6.
Company R determined that the Series A stock should not be classified as a liability under ASC 480-10 because redemption is contingent on the holders’ not exercising their conversion option. Because R is an SEC registrant, it applied the guidance in ASC 480-10-S99-3A and classified the preferred stock in temporary equity. Company R also determined that the conversion feature does not need to be bifurcated or separately recognized as a derivative instrument in accordance with ASC 815.
In June 20X6, R reached an agreement with holders on December 31, 20X5, to exchange the 1 million shares of its Series A stock for 4 million shares of new, Series B nonconvertible preferred stock in a transaction that was not akin to a troubled-debt restructuring. Company R determines that the fair value of the Series B stock is $21 million. The Series B stock is not convertible into R’s common stock but is mandatorily redeemable at par in February 20X9. The company determines that the new stock must be classified as a liability under ASC 480-10.
Company R should account for the exchange of the stock classified as temporary
equity for the stock classified as a liability as
a treasury stock repurchase of the stock
classified as temporary equity and the issuance of
new liability-classified stock measured at the
fair value of the newly issued
liability-classified stock. Below are sample
journal entries.
On January 1, 20X1, R issues the Series A preferred shares for an amount equal to their aggregate par value — $20 million.
Journal Entry — January 1, 20X1
On December 31, 20X5, R issues Series B preferred shares in exchange for the
Series A stock. The aggregate fair value of the
Series B preferred shares is $21 million, so R
recognizes a liability of $21 million. Since the
fair value of the consideration paid to repurchase
the Series A stock (i.e., the Series B preferred
stock) is $1 million more than the Series A
carrying amount, R records a debit to retained
earnings in the amount of $1 million and deducts
$1 million from net earnings in calculating EPS to
arrive at income available to common
stockholders.
Journal Entry — December 31, 20X5
Company R should reflect the $1 million
difference as an adjustment to the numerator in
the calculation of EPS in accordance with ASC
260-10-S99-2.
Chapter 5 — Obligations to Repurchase Shares by Transferring Assets
Chapter 5 — Obligations to Repurchase Shares by Transferring Assets
This chapter discusses the requirements in ASC 480-10 related to financial instruments that embody an obligation to repurchase shares by transferring assets, including the scope of this classification category (see Section 5.1); certain application issues (see Section 5.2); accounting (see Section 5.3); and reassessments (see Section 5.4).
5.1 Classification
5.1.1 Overview
ASC 480-10
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
25-9 In this Subtopic,
indexed to is used interchangeably with
based on variations in the fair value of. The
phrase requires or may require encompasses
instruments that either conditionally or unconditionally
obligate the issuer to transfer assets. If the
obligation is conditional, the number of conditions
leading up to the transfer of assets is irrelevant.
25-10 Examples of financial instruments that meet the criteria in paragraph 480-10-25-8 include forward purchase contracts or written put options on the issuer’s equity shares that are to be physically settled or net cash settled.
25-11 All obligations that permit the holder to require the issuer to transfer assets result in liabilities, regardless of whether the settlement alternatives have the potential to differ.
ASC 480-10 — Glossary
Net Cash Settlement
A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain cash equal to the gain.
Physical Settlement
A form of settling a financial instrument under which both of the following conditions are met:
- The party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller.
- The seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
ASC 480-10-25-8 requires a financial instrument to be classified as an asset or a liability if all of the following apply:
- It is not an outstanding share (see Section 5.1.2).
- It either (1) “embodies an obligation to repurchase the issuer’s equity shares” or (2) “is indexed to such an obligation” (see Section 5.1.3).
- “It requires or may require the issuer to settle the obligation by transferring assets” (see Section 5.1.4).
For example, a forward purchase contract on an entity’s own equity shares or a written put option on the entity’s own equity shares is classified as a liability if the issuer could be required to physically settle the contract by delivering cash in exchange for the issuer’s equity shares. Similarly, a forward purchase or written put option contract that permits the counterparty to net cash settle the contract would be classified as an asset or a liability. These requirements apply even if the purchase obligation is contingent upon the occurrence or nonoccurrence of an event (unless the event is solely within the entity’s control) or upon the counterparty’s exercise of an option. Further, the requirements apply even if the contract cannot be net settled (e.g., contracts that permit physical settlement only in private-company stock). Thus, contracts that are outside the scope of the derivative accounting guidance because they do not possess the net settlement characteristic in the definition of a derivative in ASC 815-10 (see Section 2.3.1) may be within the scope of ASC 480-10.
5.1.2 Not an Outstanding Share
ASC 480-10-25-8 applies to instruments other
than those in the legal form of an outstanding share. For example, it applies to
certain contracts that are indexed to, and potentially settled in, the entity’s
own shares (e.g., forward repurchase and written put option contracts on own
shares). For outstanding shares, an entity should instead consider the guidance
on mandatorily redeemable financial instruments (see Chapter 4), certain obligations to deliver
a variable number of shares (see Chapter 6), and temporary equity (see
Chapter 9). The
following are examples of instruments that are not outstanding shares and those
that are:
Not Outstanding Shares (ASC 480-10-25-8 Might Apply) | Outstanding Shares (ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
5.1.3 An Obligation to Repurchase the Issuer’s Equity Shares or One That Is Indexed to Such an Obligation
ASC 480-10-25-8 applies both to contracts that embody obligations to repurchase shares (such as forward purchase and written put option contracts that require gross physical settlement) and to contracts that embody obligations indexed to obligations to repurchase shares (such as warrants on puttable shares). Obligations that are indexed to obligations to repurchase shares have a fair value that is based on variations in the fair value of obligations to repurchase shares, although they may not involve an actual share repurchase (e.g., contracts that the issuer is required or may be required to net cash settle).
The fact that an obligation to repurchase shares is of short duration does not exempt it from the requirements of ASC 480-10. Accordingly, the issuer should evaluate treasury stock transactions to determine whether they must be classified as liabilities under ASC 480-10 in the period between the trade date and the settlement date. For example, the treasury stock repurchase component of a typical accelerated share repurchase transaction would be within the scope of ASC 480-10 (see Section 3.3.5).
Although a net-cash-settled forward sale or a net-cash-settled written call option on the issuer’s equity shares may require the issuer to transfer assets, such a contract does not require the issuer to repurchase shares and is not indexed to an obligation to repurchase the issuer’s equity shares (unless the underlying equity shares include a redemption obligation). Accordingly, ASC 480-10-25-8 does not apply to such a contract. Nevertheless, ASC 815-40 precludes equity classification for such net-cash-settled contracts on own equity.
The following are examples of contracts that embody an obligation to repurchase the issuer’s equity shares or are indexed to such an obligation (“repurchase obligations”) and those that do not (“no repurchase obligations”):
Repurchase Obligations
(ASC 480-10-25-8 Might Apply) | No Repurchase Obligations
(ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
As noted in Section 2.2.4.2, ASC 480-10-20 suggests that the term “equity share” is limited to shares that qualify, and are classified, as equity (including both permanent and temporary equity) in the reporting entity’s financial statements. Nevertheless, ASC 480-10-25-13 and ASC 480-10-55-33 imply that ASC 480-10-25-8 applies to financial instruments, such as warrants, options, or forwards, that involve the issuance of mandatorily redeemable shares that would be accounted for as liabilities when they are issued. FASB Staff Position FAS 150-5 contains the following observation:
[ASC 480-10-25-13] states: “[an] instrument that requires the issuer to settle its obligation by issuing another instrument (for example, a note payable in cash) ultimately requires settlement by a transfer of assets.” In that [sentence], it is clear that a warrant for mandatorily redeemable shares would be a liability under [ASC 480-10]. In applying [ASC 480-10-25-8], [ASC 480-10-25-13] also would apply for an instrument settled with another instrument that ultimately may require settlement by a transfer of assets (warrants for puttable shares).
5.1.4 Requires or May Require the Transfer of Assets
ASC 480-10-25-8 applies to instruments that require or may require the issuer to transfer assets. The phrase “requires or may require” encompasses instruments that either unconditionally or conditionally obligate the issuer to transfer assets. To be classified outside of equity under ASC 480-10-25-8, an obligation to transfer assets does not have to be for a fixed amount. ASC 480-10-25-8 may apply even if the monetary amount of the obligation varies on the basis of a specified underlying (e.g., the S&P 500).
An example of an unconditional obligation to transfer assets is a noncontingent physically settled forward contract to purchase the issuer’s equity shares for cash. Examples of conditional obligations to transfer assets include obligations that are contingent on events or conditions outside the issuer’s control (see Sections 2.2.1 and 9.4.2), such as any of the following:
- The holder’s exercise of an option (e.g., a written put option on the issuer’s equity shares).
- The occurrence or nonoccurrence of an event outside the issuer’s control (e.g., a contingent forward purchase contract).
- The possibility that the fair value of a contract might be in a loss position (e.g., a net-cash-settled forward purchase contract).
- The counterparty’s choice of settlement method (e.g., a written put option that the holder can elect to settle either net in shares or net in cash).
A warrant or call option that permits the holder to purchase equity shares is considered to embody an obligation that may require the transfer of assets if the shares that would be delivered upon exercise of the warrant or option embody such an obligation (e.g., if the shares that would be delivered upon exercise contain a redemption feature that either unconditionally or conditionally requires the issuer to deliver cash).
The issuer’s equity shares are assets of its shareholders, not of the issuer. Accordingly, ASC 480-10-25-8 does not apply to an instrument that the issuer must or may settle in its equity shares (e.g., a net-share-settled written put option on own shares). However, an entity should evaluate whether it must classify such an instrument outside of equity under ASC 480-20-25-14 (see Chapter 6).
In the separate financial statements of a subsidiary, shares issued by its
parent are considered assets of the subsidiary in the application of ASC
480-10-25-8. Accordingly, if the subsidiary issues a contract that it must
settle in parent shares, that contract requires assets to be transferred in the
separate financial statements of the subsidiary. In the consolidated financial
statements that include the parent, however, that contract does not require
assets to be transferred, because the parent’s equity shares are not the
parent’s assets. Accordingly, it is possible that a contract that must be
classified as a liability in the subsidiary’s separate financial statements
under ASC 480-10-25-8 qualifies as equity in the consolidated financial
statements.
An instrument that the issuer must settle by providing services (e.g., an obligation to repurchase shares in exchange for services) does not meet the definition of a financial instrument and therefore is outside the scope of ASC 480-10 (see Section 2.2.2).
The following are examples of instruments that require or may require the transfer of assets and those that do not:
Asset Transfer Required (ASC 480-10-25-8 Might Apply) | Asset Transfer Not Required (ASC 480-10-25-8 Does Not Apply) |
---|---|
|
|
For a contractual term that requires or might require a transfer of assets,
classification under ASC 480-10-25-8 as a liability (or as an asset in some
circumstances) would not be necessary in any of the following circumstances:
-
The event that would cause a transfer of assets is under the sole control of the issuer (see Section 5.2.1.3). Section 9.4.2 discusses the evaluation of whether an event is within the issuer’s control.
-
The issuer is or could be required to transfer assets only upon its final liquidation. This is analogous to the exceptions for only-upon-liquidation features in ASC 480-10-25-4 (see Section 4.1.5.2), ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.2), and ASC 815-40-25-9 (see Section 5.2.3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
-
The issuer is or could be required to transfer assets only upon the occurrence of a deemed liquidation event (e.g., a change in control) that would entitle all holders of equity instruments that are equally or more subordinated than the equity instruments underlying the contract to receive the same form of consideration (e.g., cash or shares) upon the occurrence of the deemed liquidation event. This is analogous to the limited exception for certain deemed liquidation features in ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.4). See Section 5.2.2 for further discussion.
5.2 Application Issues
5.2.1 Obligation to Issue an Instrument That Embodies an Obligation That Requires or May Require a Transfer of Assets
5.2.1.1 Overview
ASC 480-10
25-13 An instrument that requires the issuer to settle its obligation by issuing another instrument (for example, a note payable in cash) ultimately requires settlement by a transfer of assets, accordingly:
- When applying paragraphs 480-10-25-8 through 25-12, this also would apply for an instrument settled with another instrument that ultimately may require settlement by a transfer of assets (warrants for puttable shares).
- It is clear that a warrant for mandatorily redeemable shares would be a liability under this Subtopic.
ASC 480-10 applies to contracts that require or could require the issuer to
deliver equity securities (e.g., warrants, written call options, and forward
sale contracts) if the entity could ultimately be forced to redeem those
securities by transferring assets. The guidance applies irrespective of
whether the redeemable equity securities would be classified within equity
(including temporary equity) when issued. FASB Staff Position FAS 150-5
contains the following commentary:
[ASC 480-10-25-8] requires warrants or similar
instruments to acquire redeemable shares to be classified as
liabilities even though the underlying shares may be classified as
equity under other accounting guidance . . . . Additionally, SEC
registrants may be required to classify underlying instruments as
temporary equity.
For example, if an entity issues a warrant that permits the holder to purchase the entity’s equity shares, that warrant is classified as a liability if the underlying equity shares contain a redemption requirement that is not solely within the entity’s control (e.g., an investor put option embedded in preferred stock). Such a warrant must be classified as a liability under ASC 480-10-25-8 because (1) a warrant is a financial instrument other than an outstanding share and (2) a warrant on a puttable share embodies an obligation that may require the issuer to ultimately transfer assets. That is, the issuer is required to transfer assets if the holder exercises the warrant and subsequently elects to put the shares back to the issuer for cash or other assets. Although the warrant must be classified as a liability, the redeemable equity securities may qualify for classification as equity or temporary equity once issued. Similarly, a written call option or a forward sale contract on redeemable equity securities would be classified as a liability under ASC 480-10 if the entity could be required to transfer assets.
If the redemption feature could require the entity to transfer assets, a contract on redeemable shares is classified outside of equity regardless of the feature’s timing (e.g., immediately after exercise of the contract or on some subsequent date in the future) or the redemption price (e.g., fair value or a fixed price). FASB Staff Position FAS 150-5 contains the following commentary:
Questions arose as to whether (a) the timing of the redemption feature or (b) the redemption price (for example, either a fair value or a fixed redemption price) affects the application of [ASC 480-10-25-8] to warrants for shares that are puttable. Some constituents questioned whether [ASC 480-10-25-8] applies only to warrants with underlying shares that are puttable immediately after exercise of the warrants or also to those that are puttable at some date in the future. … [ASC 480-10-25-8] applies to freestanding warrants and other similar instruments on shares that are either puttable or mandatorily redeemable regardless of the timing of the redemption feature or the redemption price because those instruments embody obligations to transfer assets. Therefore, [ASC 480-10-25-8] applies to warrants on shares that are redeemable immediately after exercise of the warrants and also to those that are redeemable at some date in the future.
In addition, a contract on redeemable shares is classified outside of equity
even if the redemption feature is contingent on the occurrence or
nonoccurrence of a specified event (such as a change in control, reduction
in the issuer’s credit rating, conversion, or failure to obtain by a
designated date the SEC’s declaration that a registration statement is
effective) unless the contingency is (1) solely within the control of the
issuer or (2) a deemed liquidation event under which “all of the holders of
equally and more subordinated equity instruments of the entity would always
be entitled to also receive the same form of consideration (for example,
cash or shares) upon the occurrence of the event that gives rise to the
redemption (that is, all subordinate classes would also be entitled to
redeem,” as described in ASC 480-10-S99-3A(3)(f) [see Section 5.2.2]).
5.2.1.2 Warrant for Puttable Shares That May Require Cash Settlement
ASC 480-10
55-32 Entity B issues a warrant for shares that can be put back by Holder immediately after exercise of the warrant. The warrant feature allows Holder to purchase 1 equity share at a strike price of $10 on a specified date. The put feature allows Holder to put the shares obtained by exercising the warrant back to Entity B on that date for $12, and to require physical settlement in cash. If the share price on the settlement date is greater than $12, Holder would be expected to exercise the warrant obligating Entity B to issue a fixed number of shares in exchange for a fixed amount of cash, and retain the shares. That feature alone does not result in a liability under paragraphs 480-10-25-8 through 25-12. However, if the share price is equal to or less than $12, Holder would be expected to put the shares back to Entity B and could choose to obligate Entity B to pay $12 in cash. That feature does result in a liability, because the financial instrument embodies an obligation to repurchase the issuer’s shares and may require a transfer of assets. Therefore, those paragraphs require Entity B to classify the warrant as a liability. A warrant to issue shares that will be mandatorily redeemable is also classified as a liability, and should be analyzed under Topic 815.
55-33 A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets — the obligation is conditioned on the warrant’s being exercised and the shares obtained by the warrant being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable shares also conditionally obligates the issuer to ultimately transfer assets — the obligation is conditioned only on the warrant’s being exercised because the shares will be redeemed. Thus, warrants for both puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under paragraphs 480-10-25-8 through 25-12, even though the number of conditions leading up to the possible transfer of assets differs for those warrants. The warrants are liabilities even if the share repurchase feature is conditional on a defined contingency.
ASC 480-10-55-32 and 55-33 illustrate the application of ASC 480-10-55-8 through
55-12 to a physically settled freestanding warrant that obligates the issuer
to deliver a fixed number of the issuer’s puttable equity shares in exchange
for cash if the warrant is exercised by the holder. The puttable equity
shares include a redemption feature that permits the holder to tender the
share to the issuer in exchange for cash. In this scenario, the put feature
associated with the shares causes the warrant to be classified as a
liability under ASC 480-10-25-8 because that feature represents an
obligation to repurchase the issuer’s shares and may require the issuer to
transfer assets. Without the put feature, the warrant would have been
outside the scope of ASC 480-10.
ASC 480-10-55-13(b) and ASC 480-10-55-33 state that a freestanding warrant for
mandatorily redeemable shares would be a liability under ASC 480-10 even
though the obligation to transfer assets is conditional on the exercise of
the warrant. That guidance would apply to a forward to issue puttable or
mandatorily redeemable shares as well (see also Section 2.2.4).
Example 5-1
Warrant on Redeemable Convertible Preferred
Stock
In 20X5, Company C issues a warrant to Company D. The warrant gives D the right to purchase, for a fixed price, C’s Series A convertible preferred stock on December 31, 20X5. The Series A preferred stock that will be delivered upon exercise of the warrant is convertible into Series A common stock or is redeemable for cash at its par amount at the option of the holder on December 31, 20X8.
Because the Series A preferred stock is only conditionally (rather than
mandatorily) redeemable and, upon issuance, will
take the form of an outstanding share, C will
account for the shares (if they are issued) as
equity instruments when they are issued. However, in
its 20X5 financial statements, C is required to
classify the warrant as a liability in accordance
with ASC 480-10-25-8 because the warrant itself (1)
is not an outstanding share and (2) embodies an
obligation to transfer assets (cash) if D elects to
put the Series A convertible preferred stock back to
C.
5.2.1.3 Contracts on Redeemable Equity Shares That Do Not Require a Transfer of Assets
If a freestanding contract on redeemable equity shares cannot require the entity to transfer assets, the contract is not subject to ASC 480-10-25-8. For example, the following types of contracts on redeemable equity securities would not fall within the scope of ASC 480-10:
- A purchased put option that permits the issuer, at its option, to sell redeemable equity securities (because the entity has no obligation to issue redeemable equity securities).
- A purchased call option that permits the issuer, at its option, to repurchase redeemable equity securities (because the entity has no obligation to repurchase the redeemable equity securities).
Further, a contract that requires or might require the issuer to deliver equity shares that contain a cash-settled redemption requirement (e.g., a written warrant or call option or a forward sale contract on redeemable equity securities) would not be subject to ASC 480-10-25-8 if the share redemption requirement is solely within the issuer’s control. Although the shares are redeemable, the issuer cannot be required to transfer assets if it has discretion to avoid a share redemption (see Section 2.2.1).
5.2.2 Deemed Liquidation Events
ASC 815-40
55-2 An event that causes a change in control of an entity is not within the entity’s control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.
55-3 However, if a change-in-control provision requires that the counterparty receive, or permits the counterparty to deliver upon settlement, the same form of consideration (for example, cash, debt, or other assets) as holders of the shares underlying the contract, permanent equity classification would not be precluded as a result of the change-in-control provision. In that circumstance, if the holders of the shares underlying the contract were to receive cash in the transaction causing the change in control, the counterparty to the contract could also receive cash based on the value of its position under the contract.
55-4 If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt).
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of Redeemable Securities
S99-3A(3)(f)
Certain redemptions upon liquidation events.
Ordinary liquidation events, which involve the
redemption and liquidation of all of an entity’s equity
instruments for cash or other assets of the entity, do
not result in an equity instrument being subject to ASR
268. In other words, if the payment of cash or other
assets is required only from the distribution of net
assets upon the final liquidation or termination of an
entity (which may be a less-than-wholly-owned
consolidated subsidiary), then that potential event need
not be considered when applying ASR 268. Other
transactions are considered deemed liquidation events.
For example, the contractual provisions of an equity
instrument may require its redemption by the issuer upon
the occurrence of a change-in-control that does not
result in the liquidation or termination of the issuing
entity, a delisting of the issuer’s securities from an
exchange, or the violation of a debt covenant. Deemed
liquidation events that require (or permit at the
holder’s option) the redemption of only one or more
particular class of equity instrument for cash or other
assets cause those instruments to be subject to ASR 268.
However, as a limited exception, a deemed liquidation
event does not cause a particular class of equity
instrument to be classified outside of permanent equity
if all of the holders of equally and more subordinated
equity instruments of the entity would always be
entitled to also receive the same form of consideration
(for example, cash or shares) upon the occurrence of the
event that gives rise to the redemption (that is, all
subordinate classes would also be entitled to
redeem).
Under ASC 480-10-25-8, an entity must classify as liabilities or equity those contracts, other than outstanding shares, that require or could require the issuer to repurchase its equity shares by transferring assets. Therefore, a freestanding financial instrument that embodies an obligation (e.g., a warrant, written call option, or forward) to issue the issuer’s equity shares (either preferred or common stock) typically would be classified as an asset or liability under ASC 480-10-25-8 if those shares are puttable by the holder for cash (or other assets) upon the occurrence of a deemed liquidation event (e.g., a change in control) even if the underlying shares will be classified by the issuer as equity upon issuance.
However, the warrants should be classified as equity by analogy to ASC
815-40-55-2 through 55-4 (see Section 5.2.3.3 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity) and ASC 480-10-S99-3A(3)(f) (see Section 9.4.5.4) in the
narrow and limited circumstances in which (1) the equity shares into which the
instrument is convertible becomes puttable only upon the occurrence of a deemed
liquidation event that is not within the entity’s control (e.g., a change in
control) and (2) in accordance with ASC 480-10-S99-3A(3)(f), “all of the holders
of equally and more subordinated equity instruments of the entity would always
be entitled to also receive the same form of consideration (for example, cash or
shares) upon the occurrence of the [deemed liquidation] event . . . (that is,
all subordinate classes would also be entitled to redeem” their shares). We have
discussed this view with the FASB staff as part of a formal technical inquiry.
(Note that in practice, however, this limited exception rarely applies to
warrants on preferred stock.)
Example 5-2
Warrants on Redeemable Common Shares
In 20X1, Company Y issues a warrant to Company Z that gives Z the right to
purchase, for a fixed price, Y’s common stock on
December 31, 20X3. Under Y’s articles of incorporation,
Y is obligated to redeem all of its outstanding shares
of common stock upon the occurrence of a
change-in-control transaction that does not result in
the final liquidation or termination of Y (a “deemed
liquidation event”). That is, all common shareholders of
Y immediately before the deemed liquidation event will
be entitled to redeem their shares upon the occurrence
of the deemed liquidation event. The common stock is not
otherwise redeemable.
Each holder of Y’s common stock would always be entitled to receive the same
form of consideration (cash or other assets or both)
upon redemption at the same amount per share.
Because the common stock is only conditionally redeemable and, upon issuance,
will take the form of an outstanding share, Y will
account for the common shares issued (if the warrant is
exercised) as equity instruments (i.e., they do not
represent mandatorily redeemable financial instruments
under ASC 480-10-25-4).
In its 20X1 financial statements, Y would not classify the warrants as
liabilities under ASC 480-10-25-8 because (1) the common
stock into which the warrant is convertible becomes
redeemable only upon the occurrence of a deemed
liquidation event and (2) upon the occurrence of the
deemed liquidation event, all investors in “equally and
more subordinated equity instruments of the entity would
always be entitled to also receive the same form of
consideration (for example, cash or shares).” If the
warrant meets the conditions for equity classification
in ASC 815-40, Y would classify it as an equity
instrument.
5.2.3 Obligations With Settlement Alternatives
Some obligations give one of the parties the choice of whether the obligation will be settled by the issuer’s transfer of assets or by its issuance of shares (e.g., option or forward contracts on own shares that permit either net cash or net share settlement). In these circumstances, the issuer should determine whether ASC 480-10-25-8 or ASC 480-10-25-14 takes precedence in the assessment of whether the contract must be accounted for outside of equity under ASC 480-10.
5.2.3.1 Issuer Choice
If the issuer can elect the settlement method and has discretion to avoid a transfer of assets upon settlement (e.g., by electing net share settlement of the contract), liability classification is required to the extent that (1) the conditions in ASC 480-10-25-14 (see Chapter 6) related to changes in monetary value are met or (2) the shares that would be delivered require or may require the transfer of assets (e.g., puttable shares; see Section 5.2.1). Paragraph B48 of the Background Information and Basis for Conclusions of FASB Statement 150 states:
Certain financial instruments embody obligations that permit the issuer
to determine whether it will settle the obligation by transferring
assets or by issuing equity shares. Because those obligations
provide the issuer with discretion to avoid a transfer of assets,
the Board concluded that those obligations should be treated like
obligations that require settlement by issuance of equity shares.
That is, the Board concluded that this Statement should require
liability classification of obligations that provide the issuer with
the discretion to determine how the obligations will be settled if,
and only if, the conditions in [ASC 480-10-25-14] related to changes
in monetary value are met.
5.2.3.2 Counterparty Choice
If the counterparty can elect the settlement method and can require the issuer to transfer assets (e.g., by electing physical settlement or net cash settlement of the contract), the obligation must be evaluated under ASC 480-10-25-8. In such a scenario, ASC 480-10-25-14 does not apply. Under ASC 480-10-25-11, such an obligation may be a liability in accordance with ASC 480-10-25-8 even if the monetary values of the two settlement alternatives (shares or assets) have the potential to differ. Paragraph B49 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
Other obligations permit the holder to determine whether the issuer will
be required to transfer assets or issue equity shares to settle the
obligation. . . . [T]he Board concluded that all obligations
that permit the holder to require the issuer to transfer assets
result in liabilities, regardless of whether the [monetary values of
the] settlement alternatives have the potential to differ. The Board
reasoned that such an obligation could leave the issuer with no discretion to avoid the future sacrifice of having to transfer assets and, therefore, is a liability under the definition in Concepts Statement 6.
5.2.3.3 Summary
The following table summarizes the analysis under ASC 480-10 of financial instruments other than outstanding shares embodying obligations to repurchase shares that give the issuer or the holder a choice of settlement either in assets or nonredeemable equity shares.
Settlement Alternatives | Issuer Choice | Counterparty Choice |
---|---|---|
Transfer of assets (physical settlement or net cash) or a variable number of nonredeemable equity shares (net shares) | Evaluate as variable-share obligation under ASC 480-10-25-14 | Evaluate as an obligation to repurchase shares by transferring assets under ASC 480-10-25-8 |
Transfer of assets (physical settlement or net cash) or a fixed number of nonredeemable equity shares | Outside scope of ASC 480-10 | Evaluate as an obligation to repurchase shares by transferring assets under ASC 480-10-25-8 |
5.2.4 Financial Instruments That Embody Multiple Obligations
ASC 480-10
55-29 The implementation guidance that follows addresses financial instruments involving multiple components that embody (or are indexed to) an obligation to repurchase the issuer’s shares and that may require settlement by transferring assets. Some freestanding financial instruments composed of more than one option or forward contract embodying obligations require or may require settlement by transfer of assets. Paragraphs 480-10-15-3 through 15-4 state that the provisions of this Subtopic apply to freestanding financial instruments, including those that comprise more than one option or forward contract, and paragraphs 480-10- 25-4 through 25-14 shall be applied to a freestanding financial instrument in its entirety. Under paragraphs 480-10-25-8 through 25-12, if a freestanding instrument is composed of a written call option and a written put option, the existence of the written call option does not affect the classification. Unlike the application of paragraph 480-10-25-14, applying paragraphs 480-10-25-8 through 25-12 does not involve making any judgments about predominance among obligations or contingencies.
Some financial instruments contain more than one option or forward component
(e.g., a puttable warrant that contains both a written put option and a written
call option). Unless the financial instrument is an outstanding share, the
instrument is classified as an asset or a liability under ASC 480-10-25-8 if it
embodies any obligation to repurchase the issuer’s equity shares (or is indexed
to such an obligation) and requires or may require the issuer to transfer
assets. Unlike ASC 480-10-25-14, under which an entity evaluates the
predominance of the monetary value on settlement of variable-share obligations
(see Section
6.2.4), ASC 480-10-25-8 does not require an entity to determine
whether the obligation to transfer assets is predominant.
5.2.5 Put Warrants
ASC 815-40
55-16 Put warrants are frequently issued concurrently with debt securities of the entity, are detachable from the debt, and may be exercisable only under specified conditions. The put feature of the instrument may expire under varying circumstances, for example, with the passage of time or if the entity has a public stock offering. Under Subtopic 470-20, a portion of the proceeds from the issuance of debt with detachable warrants must be allocated to those warrants.
55-17 Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to do any of the following:
- Exercise the warrant feature to acquire the common stock of the entity at a specified price
- Exercise the put option feature to put the instrument back to the entity for a cash payment
- Exercise both the warrant feature to acquire the common stock and the put option feature to put that stock back to the entity for a cash payment.
55-18 Because the contract gives the counterparty the choice of cash settlement or settlement in shares,
entities should report the proceeds from the issuance of put warrants as liabilities and subsequently measure
the put warrants at fair value with changes in fair value reported in earnings as required by Topic 480. That is,
a put warrant that embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an
obligation, and that requires or may require a transfer of assets is within the scope of that Topic and therefore
is to be recognized as a liability.
A put warrant is an example of a contract that must be classified as a liability
under ASC 480-10. Even though the warrant gives the counterparty an option to
purchase the entity’s stock, the contract is classified as a liability in its
entirety under ASC 480-10-25-8 if the entity could be forced to repurchase the
warrant for cash or other assets because it represents an obligation that is
indexed to an obligation to repurchase the entity’s equity shares, and the
entity may be required to transfer cash or other assets. Alternatively, the
counterparty may have the right to put back to the entity for cash the stock it
received upon exercise of the warrant. In that case, the contract embodies an
obligation to repurchase equity shares for cash and is classified as a liability
in its entirety under ASC 480-10-25-8 (see Section 5.2.1). The accounting analysis
for put warrants is different from that for net-cash-settled written call
options on an entity’s equity shares. Although a net-cash-settled written call
option on an entity’s equity shares embodies an obligation to transfer cash or
other assets, it is (1) evaluated under ASC 815-40 instead of ASC 480-10 since
it does not represent an obligation to repurchase the issuer’s equity shares and
is not indexed to such an obligation and (2) classified as a liability in its
entirety under ASC 815-40.
ASC 480-10
55-30 Consider, for example, a puttable warrant that allows the holder to purchase a fixed number of the issuer’s shares at a fixed price that also is puttable by the holder at a specified date for a fixed monetary amount that the holder could require the issuer to pay in cash. The warrant is not an outstanding share and therefore does not meet the exception for outstanding shares in paragraphs 480-10-25-8 through 25-12. As a result, the example puttable warrant is a liability under those paragraphs, because it embodies an obligation indexed to an obligation to repurchase the issuer’s shares and may require a transfer of assets. It is a liability even if the repurchase feature is conditional on a defined contingency in addition to the level of the issuer’s share price.
55-31 Entity A issues a puttable warrant to Holder. The warrant feature allows Holder to purchase 1 equity share at a strike price of $10 on a specified date. The put feature allows Holder instead to put the warrant back to Entity A on that date for $2, and to require settlement in cash. If the share price on the settlement date is greater than $12, Holder would be expected to exercise the warrant, obligating Entity A to issue a fixed number of shares in exchange for a fixed amount of cash. That feature does not result in a liability under paragraphs 480-10-25-8 through 25-12. However, if the share price is equal to or less than $12, Holder would be expected to put the warrant back to Entity A and could choose to obligate Entity A to pay $2 in cash. That feature does result in a liability, because the financial instrument embodies an obligation that is indexed to an obligation to repurchase the issuer’s shares (as the share price decreases toward $12, the fair value of the issuer’s obligation to stand ready to pay $2 begins to increase) and may require a transfer of assets. Therefore, paragraphs 480-10-25-8 through 25-12 require Entity A to classify the instrument as a liability.
ASC 480-10-55-30 and 55-31 illustrate the application of ASC 480-10-55-8 through 55-12 to a physically settled warrant that (1) obligates the issuer to deliver a fixed number of nonredeemable equity shares in exchange for cash if the holder elects to exercise it and (2) contains a put feature that permits the holder to require the issuer to redeem the warrant for cash. In such a scenario, the put feature causes the entire warrant to be classified as a liability under ASC 480-10-25-8 because that feature is indexed to an obligation to repurchase the issuer’s shares and may require the issuer to transfer assets. The fact that the warrant has a potential settlement outcome for which asset or liability classification is not required under ASC 480-10 is irrelevant to the accounting analysis if at least one of the warrant’s settlement outcomes is subject to ASC 480-10-25-8. If the warrant instead had been issued without the put feature, it would have been outside the scope of ASC 480-10 because that guidance does not apply to a written warrant that requires the issuer to deliver a fixed number of nonredeemable equity shares upon exercise.
In the example in ASC 480-10-55-31, the put feature is exercisable on the same date as the option to require delivery of a fixed number of shares. If the facts in ASC 480-10-55-31 were changed so that the put feature was not exercisable until a later date (e.g., the put was embedded in the shares delivered upon exercise) or was conditional upon the occurrence or nonoccurrence of an uncertain future event (e.g., a change in control), the classification of the warrant as a liability under ASC 480-10-25-8 would not change, because the possibility that the instrument will require the issuer to settle the obligation by transferring assets is sufficient for liability classification. Further, the warrant would be classified as a liability even if the put feature is not expected to be exercised.
5.2.6 Simple Agreement for Future Equity
A simple agreement for future equity (SAFE) is a contract that gives the holder a
right to obtain the issuer’s shares in the future in exchange for an up-front
payment. For example, the terms of a SAFE might specify that (1) the issuer will
deliver to the holder a variable number of its shares if the issuer raises equity
capital (i.e., an equity financing) and (2) the investor has a right to elect to
receive either a cash payment equal to the purchase amount or a variable number of
shares if there is a change of control or an IPO (i.e., a liquidity event).
Typically, a SAFE is not in the legal form of an outstanding share. If the SAFE is
in the legal form of debt, ASC 480 does not apply and the SAFE is classified as a
liability (see Section 2.2.4). If the SAFE is
not in the legal form of an outstanding share or debt, the issuer should evaluate
whether the SAFE must be classified as a liability under ASC 480-10-25-8 or, if not,
under ASC 480-10-25-14. If the SAFE gives the holder an option to redeem the
instrument for cash upon a change of control, the issuer would classify the SAFE as
a liability under ASC 480-10-25-8 because a change of control is an event that is
considered not under the sole control of the issuer (see Section 9.4.2).
5.3 Accounting
The initial and subsequent accounting for a financial instrument
classified as an asset or a liability under ASC 480-10-25-8 depends on whether it is
a forward contract that requires physical settlement by repurchase of a fixed number
of equity shares in exchange for cash (including foreign currency).
5.3.1 Forward Contracts That Require Physical Settlement by Repurchase of a Fixed Number of Shares for Cash
5.3.1.1 Scope
Under ASC 480-10, unconditional forward purchase contracts
that require physical settlement by repurchase of a fixed number of the
issuer’s shares for cash are treated as treasury stock transactions that use
borrowed funds (i.e., debit to equity, credit to payable) rather than as
derivatives or executory contracts. In other words, such transactions are
treated as if the repurchase has already occurred and the payment for the
shares has been financed with interest on the financing arising from the
difference between the spot price of the shares repurchased and the ultimate
settlement amount paid on the forward settlement date.
Paragraph B27 of the Background Information and Basis for
Conclusions of FASB Statement 150 states, in part:
Forward purchase contracts that must be physically
settled by delivering cash in exchange for shares embody an
unconditional obligation to transfer cash to pay the full repurchase
price. The Board considers that situation as more akin to a treasury
stock purchase using borrowed funds than to participating in a
derivative instrument; put another way, such a forward contract
effectively converts the shares that the counterparty must deliver
into mandatorily redeemable instruments, which this Statement
classifies as liabilities. The Board rejected the view that forward
purchase contracts that must be physically settled by delivering
cash should be reported like other derivative instruments.
The special accounting for physically settled forward contracts to repurchase
shares applies irrespective of whether the amount of cash the issuer will
pay is fixed or variable (e.g., a stated amount of cash plus interest at a
variable interest rate). However, the accounting does not apply to forward
contracts that have settlement alternatives (e.g., the holder or the issuer
has the option to elect net cash settlement or net share settlement).
Further, the guidance does not apply to forward contracts that require the
issuer to transfer noncash assets (e.g., debt securities) rather than cash
to settle the contract. Paragraph B80 of the Background Information and
Basis for Conclusions of FASB Statement 150 states, in part:
The Board views physically settled forward purchase
contracts of an entity’s own shares in exchange for cash as being
similar to financing a stock purchase or a treasury stock
transaction and, therefore, would require the recognition of a
liability for the future sacrifice of assets, but that view holds
only if the obligation to purchase is unconditional and requires
physical settlement in exchange for cash.
Forward contracts that require physical settlement by
repurchase of a fixed number of the issuer’s shares for cash are outside the
scope of the derivative accounting literature under ASC 815-10-15-74(d) and
cannot be designated as derivative hedging instruments (see Section 2.3.1).
The special measurement guidance in ASC 480-10 on gross
physically settled forward contracts does not apply to forward contracts
that will be settled by the delivery of noncash assets. Such forward
contracts are instead measured at their fair value (see Section 5.3.2). Paragraphs B29 and B61 of the Background Information and Basis for Conclusions of FASB Statement 150 state, in part:
Forward purchase contracts that must be physically
settled by delivering assets other than cash in exchange for shares
— barter contracts — also embody an unconditional obligation.
However, the Board did not consider barter contracts akin to a
treasury stock purchase using borrowed funds, since no cash is
involved. Therefore, it decided that those contracts should be
accounted for in the same manner as conditional obligations to
purchase the issuer’s equity shares. . . . If the exchange involves
barter (for example, specified quantities of gold for shares), the
Board saw no reason to reconsider, in this limited scope project,
guidance under [ASC 815-10] under which that forward purchase
contract would be accounted for as a derivative at its fair
value.
5.3.1.2 Initial Measurement
ASC 480-10
30-3 Forward contracts that
require physical settlement by repurchase of a fixed
number of the issuer’s equity shares in exchange for
cash shall be measured initially at the fair value
of the shares at inception, adjusted for any
consideration or unstated rights or
privileges.
30-4 Two ways to obtain the
adjusted fair value include:
- Determining the amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately
- Discounting the settlement amount, at the rate implicit at inception after taking into account any consideration or unstated rights or privileges that may have affected the terms of the transaction.
30-5 Equity shall be reduced
by an amount equal to the fair value of the shares
at inception.
30-6 Cash (as that term is
used in paragraph 480-10-30-3) includes foreign
currency, so physically settled forward purchase
contracts in exchange for foreign currency shall be
measured as provided in paragraphs 480-10-30-3
through 30-5 and 480-10-35-3, then remeasured under
Topic 830.
Although ASC 480-10-30-3 specifies that a forward contract
that requires settlement by repurchase of a fixed number of shares for cash
should initially be measured at the “fair value of the shares at inception,
adjusted for any consideration or unstated rights or privileges,” ASC
480-10-30-4 permits an entity to use the following approaches in determining
that amount:
- The “amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately.” This amount is not discounted. In a manner consistent with the guidance on subsequent measurement in ASC 480-10-35-3(b), this method may be suitable when either the amount to be paid or the settlement date varies.
- The present value of “the settlement amount [discounted] at the rate implicit at inception.” In a manner consistent with the guidance on subsequent measurement in ASC 480-10-35-3(a), this method may be suitable when the amount to be paid and the settlement date are both fixed.
Regardless of the approach used, the entity should consider
the need to adjust the accounting for the forward contract to reflect any
consideration (e.g., if either party made an up-front cash payment) or
unstated (or stated) rights or privileges that may have affected the terms
of the transaction (e.g., off-market terms). Unlike ASC 480-10-30-3 and
30-4(b), ASC 480-10-30-4(a) does not specifically mention the need for such
an adjustment when the initial measurement is determined on the basis of the amount of cash that would be paid under the conditions specified in the contract if the shares were repurchased immediately. However, in paragraph B61 of the Background Information and Basis for Conclusions of FASB Statement 150, the Board suggests that, in such a scenario, an entity also
should adjust the accounting “for any consideration or unstated rights or
privileges.”
The requirement in ASC 480-10-30 to adjust the initial
measurement to reflect any consideration or unstated rights or privileges is
analogous to the requirement in ASC 835-30-25-6 to separately recognize any
unstated (or stated) rights or privileges upon the issuance of a note (e.g.,
when an entity lends cash at no interest in exchange for a contract to
purchase products at a below-market price, the difference between the amount
of cash lent and the present value of the receivable may represent an
addition to the cost of the products purchased).
The issuer recognizes the forward by crediting liabilities
and debiting equity for the amount of the initial measurement. (If the
forward is over the shares of a consolidated subsidiary, the noncontrolling
interest would be debited.) In effect, the forward is accounted for as if
two transactions had occurred: (1) a spot repurchase of the shares that will
be repurchased under the contract and (2) the issuance of debt for the
obligation to pay the share repurchase price on the forward settlement
date.
Connecting the Dots
The Inflation Reduction Act of 2022, which was signed into law on
August 16, 2022, imposes a 1 percent excise tax on stock repurchases
that occur after December 31, 2022, by publicly traded companies.
Specifically, a covered corporation would be subject to a tax equal
to 1 percent of (1) the fair market value of any of its stock that
it (or certain affiliates) repurchased during any taxable year, with
limited exceptions, minus (2) the fair market value of any of its
stock that it (or certain affiliates) issued during the taxable year
(including compensatory stock issuances). The 1 percent excise tax
would also be imposed on acquisitions of stock in certain mergers or
acquisitions involving covered corporations.
Because the excise tax is not based on a measure of
income, it is not an income tax and thus is outside the scope of ASC
740. While the accounting for taxes paid in connection with the
repurchase of stock is not specifically addressed in U.S. GAAP,
entities may consider the guidance in AICPA Technical Q&As
Section 4110.09, which indicates that direct and incremental legal
and accounting costs associated with the acquisition of treasury
stock may be added to the cost of the treasury stock. Therefore, it
is acceptable for an entity to account for an excise tax obligation
that results from the repurchase of common stock classified within
permanent equity as a cost of the treasury stock transaction.
Any reductions in such excise tax obligation arising from share
issuances would also be recognized as part of the original treasury
stock transaction regardless of the nature of the share issuances.
Additional considerations are necessary when redemptions of
preferred stock result in an excise tax obligation, which would be
recognized as a cost of redeeming the preferred stock. The
accounting for redemptions of preferred stock differs depending on
the classification of the preferred stock as permanent equity,
temporary equity, or a liability. An entity that has repurchased
both common stock and preferred stock during a taxable period would
need to use a systematic and rational allocation approach to account
for the effect of share issuances on the excise tax obligation.
5.3.1.3 Subsequent Measurement
ASC 480-10
35-3 Forward contracts that
require physical settlement by repurchase of a fixed
number of the issuer’s equity shares in exchange for
cash and mandatorily redeemable financial
instruments shall be measured subsequently in either
of the following ways:
- If both the amount to be paid and the settlement date are fixed, those instruments shall be measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception.
- If either the amount to be paid or the settlement date varies based on specified conditions, those instruments shall be measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost.
35-4 Cash (as that term is
used in the preceding paragraph) includes foreign
currency, so physically settled forward purchase
contracts in exchange for foreign currency shall be
measured as provided in the preceding paragraph then
remeasured under Topic 830.
The subsequent measurement
guidance that applies to forward contracts that require physical settlement
by repurchase of a fixed number of the issuer’s equity shares in exchange
for cash is similar to the guidance applicable to mandatorily redeemable
financial instruments (see Section 4.3). Thus, the “debt” component of such a forward
contract is measured subsequently in one of two ways depending on whether
the repurchase amount or the repurchase date varies on the basis of
specified conditions:
Repurchase Amount
|
Repurchase Date
|
Subsequent Measurement
|
---|---|---|
Fixed | Fixed | Present value of the amount to be paid at
settlement discounted by using the implicit rate at
inception (i.e., effective interest
method) |
Fixed Varies Varies | Varies Fixed Varies | Amount of cash that would be paid under the
conditions specified in the contract if settlement
occurred as of the reporting date (settlement
value) |
Paragraph B27 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
The Board concluded that the unconditional
obligation should result in recognition of a liability that, like
many other liabilities that require cash payments, should be
subsequently measured at the present value of the full repurchase
price, if the amounts to be paid and the settlement date are fixed,
or at the (undiscounted) amounts that would be paid under the
conditions specified in the contract if the shares were repurchased
at the reporting date if the amounts or settlement date can
vary.
5.3.1.3.1 Fixed Date and Fixed Amount
If the repurchase date and the repurchase amount are
both fixed, the instrument is subsequently measured at the present value
of the amount to be paid at settlement, discounted by using the implicit
rate at inception. The implicit rate is calculated by using the
effective interest method (i.e., the rate that makes the present value
of the instrument’s cash flows equal to the initial measurement
amount).
5.3.1.3.2 Variable Date or Redemption Amount
If either the repurchase date or the repurchase amount
or both vary, the instrument is subsequently measured at the amount of
cash that would be paid under the conditions specified in the contract
if settlement occurred as of the reporting date. Under this method, the
amount to be paid is not discounted. Examples of instruments with a
varying redemption amount include those for which the repurchase amount
is based on the issuer’s stock price or a formula (e.g., one that
depends on the issuer’s most recent financial year’s EBIT or EBITDA). An
example of an instrument for which the redemption date varies includes
one that will be settled upon the occurrence of an event that is certain
to occur but whose timing is uncertain.
In estimating the amount of cash that would be paid
under the conditions specified in the contract if settlement occurred as
of the reporting date, an issuer should not incorporate projected
changes in the factors that affect a variable repurchase price (e.g.,
forward projections of EBITDA if the repurchase price is a function of
EBITDA). Instead, the issuer should calculate the repurchase amount on
the basis of the conditions that exist as of the balance sheet date
(e.g., the most recent EBITDA measure if the repurchase price is a
function of EBITDA). This view is consistent with the guidance that
applies to redeemable equity securities classified in temporary equity
under ASC 480-10-S99-3A (see Section 9.5.2). Paragraph 14 of
ASC 480-10-S99-3A states, in part:
If the maximum redemption amount is contingent
on an index or other similar variable (for example, the fair
value of the equity instrument at the redemption date or a
measure based on historical EBITDA), the amount presented in
temporary equity should be calculated based on the conditions
that exist as of the balance sheet date (for example, the
current fair value of the equity instrument or the most recent
EBITDA measure).
If the repurchase amount varies (e.g., as a function of
EBITDA), an entity should not reduce the carrying amount of the
liability below the initially recorded amount, because ASC 480-10-45-3
implies that the amount of reported interest cost cannot be less than
zero on a cumulative basis from the date of initial recognition. This is
consistent with the view that an entity cannot recognize interest income
on a liability as well as with the guidance that applies to redeemable
securities classified in temporary equity under ASC 480-10-S99-3A (see
Section
9.5.2). Paragraph 16(e) of ASC 480-10-S99-3A states, in
part:
[T]he amount presented in temporary equity
should be no less than the initial amount reported in temporary
equity for the instrument. That is, reductions in the carrying
amount of a redeemable equity instrument . . . are appropriate
only to the extent that the registrant has previously recorded
increases in the carrying amount of the redeemable equity
instrument.
If the instrument is redeemed for an amount less than
its net carrying amount, the issuer recognizes the difference as an
extinguishment gain.
5.3.1.3.3 Interest Cost
ASC 480-10
45-3 Any amounts paid or to
be paid to holders of the contracts discussed in
paragraph 480-10-35-3 in excess of the initial
measurement amount shall be reflected in interest
cost.
After the execution of a forward contract that requires
physical settlement by repurchase of a fixed number of the issuer’s
equity shares in exchange for cash, changes in the contract’s carrying
amount and any amounts paid to the holder in excess of the initial
measurement amount must be presented as interest cost.
5.3.1.4 Example
ASC 480-10
55-14 For example, an entity
may enter into a forward contract to repurchase 1
million shares of its common stock from another
party 2 years later. At inception, the forward
contract price per share is $30, and the current
price of the underlying shares is $25. The
contract’s terms require that the entity pay cash to
repurchase the shares (the entity is obligated to
transfer $30 million in 2 years). Because the
instrument embodies an unconditional obligation to
transfer assets, it is a liability under paragraphs
480-10-25-8 through 25-12. The entity would
recognize a liability and reduce equity by $25
million (which is the present value, at the 9.54
percent rate implicit in the contract, of the $30
million contract amount, and also, in this example,
the fair value of the underlying shares at
inception). Interest would be accrued over the
2-year period to the forward contract amount of $30
million, using the 9.54 percent rate implicit in the
contract. If the underlying shares are expected to
pay dividends before the repurchase date and that
fact is reflected in the rate implicit in the
contract, the present value of the liability and
subsequent accrual to the contract amount would
reflect that implicit rate. Amounts accrued are
recognized as interest cost.
55-15 In this example, no
consideration or other rights or privileges changed
hands at inception. If the same contract price of
$30 per share had been agreed to even though the
current price of the issuer’s shares was $30,
because the issuer had simultaneously sold the
counterparty a product at a $5 million discount,
that right or privilege unstated in the forward
purchase contract would be taken into consideration
in arriving at the appropriate implied discount rate
— 9.54 percent rather than 0 percent — for that
contract. That entity would recognize a liability
for $25 million, reduce equity by $30 million, and
increase its revenue for the sale of the product by
$5 million. Alternatively, if the same contract
price of $30 per share had been agreed to even
though the current price of the issuer’s shares was
only $20, because the issuer received a $5 million
payment at inception of the contract, the issuer
would recognize a liability for $25 million and
reduce equity by $20 million. In both examples,
interest would be accrued over the 2-year period
using the 9.54 percent implicit rate, increasing the
liability to the $30 million contract
price.
55-16 If a variable-rate
forward contract requires physical settlement, a
different measurement method is required
subsequently, as set forth in paragraph
480-10-35-3.
The three related examples in ASC 480-10-55-14 and 55-15
illustrate the accounting for physically settled forward purchase contracts
that require the repurchase of a fixed number of equity shares for cash. In
each of the examples, the issuer is obligated to repurchase equity shares in
exchange for cash of $30 million in two years. Further, the initial amount
of the liability recognized is the same in the examples ($25 million).
However, the fair value of the shares at inception differs and, in two of
the examples, consideration or other rights or privileges are exchanged.
In the example in ASC
480-10-55-14, no consideration or other rights or privileges are exchanged
at the inception of the contract, and the fair value of the shares at
inception is $25 million. Under ASC 480-10-30-3, the liability is initially
recognized at an amount equal to fair value of the shares at inception ($25
million). In accordance with ASC 480-10-30-5, the offsetting entry is to
equity. Accordingly, the accounting entries at inception are (in
millions):
In the two examples in ASC 480-10-55-15, consideration or
other unstated rights or privileges are exchanged at inception:
- In the first example in ASC 480-10-55-15, the fair value of the shares at inception is $30 million. The repurchase price in two years is also $30 million, which is favorable to the issuer. To compensate the counterparty, the issuer provides a sales discount of $5 million to the counterparty at the same time as the issuance of the forward contract. In accordance with ASC 480-10-30-3, the liability is initially recognized at $25 million, which is the fair value of the shares at inception ($30 million) adjusted for the value of the sales discount ($5 million). Under ASC 480-10-30-5, the offsetting entry reduces equity. The value of the sales discount represents consideration paid for the off-market element of the contract to repurchase equity shares and reduces equity by another $5 million, with an offsetting entry to sales revenue. Thus, the accounting entries at inception are (in millions):
- In the second example in ASC 480-10-55-15, the fair value of the shares at inception is $20 million. The repurchase price in two years is $30 million, which is unfavorable to the issuer. To compensate the issuer, the counterparty pays $5 million at the inception of the forward contract. In accordance with ASC 480-10-30-3, the liability is initially recognized at an amount equal to the fair value of the shares at inception ($20 million), adjusted for the cash payment received ($5 million). The initial measurement of the liability is therefore $25 million. Under ASC 480-10-30-5, the offsetting entry is to equity. The up-front cash payment of $5 million is consideration received from the counterparty for the off-market element of the contract to repurchase equity shares and increases cash and equity by $5 million. Therefore, the accounting entries at inception are as follows (in millions):While not discussed in ASC 480-10-55-14 and 55-15, the implicit rate used to calculate interest cost over the life of the instrument in each of the three examples is determined by solving for the interest rate that equates the present value of $30 million in two years to the initial measurement amount of $25 million. If annual compounding is used, this rate is approximately 9.545 percent. In year one, the issuer records interest cost of $2.386 million by increasing the carrying amount of the liability to $27.386 million. In year two, the issuer records interest cost of $2.614 million by increasing the carrying amount to $30 million, which equals the settlement amount to be paid in cash at that time.
5.3.2 Other Contracts
ASC
480-10
30-7 All other financial
instruments recognized under the guidance in Section
480-10-25 shall be measured initially at fair
value.
35-1 Financial instruments
within the scope of Topic 815 shall be measured
subsequently as required by the provisions of that
Topic.
35-4A Contingent consideration
issued in a business combination that is classified as a
liability in accordance with the requirements of this
Topic shall be subsequently measured at fair value in
accordance with 805-30-35-1.
35-5 All other financial
instruments recognized under the guidance in Section
480-10-25 shall be measured subsequently at fair value
with changes in fair value recognized in earnings,
unless either this Subtopic or another Subtopic
specifies another measurement attribute.
55-17 In contrast to forward
purchase contracts that require physical settlement in
exchange for cash, forward purchase contracts that
require or permit net cash settlement, require or permit
net share settlement, or require physical settlement in
exchange for specified quantities of assets other than
cash are measured initially and subsequently at fair
value, as provided in paragraphs 480-10-30-2,
480-10-30-7, 480-10-35-1, and 480-10- 35-5 (as
applicable), and classified as assets or liabilities
depending on the fair value of the contracts on the
reporting date.
Except for forward contracts that require the issuer to
repurchase a fixed number of shares for cash, contracts that are classified as
assets or liabilities under ASC 480-10-25-8 are measured initially and
subsequently at their fair value (i.e., they are accounted for in a manner
similar to derivatives under ASC 815-10). For example, this measurement applies
to:
- Net-cash-settled forward purchase contracts on own stock.
- Forward purchase contracts on own stock that permit the counterparty to elect either net cash settlement or net share settlement.
- Forward contracts that require or may require the repurchase of a variable number of equity shares for cash.
- Forward contracts that require or may require the repurchase of equity shares for noncash assets.
- Written put options on own equity shares that require or may require the repurchase of equity shares by the transfer of assets.
- Written warrants or call options on own equity shares that require or may require the repurchase of the warrants or options by the transfer of assets.
- Written warrants or call options on equity shares that require or may require the repurchase of the equity shares that would be delivered upon the exercise of the warrant or option by the transfer of assets.
5.4 Reassessment
Under ASC 480-10-25-8, an issuer assesses at inception whether a financial
instrument, other than an outstanding share, embodies an obligation to repurchase
the issuer’s equity shares (or is indexed to such an obligation) and therefore
requires or may require the issuer to settle the obligation by transferring assets.
If an outstanding instrument ceases to embody such an obligation after inception
(e.g., because the contract specifies that the obligation expires on a specific date
or upon the occurrence of a specified event, such as an IPO), an issuer may elect to
apply either of the following two views as an accounting policy choice under ASC
480-10-25-8:
-
View A: No reassessment — An issuer does not subsequently reassess whether an instrument should be classified as an asset or a liability under ASC 480-10-25-8 unless the instrument is treated as a new instrument for accounting purposes (e.g., as a result of a modification or exchange that is accounted for as an extinguishment of the existing instrument; see ASC 470-50). That is, the issuer applies literally the requirement in ASC 480-10-25-8 to perform the evaluation “at inception.”
-
View B: Reassessment — An issuer reassesses whether an instrument that was classified as an asset or a liability under ASC 480-10-25-8 should continue to be classified as an asset or a liability under ASC 480-10, ASC 815-40, and any other applicable GAAP if the obligation that caused the instrument to be classified as an asset or a liability under ASC 480-10-25-8 no longer exists. That is, the classification of an instrument reflects its operative terms as of the assessment date, but not any expired terms. (As discussed in Section 3.2.1, however, the issuer does not reassess whether any feature is nonsubstantive or minimal after inception.) If reclassification is appropriate, it is performed as of the date the obligation ceases to exist. This view is consistent with the reassessment guidance in ASC 480-10-25-4 (see Section 4.4.1) and ASC 815-40 that applies to instruments within the scope of that guidance (see Section 5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
Example 5-3
Reassessment of the Classification of Warrants on
Redeemable Shares
Company A issues physically settled warrants on its convertible preferred stock. The convertible preferred stock includes a provision that requires A to redeem the stock for cash upon a deemed liquidation event (e.g., a change of control). Further, the convertible preferred stock includes a mandatory conversion feature that requires the stock to be converted into nonredeemable common stock upon an IPO. If an IPO were to occur, therefore, the warrants would no longer be settleable in convertible preferred stock but in nonredeemable common stock. At inception, A classifies the warrants as liabilities under ASC 480-10-25-8 because the deemed liquidation provision represents an obligation to repurchase shares of A’s convertible preferred stock that may require the issuer to transfer assets under ASC 480-10-25-8 (see Section 5.2.2).
After inception, A undergoes an IPO. On the IPO date, all of A’s outstanding series of convertible preferred stock are converted into shares of nonredeemable common stock in accordance with the mandatory conversion terms of the convertible preferred stock. Further, the warrants are no longer settleable in convertible preferred stock. Therefore, the warrants no longer embody an obligation that requires or may require the issuer to transfer assets under ASC 480-10-25-8.
Depending on its accounting policy for reassessment under ASC 480-10-25-8, A
could elect either to continue to classify the warrants as
liabilities under ASC 480-10-25-8 or to reclassify them to
equity provided that they meet all the conditions for equity
classification in ASC 815-40 and any other applicable
GAAP.
Chapter 6 — Certain Variable-Share Obligations
Chapter 6 — Certain Variable-Share Obligations
This chapter discusses the requirements in ASC 480-10 related to certain financial instruments that embody an obligation to issue a variable number of shares, including the scope of this classification category (see Section 6.1); certain application issues (see Section 6.2); accounting (see Section 6.3); and the absence of reassessments (see Section 6.4).
6.1 Classification
6.1.1 Overview
ASC
480-10
25-14 A financial instrument
that embodies an unconditional obligation, or a
financial instrument other than an outstanding share
that embodies a conditional obligation, that the issuer
must or may settle by issuing a variable number of its
equity shares shall be classified as a liability (or an
asset in some circumstances) if, at inception, the
monetary value of the obligation is based solely or
predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).
See paragraph 480-10-55-21
for related implementation guidance.
In certain circumstances, ASC 480-10 requires an issuer to
classify share-settled obligations as assets or liabilities even if the issuer
is not required to deliver cash or other assets. ASC 480-10-25-14 applies to a
financial instrument with all of the following characteristics:
- It embodies an obligation (see Section 6.1.1.1). If the instrument is an outstanding share, the obligation must be unconditional. For other instruments, the obligation may be either conditional or unconditional.
- It requires or may require the issuer to settle the obligation by delivering a variable number of its equity shares (see Section 6.1.1.2).
- The monetary value of the obligation is based solely or predominantly on one of three specified factors (see Sections 6.1.1.3, 6.1.2, 6.1.3, and 6.1.4).
If a financial instrument embodies an obligation that the entity
must or may settle by delivering its own equity shares, the issuer should
evaluate whether the instrument must be classified as an asset or a liability
under ASC 480-10-25-14.
6.1.1.1 Obligation
Like other requirements in ASC 480-10, ASC 480-10-25-14
applies only to instruments that embody obligations of the issuer (see
Section
2.2.1).
For outstanding shares (e.g., convertible preferred stock),
that guidance is limited to obligations that are unconditional and for which
the delivery of a variable number of equity shares is certain to occur
(e.g., mandatory conversion of preferred shares into a variable number of
common shares). If an outstanding share conditionally requires the issuer to
deliver a variable number of shares (e.g., upon an IPO, a change of control,
or the holder’s exercise of an embedded put option), ASC 480-10-25-14 does
not apply.
For financial instruments other than an outstanding share
(e.g., net-share-settled written put options and forward contracts), ASC
480-10-25-14 applies irrespective of whether the obligation is unconditional
or conditional (e.g., contingent on the counterparty's exercise of an
option). The issuer's purchased put or call option on the issuer’s equity
shares would not be within the scope of ASC 480-10, however, because it does
not embody an obligation of the issuer.
6.1.1.2 Requires or May Require the Transfer of a Variable Number of Equity Shares
ASC 480-10 — Glossary
Equity Shares
Equity shares refers only to shares
that are accounted for as equity.
Net Share
Settlement
A form of
settling a financial instrument under which the
entity with a loss delivers to the entity with a
gain shares of stock with a current fair value equal
to the gain.
Although an obligation to deliver equity shares is not included in the definition of a liability in FASB Concepts Statement 6,
certain of these obligations must be classified as liabilities under ASC
480-10-25-14 (see Section
2.2.1.1). The FASB developed this requirement because it was
concerned that some share-settled obligations have risks and benefits that
are dissimilar from ownership interests. Paragraphs B31 and B36 of the Background Information and Basis for Conclusions of FASB Statement 150
state, in part:
[C]ertain
share-settled obligations establish relationships that, in the
Board’s view, have little if anything in common with ownership
interests. . . . To be classified as equity, the Board believes that
an obligation must expose the holder of the instrument that embodies
that obligation to certain risks and benefits that are similar to
those to which an owner (that is, a holder of an outstanding share
of the entity’s equity) is exposed.
Example 6-1
Variable-Share-Settled Obligation
An instrument embodies an obligation that the
issuer must or may settle in its own equity shares.
The terms of the instrument specify that the number
of shares that will be delivered is variable and
that the shares will have an aggregate
settlement-date fair value equal to the monetary
amount of the obligation. The monetary amount of the
obligation might be fixed (e.g., $10,000), indexed
(e.g., $10,000 adjusted for changes in the price of
gold), or move inversely with changes in the
entity’s stock price (e.g., when the stock price
increases, the monetary amount of the obligation
decreases). Accordingly, although the issuer uses
its own equity shares to settle the obligation, the
risks and benefits associated with holding the
obligation are dissimilar from those associated with
holding equity shares. Effectively, the issuer is
using its own shares as a means of payment
(currency) to settle an obligation whose risks and
characteristics are different from those of equity
shares.
ASC 480-10-25-14 only applies to contracts that may require
the issuance of a variable number of shares. It does not apply to contracts
that require the issuance of a fixed number of shares.
Example 6-2
Fixed-Share-Settled Obligation
Under a range forward sales contract, an issuer agrees to sell a fixed number of
its own shares in exchange for cash. The cash price
is defined as the current stock price subject to a
cap ($80) and a floor ($60). Accordingly, the
issuer’s economic payoff profile is similar to the
purchase of a put option (the floor) and the sale of
a call option (the cap) on its own stock. The
contract would be outside the scope of ASC 480-10
because it is not a mandatorily redeemable financial
instrument, it does not embody an obligation to
repurchase shares by transferring assets (it is
selling shares), and it requires the issuance of a
fixed number of shares for a variable amount of
cash. Instead, the contract should be evaluated
under ASC 815-40; see Deloitte’s Roadmap Contracts on an Entity’s Own
Equity. (Note, however, that if the
issuer instead was obligated to deliver a variable
number of shares subject to a cap and a floor, the
contract potentially would be within the scope of
ASC 480-10. See Section
6.2.4.)
ASC 480-10-25-14 does not apply to obligations that require
or may require the issuer to deliver cash or other assets. Such obligations
are instead evaluated under ASC 480-10-25-4 and ASC 480-10-25-8 (see
Chapters 4
and 5).
Obligations that the issuer is permitted to settle either in cash or a
variable number of shares, however, should be assessed under ASC
480-10-25-14 (see Section
6.2.6).
6.1.1.3 Monetary Value
ASC 480-10
05-4 For certain financial
instruments, Section 480-10-25 requires
consideration of whether monetary value would remain
fixed or would vary in response to changes in market
conditions.
05-5 How the monetary value
of a financial instrument varies in response to
changes in market conditions depends on the nature
of the arrangement, including, in part, the form of
settlement.
ASC 480-10 — Glossary
Monetary Value
What the fair value of the cash,
shares, or other instruments that a financial
instrument obligates the issuer to convey to the
holder would be at the settlement date under
specified market conditions.
In determining whether a financial instrument that embodies a share-settled obligation must be accounted for as an asset or a liability, an issuer is required under ASC 480-10-25-14 to evaluate the monetary value of the obligation. That value is defined in ASC 480-10-20 by reference to the fair value of the shares or other items the issuer is required to deliver on the settlement date of the instrument. Paragraphs B38 and B39 of the Background Information and Basis for Conclusions of FASB Statement 150
state, in part:
The Board developed
the notion of monetary value to assist in determining whether the
risks or benefits from changes in fair value of the issuer’s equity
shares to which a holder of a financial instrument that embodies an
obligation is exposed are similar to those to which a holder of
outstanding equity shares is exposed. . . . The Board concluded that
the relationship between changes in the monetary value of an
instrument that embodies an obligation and changes in the fair value
of the issuer’s equity shares during the period the obligation is
outstanding would be an effective basic principle to assess whether
the holder of the instrument is exposed to risks and benefits that
are similar to those to which a holder of a corresponding number of
outstanding equity shares (an owner) is exposed.
Under ASC 480-10-25-14, a share-settled obligation (which
must be unconditional if the instrument is an outstanding share but
otherwise could be either conditional or unconditional) is classified as an
asset or a liability if, at inception, the obligation’s monetary value is
based solely or predominantly on one of three factors:
- A fixed monetary amount known at inception (see Section 6.1.2).
- Variations in something other than the fair value of the issuer’s equity shares (see Section 6.1.3).
- Variations inversely related to changes in the fair value of the issuer’s equity shares (see Section 6.1.4).
The FASB concluded that the requirement in ASC 480-10-25-14
should apply not just to obligations whose monetary value is based solely on
one of the three factors identified in that paragraph but also to those
whose monetary value is based predominantly on one of them. The Board
was concerned that an entity otherwise might structure transactions to
circumvent the requirement. For example, an issuer is not able to avoid
liability classification by “embedding a small amount of monetary value
variation in response to changes in the fair value of the issuer’s equity
shares [if] the overall variation would predominantly respond to something else” (see paragraph B47 of the Background Information and Basis for Conclusions of FASB Statement 150).
ASC 480-10 does not define “predominantly.” In developing the requirements in ASC 480-10, the FASB acknowledged that an entity will need to use judgment in assessing predominance. Paragraph B47 of the Background Information and Basis for Conclusions of FASB Statement 150
states, in part:
[J]udgment will be
required to distinguish instruments with monetary values
predominantly based on one of those three factors from instruments
with monetary values that are indexed both to the issuer’s equity
shares and to one or more other factors and, thus, are excluded from
this Statement’s scope.
In the predominance assessment, different considerations
apply depending on whether the instrument embodies a single, dual-indexed
obligation (see Section
6.2.3) or multiple-component obligations (see Section 6.2.4).
A share-settled obligation may have multiple possible
outcomes, and some (but not all) of those outcomes may have a monetary value
that is determined on the basis of one of the three factors in ASC
480-10-25-14. In practice, we have considered an outcome to be predominant
if it is more likely than not (i.e., greater than 50 percent) to occur (see
Section
6.2.4). Accordingly, if an outcome is reasonably possible,
but not more likely than not, to occur, it is not predominant.
The following table provides
some examples of contracts that would be accounted for as assets or
liabilities because they require or may require the issuer to deliver a
variable number of equity shares and have a monetary value that is based
solely or predominantly on one of the factors in ASC 480-10-25-14:
Fixed monetary value (see Section
6.1.2) |
|
Monetary value based on something other than stock
price (see Section
6.1.3) |
|
Monetary value moves inversely with stock price
(see Section
6.1.4) |
|
Examples of contracts that would not be accounted for as
assets or liabilities under ASC 480-10-25-14 because their monetary value
moves directly with the fair value of the issuer’s equity shares include:
- Fixed-for-fixed net-share-settled forward contracts to sell the issuer’s equity shares.
- Fixed-for-fixed net-share-settled written call options on the issuer’s equity shares.
ASC 480-10
55-2 Paragraph 480-10-05-5
explains that how the monetary value of a financial
instrument varies in response to changes in market
conditions depends on the nature of the arrangement,
including, in part, the form of settlement. For
example, for a financial instrument that embodies an
obligation that requires:
- Settlement either by transfer of $100,000 in cash or by issuance of $100,000 worth of equity shares, the monetary value is fixed at $100,000, even if the share price changes.
- Physical settlement by transfer of $100,000 in cash in exchange for the issuer’s equity shares, the monetary value is fixed at $100,000, even if the fair value of the equity shares changes.
- Net share settlement by issuance of a variable number of shares based on the change in the fair value of a fixed number of the issuer’s equity shares, the monetary value varies based on the number of shares required to be issued to satisfy the obligation. For example, if the exercise price of a net-share-settled written put option entitling the holder to put back 10,000 of the issuer’s equity shares is $11, and the fair value of the issuing entity’s equity shares on the exercise date decreases from $13 to $10, that change in fair value of the issuer’s shares increases the monetary value of that obligation at settlement from $0 to $10,000 ($110,000 minus $100,000), and the option would be settled by issuance of 1,000 shares ($10,000 divided by $10).
- Net cash settlement based on the change in the fair value of a fixed number of the issuer’s equity shares, the monetary value varies in the same manner as in (c) for net share settlement, but the obligation is settled with cash. In a net-cash-settled variation of the previous example, the option would be settled by delivery of $10,000.
- Settlement by issuance of a variable number of shares that is based on variations in something other than the issuer’s equity shares, the monetary value varies based on changes in the price of another variable. For example, a net-share-settled obligation to deliver the number of shares equal in value at settlement to the change in fair value of 100 ounces of gold has a monetary value that varies based on the price of gold and not on the price of the issuer’s equity shares.
55-51 Some financial
instruments that are composed of more than one
option or forward contract embody an obligation to
issue a fixed number of shares and, once those
shares are issued, potentially to issue a variable
number of additional shares. The issuer must analyze
that kind of financial instrument, at inception, to
assess whether the possibility of issuing a variable
number of shares in which the monetary value of that
obligation meets one of the conditions in paragraph
480-10-25-14 is predominant.
ASC 480-10-55-2 illustrates how the monetary value of
various financial instruments may be defined:
- The financial instruments in ASC 480-10-55-2(a) and (b) represent obligations for a fixed monetary amount.
- The financial instruments in ASC 480-10-55-2(c) and (d) have a monetary value that is based on the issuer’s equity shares.
- The financial instrument in ASC 480-10-55-2(e) has a monetary value that is based on a variable other than the issuer’s stock price (e.g., the price of gold).
6.1.2 Fixed Monetary Amount Known at Inception
ASC
480-10
25-14 A financial instrument
that embodies an unconditional obligation, or a
financial instrument other than an outstanding share
that embodies a conditional obligation, that the issuer
must or may settle by issuing a variable number of its
equity shares shall be classified as a liability (or an
asset in some circumstances) if, at inception, the
monetary value of the obligation is based solely or
predominantly on any one of the following:
a. A fixed monetary amount known at inception
(for example, a payable settleable with a variable
number of the issuer’s equity shares). . . .
55-22 Certain financial
instruments embody obligations that require (or permit
at the issuer’s discretion) settlement by issuance of a
variable number of the issuer’s equity shares that have
a value equal to a fixed monetary amount. For example,
an entity may receive $100,000 in exchange for a promise
to issue a sufficient number of its own shares to be
worth $110,000 at a future date. The number of shares
required to be issued to settle that unconditional
obligation is variable, because that number will be
determined by the fair value of the issuer’s equity
shares on the date of settlement. Regardless of the fair
value of the shares on the date of settlement, the
holder will receive a fixed monetary value of $110,000.
Therefore, the instrument is classified as a liability
under paragraph 480-10-25-14(a). . . .
The first of the three categories of instruments that are
classified as assets or liabilities under ASC 480-10-25-14 consists of those
instruments that embody obligations that the issuer must or may satisfy by
delivering a variable number of shares that have a monetary value that is fixed
or predominantly fixed. For such instruments, the number of shares delivered is
determined on the basis of (1) the fixed monetary amount and (2) the current
stock price at settlement, so that the aggregate fair value of the shares
delivered equals the monetary value of the obligation. Accordingly, the holder
is not significantly exposed to gains and losses attributable to changes in the
fair value of the issuer’s equity shares. Instead the issuer is using its own
equity shares as currency to settle a monetary obligation.
Paragraphs B13 and B42 of the Background Information and Basis for Conclusions of FASB Statement 150 state, in part:
[N]ot all . . . obligations [that require (or permit at
the issuer’s discretion) settlement by issuance of the issuer’s equity
shares] establish the type of relationship that exists between an entity
and its owners. For example, a financial instrument that requires
settlement by issuance of $100,000 worth of equity shares establishes
something more akin to a debtor-creditor relationship than to an
ownership relationship, because it requires that the issuer convey a
fixed amount of value to the holder that does not vary with the issuer’s
equity shares. . . . The holder of that instrument does not benefit if
the fair value of the issuer’s equity shares increases and does not bear
the risk that the fair value of those shares might decrease. The Board
decided that that type of instrument should be classified as a liability
because it does not establish an ownership relationship. That is, even
though the obligation will be settled by issuance of equity shares, the
instrument has more characteristics of a liability than of equity
because the holder’s return is fixed and, thus, unrelated to changes in
the fair value of the issuer’s equity shares.
Example 6-3
Variable-Share-Settled Obligation — Fixed Monetary
Amount
The
terms of a contract specify that the number of shares to
be delivered will have an aggregate settlement-date fair
value of $10,000 (i.e., the number of shares is defined
as $10,000 divided by the current stock price). Although
the number of equity shares to be delivered depends on
the entity’s stock price, the aggregate value of those
shares does not depend on the stock price but represents
a fixed monetary amount known at inception. If the stock
price is $20 at settlement, the entity would deliver 500
shares. If the share price is $10, the entity would
deliver 1,000 shares. In both cases, the value of the
shares delivered equals $10,000.
A share is classified as a liability if it embodies an
obligation that the issuer must or may satisfy by delivering a variable number
of shares that have a monetary value that is fixed or predominantly fixed and
the obligation is unconditional. Under this guidance, preferred stock is
classified as a liability if it is mandatorily convertible into a variable
number of common shares worth a fixed monetary amount on a specified date. ASC
480-10 does not apply if a share embodies a conditional obligation to deliver a
variable number of shares (e.g., preferred stock that is mandatorily converted
into a variable number of shares worth a fixed monetary amount upon an event
that is not certain to occur, such as an IPO or the holder’s exercise of a put
option).
Instruments other than outstanding shares that embody an
obligation that the issuer must or may satisfy by delivering a variable number
of shares that have a monetary value that is fixed or predominantly fixed are
classified as an asset or a liability irrespective of whether the obligation is
conditional or unconditional.
Examples of obligations that are required to be classified as
liabilities under ASC 480-10-25-14(a) include:
-
Share-settled debt (i.e., a share-settled obligation that is not in the legal form of debt but has the same economic payoff profile as debt, such as an unconditional obligation to deliver a variable number of common shares worth a fixed monetary amount upon settlement of a preferred share).
-
Preferred shares that are mandatorily convertible into a variable number of common shares equal in value to a fixed monetary amount. (However, the requirement does not apply to preferred shares that are optionally convertible, because outstanding shares that embody conditional obligations are exempt.)
-
Warrants that upon exercise would be settled in a variable number of equity shares worth a fixed monetary amount.
-
Mandatorily redeemable preferred shares that are contingently convertible into a variable number of shares worth a fixed monetary amount.
Some instruments permit multiple settlement methods that are
triggered by predefined conditions. If only one of those methods requires the
issuer to settle its obligation by issuing a variable number of shares equal in
value to a fixed monetary amount known at inception, a question arises regarding
whether the obligation’s monetary value is based predominantly on a fixed
monetary amount known at inception. A variable-share forward contract that
involves the issuance of the entity’s common stock is one example of this type
of instrument. A variable-share forward has different outcomes depending on the
price of the issuer’s common stock as of the date the forward contract settles.
If the stock price is within a specified range, the issuer will deliver a
variable number of shares equivalent to a fixed monetary amount known at
inception (the “dead zone”). This type of variable-share forward should be
classified as a liability if it is more likely than not that the variable-share
forward will settle within the range in which the company will issue a variable
number of shares equal to a fixed monetary amount. An entity assesses this
likelihood at inception of the contract (see Section 6.2.4).
6.1.3 Amount Indexed to Something Other Than Own Equity
ASC
480-10
25-14 A financial instrument
that embodies an unconditional obligation, or a
financial instrument other than an outstanding share
that embodies a conditional obligation, that the issuer
must or may settle by issuing a variable number of its
equity shares shall be classified as a liability (or an
asset in some circumstances) if, at inception, the
monetary value of the obligation is based solely or
predominantly on any one of the following: . . .
b. Variations in something other than the fair
value of the issuer’s equity shares (for example,
a financial instrument indexed to the Standard and
Poor’s S&P 500 Index and settleable with a
variable number of the issuer’s equity shares) . .
. .
The second of the three categories of instruments that are
classified as assets or liabilities under ASC 480-10-25-14 consists of those
instruments that require the issuer to deliver a variable number of shares that
have a monetary value that is based solely or predominantly on variations in
something other than the fair value of the issuer’s equity shares. For instance,
the amount may be calculated on the basis of changes in a stock market index
(e.g., the S&P 500) or changes in a commodity price (e.g., the price of a
specified quantity of gold). For such instruments, the number of shares
delivered is determined on the basis of (1) the monetary value of the obligation
and (2) the current stock price at settlement, so that the aggregate fair value
of the shares delivered equals or approximates the monetary value of the
obligation.
A share that embodies such an obligation is classified as a
liability if the obligation is unconditional and the issuer must or may settle
it in equity shares. Under this guidance, preferred stock that is mandatorily
convertible into a variable number of common shares that have a monetary value
that is based solely or predominantly on variations in something other than the
fair value of the issuer’s equity shares is classified as a liability. If a
share embodies a conditional obligation to deliver a variable number of shares
upon an event that is not certain to occur, such as an IPO or the holder’s
exercise of a put option, ASC 480-10 does not apply. However, the instrument may
contain an embedded derivative that must be accounted for separately under ASC
815-15-25-1.
A contract other than shares that embody such an obligation is
classified as an asset or a liability if the issuer must or may settle it in
equity shares irrespective of whether the obligation is conditional or
unconditional. For instance, certain contingent consideration arrangements in
business combinations may fall within the scope of this requirement.
Examples of obligations that are required to be classified as
liabilities under ASC 480-10-25-14(b) include:
- Preferred equity securities that are mandatorily convertible into a variable number of shares equal in value to the face value of the preferred stock adjusted for changes in the price of crude oil.
- Written call options on a fixed quantity of gold at a fixed strike price if the options are required to be settled in a variable number of the issuer’s equity shares whose fair value at settlement is equal to the fair value of the options.
- Certain share-settled guarantee obligations (see Section 6.2.2).
6.1.4 Amount Inversely Related to Own Equity
ASC
480-10
25-14 A financial instrument
that embodies an unconditional obligation, or a
financial instrument other than an outstanding share
that embodies a conditional obligation, that the issuer
must or may settle by issuing a variable number of its
equity shares shall be classified as a liability (or an
asset in some circumstances) if, at inception, the
monetary value of the obligation is based solely or
predominantly on any one of the following: . . .
c. Variations inversely related to changes in
the fair value of the issuer’s equity shares (for
example, a written put option that could be net
share settled). . . .
55-26 A freestanding forward
purchase contract, a freestanding written put option, or
a net written option (otherwise similar to the example
in paragraphs 480-10-55-18 through 55-19) that must or
may be net share settled is a liability under paragraph
480-10-25-14(c), because the monetary value of the
obligation to deliver a variable number of shares
embodied in the contract varies inversely in relation to
changes in the fair value of the issuer’s equity shares;
when the issuer’s share price decreases, the issuer’s
obligation under those contracts increases. Such a
contract is measured initially and subsequently at fair
value (with changes in fair value recognized in
earnings) and classified as a liability or an asset,
depending on the fair value of the contract on the
reporting date. . . .
Entities may structure share-settled obligations so that the
monetary value of the obligation moves inversely to changes in the price of the
entity’s equity shares. The number of shares to be delivered is determined on
the basis of (1) the monetary value of the obligation and (2) the current stock
price at settlement, so that the aggregate fair value of the shares delivered
equals or approximates the monetary value of the obligation. As the entity’s
stock price increases, the aggregate fair value of the equity shares to be
delivered at settlement decreases and, conversely, as the entity’s stock price
decreases, the aggregate fair value of the equity shares to be delivered at
settlement increases. Accordingly, the counterparty has an exposure to the value
of the entity’s equity shares that is inverse to that of a holder of the
entity’s equity shares.
Paragraph B44 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
Some obligations to issue a variable number of shares
have monetary values that are indexed or otherwise tied to the fair
value of the issuer’s equity shares, but those monetary values vary
inversely with changes in the fair value of the issuer’s shares.
Examples include forward purchase contracts, written put options, or net
written (or purchased or zero-cost) options or collars that require or
permit net share settlement. Because the interests of holders of those
instruments are diametrically opposed to those of holders of the
issuer’s equity shares, the Board concluded that the issuer’s
obligations under those instruments could not be considered equity
interests and, therefore, must be liabilities (or assets in some
circumstances).
Further, paragraph B13 states, in part:
A share-settled put option on the issuer’s equity
shares establishes the opposite (inverse) of an ownership relationship,
because it requires the issuer to convey value to the holder that
increases as the value of other owners’ interests
decreases.
An outstanding share that embodies such an obligation is
classified as a liability if the obligation is unconditional. One example is a
preferred equity security that is mandatorily convertible into a variable number
of common shares equal in value to an amount that declines as the price of the
issuing entity’s common shares increases. An instrument other than an
outstanding share that embodies such an obligation is classified as an asset or
a liability irrespective of whether the obligation is conditional or
unconditional. Examples include forward purchase contracts or written put
options on the entity’s own stock that the entity must settle net in shares.
The monetary value of a net-share-settled fixed-for-fixed
written call option or forward sale contract on the issuer’s equity shares moves
directly with the price of the issuer’s equity shares. Similarly, a
net-share-settled written call option or forward sale contract on the issuer’s
equity shares that includes a standard-dilution adjustment intended to
neutralize the impact on the fair value of the contract of dilutive events
involving the issuer’s equity shares would have a monetary value that moves
directly with the price of the issuer’s equity shares. Therefore, the
counterparty in such contracts does not have an exposure to the value of the
entity’s equity shares that is inverse to that of a holder of the entity’s
equity shares. Accordingly, the contracts do not fall within the scope of the
guidance in ASC 480-10-25-14(c) even though their settlement might require the
issuer to deliver a variable number of equity shares.
ASC 480-10-25-14(c) only applies to instruments that embody
obligations of the issuer. Therefore, it does not apply to the following types
of contracts even if their monetary value moves inversely with changes in the
fair value of the issuer’s equity shares:
- Prepaid written put options on own equity.
- Prepaid forward purchase contracts on own equity.
- Purchased options on own equity.
6.2 Application Issues
6.2.1 Obligations to Deliver a Variable Number of Shares on the Basis of an Average Stock Price
ASC
480-10
55-22 Certain financial
instruments embody obligations that require (or permit
at the issuer’s discretion) settlement by issuance of a
variable number of the issuer’s equity shares that have
a value equal to a fixed monetary amount. . . . Some
share-settled obligations of this kind require that the
variable number of shares to be issued be based on an
average market price for the shares over a stated period
of time, such as the average over the last 30 days
before settlement, instead of the fair value of the
issuer’s equity shares on the date of settlement. Thus,
if the average market price differs from the share price
on the date of settlement, the monetary value of the
obligation is not entirely fixed at inception and is
based, in small part, on variations in the fair value of
the issuer’s equity shares. Although the monetary amount
of the obligation at settlement may differ from the
initial monetary value because it is tied to the change
in fair value of the issuer’s equity shares over the
last 30 days before settlement, the monetary value of
the obligation is predominantly based on a fixed
monetary amount known at inception. The obligation is
classified as a liability under paragraph
480-10-25-14(a). Upon issuance of the shares to settle
the obligation, equity is increased by the amount of the
liability and no gain or loss is recognized for the
difference between the average and the ending market
price.
For an instrument to be classified as a liability under ASC
480-10-25-14, the number of shares used to settle the variable-share obligation
does not necessarily need to be determined on the basis of the stock price on
the settlement date. The number of shares might alternatively be calculated on
the basis of an average stock market price over some period (e.g., the last 30
days before settlement). The instrument is a liability under ASC 480-10-25-14 as
long as the monetary value of the obligation (i.e., the current value of the
shares delivered to settle the obligation) is based predominantly on a fixed
monetary amount, on variations in something other than the fair value of the
issuer’s equity shares, or on variations inversely related to changes in the
fair value of the issuer’s equity shares.
However, if the monetary amount of a variable-share obligation
moves directly with the stock price (e.g., the monetary amount increases when
the stock price increases and vice versa), the obligation would not be a
liability under ASC 480-10-25-15 irrespective of whether the stock price used in
the calculation of the settlement value is a current stock price or an average
stock price. ASC 815-40-55-38 contains an example that suggests that a forward
contract to sell shares at a fixed price in which the stock price used in the
calculation of the settlement amount is based on a 30-day
volume-weighted-average daily market price of the issuer’s equity shares would
be considered indexed to the issuer’s stock (see Section 4.3.5.1 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
6.2.2 Share-Settled Guarantee Obligations
ASC
480-10
55-23 An entity’s guarantee of
the value of an asset, liability, or equity security of
another entity may require or permit settlement in the
entity’s equity shares. For example, an entity may
guarantee that the value of a counterparty’s equity
investment in another entity will not fall below a
specified level. The guarantee contract requires that
the guarantor stand ready to issue a variable number of
its shares whose fair value equals the deficiency, if
any, on a specified date between the guaranteed value of
the investment and its current fair value. Upon
issuance, unless the guarantee is accounted for as a
derivative instrument, the obligation to stand ready to
perform is a liability addressed by Topic 460. If,
during the period the contract is outstanding, the fair
value of the guaranteed investment falls below the
specified level, absent an increase in value, the
guarantor will be required to issue its equity shares.
At that point in time, the liability recognized in
accordance with that Topic would be subject to the
requirements of Topic 450. This Subtopic establishes
that, even though the loss contingency is settleable in
equity shares, the obligation under that Topic is a
liability under paragraph 480-10-25-14(b) until the
guarantor settles the obligation by issuing its shares.
That is because the guarantor’s conditional obligation
to issue shares is based on the value of the
counterparty’s equity investment in another entity and
not on changes in the fair value of the guarantor’s
equity instruments.
ASC 480-10-25-14(b) applies to guarantee contracts that will be
settled in a variable number of the issuer’s equity shares (see Sections 2.8, 6.1.3, and 6.2.3). Paragraph B43 of the Background Information and Basis for Conclusions of FASB Statement 150
states:
Some obligations to issue a
variable number of shares are indexed or otherwise tied to the value of
something other than the issuer’s equity shares. One example is a
guarantee contract that requires that the guarantor issue a variable
number of its shares whose fair value equals the deficiency on a
specified date between the guaranteed value of the investment and its
current market value. Even though the issuer’s equity shares will be
issued in settlement of the obligation, that type of contract should be
classified as a liability because it does not establish an ownership
relationship. That is, even though the obligation will be settled by
issuance of equity shares, the component has more characteristics of a
liability than of equity because the guaranteed party’s return is
unrelated to changes in the fair value of the issuer’s equity
shares.
6.2.3 Financial Instruments That Embody Dual-Indexed Obligations
6.2.3.1 Overview
If a financial instrument embodies only one obligation, and
that obligation must be share settled, the financial instrument is
classified as an asset or a liability under ASC 480-10-25-14 if at
inception, the obligation’s monetary value is based either solely or
predominantly on one of three factors: (1) a fixed monetary amount, (2)
variations in something other than the fair value of the issuer’s equity
shares, or (3) variations inversely related to changes in the fair value of
the issuer’s equity shares. If the monetary value of a financial instrument
embodies only one obligation that must be share settled, and that monetary
value is not based solely on one of these three factors, the issuer should
evaluate whether the monetary value is based predominantly on one of them.
Special considerations apply to instruments with multiple component
obligations (see Section
6.2.4).
If a financial instrument embodies only one obligation, and
that obligation must (1) be share settled and (2) has a monetary value that
varies at least in part with the price of the issuer’s equity shares, the
financial instrument is outside the scope of ASC 480-10 unless its monetary
value is based predominantly on one of the three factors in ASC
480-10-25-14. If an obligation is dual-indexed both to the entity’s stock
price and to something other than the entity’s stock price (e.g., both to
the fair value of the issuer’s equity shares and to a foreign currency or
the entity’s sales revenue), ASC 480-10 therefore does not apply unless the
monetary value of the obligation is based predominantly on the variable
other than the fair value of the issuer’s equity shares. (Dual-indexed
contracts should be assessed under ASC 815-10, ASC 815-15, and ASC 815-40 if
ASC 480-10 does not apply.)
If a contract is solely and explicitly indexed to a variable
other than the fair value of the issuer’s equity shares, an entity would not
consider the contract to be based on the fair value of the issuer’s equity
shares even if that variable is highly correlated with the fair value of the
issuer’s equity shares. For example, the monetary value of an obligation to
deliver shares may be solely indexed to a multiple of the issuer’s trailing
EBITDA (e.g., 10 times EBITDA). In such a scenario, there is no assurance
that the formula will produce a monetary value that equals the fair value of
the issuer’s equity shares because the EBITDA multiple applied in the
marketplace may vary significantly over time, and all the factors that may
affect fair value of the issuer’s equity shares are not captured in EBITDA.
Thus, even though a formula for determining the number of shares to be
delivered by the issuer under a contract may be designed to approximate the
fair value of the issuer’s equity shares, the fact that a contract is not
explicitly indexed at least in part to the fair value of the equity shares
suggests that the contract should be classified as a liability under ASC
480-10 irrespective of the degree of correlation between the changes in the
variable and the fair value of the issuer’s shares. In other words, the
evaluation of predominance applies to obligations that are dual-indexed to
the issuer’s shares and one or more additional variables. It does not apply
to obligations that are explicitly and solely indexed to a variable other
than the issuer’s equity shares.
6.2.3.2 Evaluating Predominance — Contract Indexed to Issuer’s Stock Price and Foreign Exchange Rate
ASC 480-10
55-25 . . . For example, an
instrument meeting the definition of a derivative
instrument that requires delivery of a variable
number of the issuer’s equity shares with a monetary
value equaling changes in the price of a fixed
number of the issuer’s shares multiplied by the
Euro/U.S. dollar exchange rate embodies an
obligation with a monetary value that is based on
variations in both the issuer’s share price and the
foreign exchange rate and, therefore, is not within
the scope of this Subtopic. (However, that
instrument would be a derivative instrument under
Topic 815. Paragraphs 815-10-15-74[a] and
815-10-15-75[b] address derivative instruments that
are dual indexed and require an issuer to report
those instruments as derivative instrument
liabilities or assets.)
As illustrated in ASC 480-10-55-25, an instrument that
embodies no other obligation than one to deliver a variable number of equity
shares equal in value to the change in the price of a fixed number of the
issuer’s equity shares multiplied by the change in a foreign exchange rate
would not be within the scope of ASC 480-10, because the monetary value of
that obligation is not based predominantly on foreign exchange rates or on
any of the other factors that would cause an instrument to be an asset or a
liability under ASC 480-10-25-14. Note, however, that if an issuer concludes
that a dual-indexed instrument is not required to be classified outside of
equity under ASC 480-10, the issuer must assess whether the instrument is
required to be classified outside of equity under other GAAP (including ASC
815-10 and ASC 815-40). A contract on own equity that is indexed in part to
a currency other than the issuer’s functional currency would not qualify as
equity under ASC 815-40-15-7I (see Section 4.3.8 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
6.2.3.3 Evaluating Predominance — Dual-Indexed Guarantee Obligation
ASC 480-10
55-23 An entity’s guarantee
of the value of an asset, liability, or equity
security of another entity may require or permit
settlement in the entity’s equity shares. For
example, an entity may guarantee that the value of a
counterparty’s equity investment in another entity
will not fall below a specified level. The guarantee
contract requires that the guarantor stand ready to
issue a variable number of its shares whose fair
value equals the deficiency, if any, on a specified
date between the guaranteed value of the investment
and its current fair value. . . .
55-24 If this example were
altered so that the monetary value of the obligation
is based on the deficiency on a specified date
between the guaranteed value of the investment in
another entity and its current fair value plus .005
times the change in value of 100 of the guarantor’s
equity shares, the monetary value of the obligation
would not be solely based on variations in something
other than the fair value of the issuer’s
(guarantor’s) equity shares.
55-25 However, the monetary
value of the obligation would be predominantly based
on variations in something other than the fair value
of the issuer’s (guarantor’s) equity shares and,
therefore, the obligation would be classified as a
liability under paragraph 480-10-25-14(b). That
obligation differs in degree from the obligation
under a contract that is indexed in part to the
issuer’s shares and in part (but not predominantly)
to something other than the issuer’s shares
(commonly called a dual-indexed obligation). The
latter contract is not within the scope of this
Subtopic. That paragraph applies only if the
monetary value of an obligation to issue equity
shares is based solely or predominantly on
variations in something other than the fair value of
the issuer’s equity shares. . . .
ASC 480-10-55-24 and 55-25 address a guarantee obligation
that requires the issuer to deliver a variable number of its equity shares
with a monetary value that is based on both (1) the fair value of the
issuer’s equity shares (0.005 times the change in the value of 100 of the
issuer’s equity shares) and (2) any deficiency in the fair value of a
third-party equity investment held by the counterparty below a specified
level. Because the monetary value of the obligation is based predominantly
on something other than the fair value of the issuer’s equity shares, ASC
480-10-25-14(b) requires the obligation to be classified as a liability.
Alternatively, an instrument may embody no obligation other
than one to deliver a variable number of equity shares worth a fixed
monetary amount plus 0.005 times the change in the value of 100 of the
issuer’s equity shares. That instrument would be classified as a liability
under ASC 480-10-25-14(a) because it embodies an obligation to deliver a
variable number of shares that have a value equal to a predominantly fixed
monetary amount.
6.2.4 Financial Instruments That Embody Multiple Obligations
6.2.4.1 Overview
ASC 480-10
55-42 A financial instrument
composed of more than one option or forward contract
embodying obligations to issue shares must be
analyzed to determine whether the obligations under
any of its components have one of the
characteristics in paragraph 480-10-25-14, and if
so, whether those obligations are predominant
relative to other obligations. For example, a
puttable warrant that allows the holder to purchase
a fixed number of the issuer’s shares at a fixed
price that also is puttable by the holder at a
specified date for a fixed monetary amount to be
paid, at the issuer’s discretion, in cash or in a
variable number of shares.
55-43 The analysis can be
summarized in two steps:
- Identify any component obligations that, if freestanding, would be liabilities under paragraph 480-10- 25-14. Also identify the other component obligation(s) of the financial instrument.
- Assess whether the monetary value of any obligations embodied in components that, if freestanding, would be liabilities under paragraph 480-10-25-14 is (collectively) predominant over the (collective) monetary value of other component obligation(s). If so, account for the entire instrument under that paragraph. If not, the financial instrument is not in the scope of this Subtopic and other guidance applies.
Freestanding instruments sometimes contain multiple
obligations, and only some of those obligations would be classified as
liabilities under ASC 480-10 if they were issued on a freestanding basis.
For example, a single freestanding financial instrument may contain both (1)
a physically settled written call option that requires the issuer to deliver
a fixed number of equity shares for cash if exercised by the holder and (2)
a written put option that requires the issuer to deliver a variable number
of shares equal in value to a fixed monetary amount if the holder elects to
put the instrument to the issuer.
The evaluation of whether a freestanding financial
instrument (other than a mandatorily redeemable financial instrument) that
contains multiple obligations must be classified as an asset or a liability
under ASC 480-10 differs depending on whether the instrument embodies at
least one obligation to which ASC 480-10-25-8 applies (i.e., obligations to
repurchase equity shares by transferring assets):
- If any of an instrument’s component obligations requires or may require the issuer to repurchase equity shares by transferring assets, the entire instrument is classified as an asset or a liability under ASC 480-10-25-8, and there is no assessment of the predominance of individual component obligations or settlement outcomes.
- If ASC 480-10-25-8 does not apply, and the instrument embodies at least one component obligation to transfer a variable number of shares as described in ASC 480-10-25-14 (e.g., a net-share-settled written put component), the issuer must consider all possible outcomes to determine whether the component obligation is predominant relative to any component obligations to which ASC 480-10 does not apply (e.g., a fixed-for-fixed written call option on equity shares). If a component obligation to which ASC 480-10-25-14 applies is predominant, the entire instrument is classified as an asset or a liability under ASC 480-10 irrespective of the other component obligations and potential settlement outcomes.
ASC 480-10-55-42 and 55-43 suggest that entities apply a
two-step approach in performing this assessment:
-
Step 1 — Identify each of the component obligations of the financial instruments (e.g., forwards and written options). Separately identify those obligations that would be classified as liabilities under ASC 480-10-25-14 if they were freestanding.
-
Step 2 — Evaluate whether the monetary value of the component obligations that would be classified as liabilities under ASC 480-10-25-14 if the obligations were freestanding is (collectively) predominant relative to the (collective) monetary value of any component obligations that would not be within the scope of ASC 480-10. If it is, the entire instrument is classified as an asset or a liability under ASC 480-10-25-14. If it is not, the instrument is outside the scope of ASC 480-10.
An obligation could have multiple outcomes, and some of
those outcomes may have a monetary value that is determined on the basis of
one of the three factors in ASC 480-10-25-14. In such a scenario, an outcome
is predominant if it is more likely than not (i.e., greater than 50 percent)
to occur (see Section
6.1.1.3).
Example 6-4
Variable-Share-Settled Preferred Stock — Range of
Monetary Amounts
A
preferred stock instrument will be automatically
converted into nonredeemable common stock on a
specified date. The number of common shares that the
issuer will deliver to settle the instrument depends
on the current price of common stock at settlement.
If the stock price exceeds $25, the issuer delivers
40 common shares. If the stock price is less than
$20, the issuer delivers 50 common shares. If the
stock price is between $20 and $25 (the “dead
zone”), the issuer delivers a variable number of
common shares equal in value to $1,000.
The issuer should evaluate whether
dead-zone conversion (i.e., delivering common shares
equal in value to a fixed monetary amount of $1,000)
is the predominant settlement outcome. If it is, the
issuer must classify the preferred stock as a
liability under ASC 480-10-25-14(a). In evaluating
whether an outcome in the dead zone is predominant,
the issuer considers the expected growth rate of,
and expected variability in, the price of its common
stock. If all else is unchanged, the smaller the
price range in which dead-zone conversion will be
triggered, the more likely the stock price will be
outside of the dead zone at settlement. If dead-zone
conversion is not the predominant settlement
outcome, the preferred stock would not be classified
as a liability under ASC 480-10.
6.2.4.2 Warrant With Share-Settleable Put
ASC 480-10
55-44 In an instrument that
allows the holder either to purchase a fixed number
of the issuer’s shares at a fixed price or to compel
the issuer to reacquire the instrument at a fixed
date for shares equal to a fixed monetary amount
known at inception, the holder’s choice will depend
on the issuer’s share price at the settlement date.
The issuer must analyze the instrument at inception
and consider all possible outcomes to judge which
obligation is predominant. To do so, the issuer
considers all pertinent information as applicable,
which may include its current stock price and
volatility, the strike price of the instrument, and
any other factors. If the issuer judges the
obligation to issue a variable number of shares
based on a fixed monetary amount known at inception
to be predominant, the instrument is a liability
under paragraph 480-10-25-14. Otherwise, the
instrument is not a liability under this Subtopic
but is subject to other applicable guidance such as
Subtopic 815-40.
55-45 Entity C issues a
puttable warrant to Holder. The warrant feature
allows Holder to purchase 1 equity share at a strike
price of $10 on a specified date. The put feature
allows Holder instead to put the warrant back to
Entity C on that date for $2, settleable in
fractional shares. If the share price on the
settlement date is greater than $12, Holder would be
expected to exercise the warrant, obligating Entity
C to issue a fixed number of shares in exchange for
a fixed amount of cash; the monetary value of the
shares varies directly with changes in the share
price above $12. If the share price is equal to or
less than $12, Holder would be expected to put the
warrant back to Entity C obligating the entity to
issue a variable number of shares with a fixed
monetary value, known at inception, of $2. Thus, at
inception, the number of shares that the puttable
warrant obligates Entity C to issue can vary, and
the financial instrument must be examined under
paragraph 480-10-25-14.
55-46 The facts and
circumstances should be considered in judging
whether the monetary value of the obligation to
issue a number of shares that varies is
predominantly based on a fixed monetary amount known
at inception; if so, it is a liability under
paragraph 480-10-25-14(a). For example, if the
following circumstances existed, they would suggest
that the monetary value of the obligation to issue
shares would be judged to be based predominantly on
a fixed monetary amount known at inception ($2 worth
of shares), and the instrument would be classified
as a liability:
- Entity C’s share price is well below the $10 exercise price of the warrant at inception of the instrument.
- The warrant has a short life.
- Entity C’s stock is determined to have very low volatility.
The example in ASC 480-10-55-44 through 55-46 illustrates
the issuer’s assessment of predominance in connection with a freestanding
financial instrument that consists of multiple component obligations. The
financial instrument in that example contains (1) a warrant on own equity
that allows the holder to purchase a fixed number of the issuer’s shares at
a fixed price and (2) a share-settled put option that permits the holder to
put the instrument on a specified date for a fixed monetary amount
settleable in a variable number of shares.
The instrument is not subject to ASC 480-10-25-4 because it
does not represent an outstanding share. It is also not subject to ASC
480-10-25-8 because it neither requires nor may require the issuer to
transfer assets. In analyzing the instrument at inception, the issuer
concludes that the instrument contains two component obligations that the
issuer must consider in determining whether ASC 480-10-25-14 applies:
-
A conditional obligation to deliver a fixed number of shares if the holder exercises the warrant.
-
A conditional obligation to issue a variable number of shares if the holder puts the instrument back to the issuer.
The first obligation does not cause the instrument to be
within the scope of ASC 480-10-25-14 because it does not involve the
delivery of a variable number of shares. However, the second obligation
would be classified as a liability under ASC 480-10-25-14(a) if it were
freestanding since it involves the delivery of a variable number of shares
worth a fixed monetary amount. Accordingly, the issuer must assess whether
the second obligation is predominant (relative to the first) and, if it is,
must classify the entire instrument as a liability under ASC
480-10-25-14(a).
In this scenario, the actual settlement outcome will depend
on the warrant’s exercise price and the price of the issuer’s equity shares
on the settlement date because those factors will affect whether the holder
elects to exercise the warrant or put it back to the issuer for a variable
number of shares. In assessing whether the component obligation to deliver a
variable number of shares worth a fixed monetary amount is predominant at
inception, the issuer considers factors such as the relationship between the
current stock price and the warrant strike price, expected stock price
growth, expected stock price volatility, and the time to expiration of the
warrant. If the stock price is significantly lower than the strike price,
the stock price volatility is very low, and the warrant term is short, the
likelihood increases that the issuer will determine that the obligation to
issue a variable number of shares if the holder puts the instrument back to
the issuer is predominant relative to the obligation to deliver a fixed
number of shares if the holder exercises the warrant. If the obligation to
deliver a variable number of shares worth a fixed monetary amount is judged
not to be predominant relative to the obligation to deliver a fixed number
of shares, the entire instrument is outside the scope of ASC 480-10 and is
evaluated under other GAAP, including ASC 815-40.
6.2.4.3 Warrant With Share-Settleable Make-Whole Put
ASC 480-10
55-47 Entity E issues a
warrant to Holder allowing Holder to purchase 1
equity share at a strike price of $10. The warrant
has an embedded liquidity make-whole put that
entitles Holder to receive from Entity E the net
amount of any difference between the share price on
the date the warrants are exercised and the sales
price the holder receives when the shares are later
sold. The make-whole provision is not legally
detachable. Entity E can settle by issuing a
variable number of shares. For example, if on the
date Holder exercises the warrant, the share price
is $15 and the share price subsequently decreases to
$12 at the date Holder sells the shares, Holder
would receive $3 worth of equity shares from Entity
E.
55-48 The financial
instrument embodies an obligation to deliver a
number of shares that varies-either a fixed number
of shares under exercise of the warrant or
additional shares if the share price declines after
the warrant is exercised. However, unless it is
judged that the possibility of having to issue a
variable number of shares with a monetary value that
is inversely related to the share price is
predominant, the financial instrument is not in the
scope of paragraph 480-10-25-14(c) and would be
evaluated under Subtopic 815-40.
ASC 480-10-55-47 and 55-48 illustrate the issuer’s
assessment of predominance in connection with a freestanding financial
instrument that contains multiple component obligations. The financial
instrument contains (1) a warrant on own equity that allows the holder to
purchase a fixed number of the issuer’s shares at a fixed price and (2) a
net-share-settled make-whole provision that gives the holder the right to
compensation for any loss it incurs if it subsequently sells the shares it
receives upon the exercise of the warrants at a price lower than the stock
price on the warrant exercise date.
This instrument is not subject to ASC 480-10-25-4 because it
does not represent an outstanding share. It is also not subject to ASC
480-10-25-8 because it neither requires nor may require the issuer to
transfer assets. In analyzing this instrument at inception to determine
whether ASC 480-10-25-14 applies, the issuer concludes that the instrument
contains two component obligations that must be considered:
-
A conditional obligation to deliver a fixed number of shares if the holder exercises the warrant.
-
A conditional obligation to issue a variable number of shares if the holder sells the shares it receives upon exercise of the warrants at a price lower than the stock price on the warrant exercise date.
The first conditional obligation does not cause the
instrument to be within the scope of ASC 480-10-25-14 because it does not
involve the delivery of a variable number of shares. However, the second
conditional obligation would be classified as a liability under ASC
480-10-25-14(c) if it were freestanding since it involves the delivery of a
variable number of shares with a monetary value that is inversely related to
the issuer’s stock price. Accordingly, the issuer must assess whether the
second obligation is predominant (relative to the first). If it is, the
issuer must classify the entire instrument as a liability under ASC
480-10-25-14(c). If the second obligation is not predominant, the entire
instrument is outside the scope of ASC 480-10 and is evaluated under other
GAAP, including ASC 815-40. (The guidance in ASC 815-40-25-30 suggests that
a make-whole provision would not cause a contract to be classified as an
asset or a liability under ASC 815-40 if the provision can be net share
settled and the maximum number of shares that could be required to be
delivered under the contract, including the make-whole provision, is both
fixed and less than the number of available and authorized shares. See
Section 5.3.6 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity.)
6.2.4.4 Variable-Share Forward Sales Contracts
ASC 480-10
55-50 Entity D enters into a
contract to issue shares of Entity D’s stock to
Counterparty in exchange for $50 on a specified
date. If Entity D’s share price is equal to or less
than $50 on the settlement date, Entity D will issue
1 share to Counterparty. If the share price is
greater than $50 but equal to or less than $60,
Entity D will issue $50 worth of fractional shares
to Counterparty. Finally, if the share price is
greater than $60, Entity D will issue .833 shares.
At inception, the share price is $49. Entity D has
an obligation to issue a number of shares that can
vary; therefore, paragraph 480-10-25-14 may apply.
However, unless it is determined that the monetary
value of the obligation to issue a variable number
of shares is predominantly based on a fixed monetary
amount known at inception (as it is in the $50 to
$60 share price range), the financial instrument is
not in the scope of this Subtopic.
Variable-share forward (VSF) contracts are frequently issued
as a component of a unit offering that consists of a separable (1) debt
security and (2) the VSF. A VSF can bear various acronyms, depending on the
underwriter, including PRIDES, FELINE PRIDES, PEPS, and DECS. The contract
has different settlement outcomes depending on the price of the issuer’s
common stock as of the date it settles.
Example 6-5
Variable-Share-Settled Forward Contract — Range of
Monetary Values
The terms of a VSF are as follows:
- The per-share fair value of the issuer’s common stock at the inception of the contract is $100.
- On a stipulated fixed date in the future, the counterparty is required to pay the share issuer $100 in exchange for a variable number of shares of the issuer’s common stock.
- The variable number of shares is based on the fair value of the issuer’s common stock on the date the contract settles, as shown in the table below.
- The counterparty cannot compel the issuer to settle on a net cash basis, and the contract complies with the requirements of ASC 815-40-25-10 to be accounted for as an equity instrument (thus, the VSF is accounted for as an equity instrument unless it must be classified outside of equity under ASC 480-10).
Share settlement
amounts are as follows:
Company Stock Price at
Contract Settlement Date
|
Number of Common Shares
Forward Counterparty Receives
|
Observations
|
---|---|---|
Below $100 | One share of stock | The counterparty is exposed to
declines in the price of the issuer’s stock below
$100 |
Above $100 but below
$120 | A number of shares equal in value
to $100 | The counterparty neither benefits
nor loses as the price of the common stock
changes |
$120 and above | 0.8333 shares | The counterparty participates in
a portion of the appreciation of the issuer’s
stock above $120* |
* For example,
assume that the stock price closes at $135 per
share on the date the contract settles. The
counterparty will receive 0.8333 shares, worth
$112.50, in exchange for $100. The counterparty
only partially participated in the $15
appreciation above the upper limit of the original
range. |
As the table
indicates, the VSF is a hybrid instrument whose
components consist of (from the issuer’s
perspective) (1) a purchased put option on its own
shares, (2) an agreement to issue shares at fair
value, and (3) a written call option on its own
shares.
Under ASC 480-10-25-14(a), contracts that require the issuance of a variable
number of shares worth a fixed dollar amount are
accounted for as assets or liabilities. Under
certain scenarios, a VSF requires this type of
settlement (in the example above, if the price of
one share of the issuer’s common stock is between
$100 and $120 on the contract settlement date, the
issuer receives a fixed amount of cash [$100] and
delivers a variable number of shares that have a
monetary value equal to $100).
When the VSF settles within the
range, the company will issue a variable number of
shares equal to a fixed monetary amount. An
instrument that consists entirely of this
characteristic is a liability. If an instrument
embodies such an obligation (as does the VSF
described in this example), it is an asset or a
liability according to ASC 480-10 when the
possibility of settling within the range is
predominant (see ASC 480-10-55-51).
There are two possible outcomes for a VSF that has terms
similar to those in Example 6-5: (1)
it can be settled in a manner consistent with equity treatment (above or
below the specified range) or (2) it can be settled in a manner consistent
with ASC 480-10 asset or liability treatment (within the specified range).
Accordingly, if at the inception of the contract it is more likely than not
that the VSF will settle within the specified range, the VSF should be
accounted for as an asset or a liability.
Factors that an issuer should consider in evaluating the
likelihood of a VSF’s outcomes include:
- The terms of the VSF, including its maturity date and the formula for adjustments to the range.
- The volatility of the underlying stock.
- The relationship between the price of the common stock on the date the VSF is entered into and the low and high end of the original range.
- Historical and expected dividend levels.
When evaluating the likelihood of a VSF’s outcomes, an
issuer may want to engage a third-party valuation specialist to help with
quantitative determinations.
Other financial instruments may incorporate features that
are similar to those of a VSF, such as a mandatorily convertible preferred
stock in which the conversion feature is settled in (1) a fixed number of
common shares if the price of the issuer’s common share on the settlement
date is above a ceiling price per share or below a floor price per share or
(2) a variable number of shares equal to the face amount of the convertible
preferred stock if the price of the issuer’s common share on the settlement
date is between the ceiling and the floor price per share. To evaluate
whether such instruments are liabilities or equity under ASC 480-10, the
issuer should apply the same guidance as that on VSFs. Accordingly, if it is
more likely than not that the mandatorily convertible preferred stock will
convert within the variable-share range, it should be classified as a
liability under ASC 480-10-25-14.
6.2.5 Financial Instruments With Contingent Obligation
6.2.5.1 Outstanding Shares
ASC 480-10 only applies to outstanding shares that embody
unconditional obligations that fall within the scope of either ASC
480-10-25-4 or ASC 480-10-25-14. Accordingly, an outstanding share that
embodies an obligation that is contingent on the occurrence or nonoccurrence
of an uncertain future event would not be within the scope of ASC 480-10.
An outstanding share may contain both (1) a conditional
obligation to deliver a variable number of shares whose monetary value is
based on one of the factors in ASC 480-10-25-14 (i.e., a fixed monetary
amount, variations in something other than the fair value of the issuer’s
equity shares, or variations inversely related to changes in the fair value
of the issuer’s equity shares) and (2) a conditional obligation to
repurchase the share for cash or other assets. Even though those conditional
obligations would individually be outside the scope of ASC 480-10, the
outstanding share would be classified as a liability under ASC 480-10 if the
obligations in combination represent an unconditional obligation to
repurchase the shares by either transferring assets or issuing a variable
number of shares in accordance with one of the factors in ASC 480-10-25-14
(see ASC 480-10-55-28 for analogous guidance). For example, an outstanding
share would be classified as a liability if the obligations are contingent
upon the occurrence or nonoccurrence of the same event (e.g., an obligation
to repurchase an outstanding share for cash if an IPO occurs and an
obligation to repurchase the share in exchange for a variable number of
shares worth a fixed monetary amount if an IPO does not occur).
Alternatively, a preferred share with a stated redemption date on which it
will be settled in a fixed monetary amount of cash may include an option for
the issuer to settle the share instead by delivering a variable number of
common shares equal in value to the fixed monetary amount. That preferred
share would be classified as a liability under ASC 480-10 since the
obligations in combination represent an unconditional obligation to
repurchase the shares by either transferring assets or issuing a variable
number of shares worth a fixed monetary amount.
However, for the outstanding share to be classified as a
liability under ASC 480, each individual obligation would need to meet the
criteria for liability classification under ASC 480-10-25-4 or ASC
480-10-25-14 on the basis of an assumption that it was individually
unconditional. That is, an outstanding share with multiple embedded
obligations would not be classified as a liability even if the obligations
in combination represent an unconditional obligation to repurchase the
shares by either transferring assets or issuing a variable number of shares
in a circumstance in which the variable-share obligation does not meet the
criteria for liability classification in ASC 480-10-25-14.
Example 6-6
Redeemable Convertible Preferred Stock — Fixed and
Variable Conversion Features
Entity A has issued preferred stock for $1,000 that
has a stated redemption date of 10 years, at which
time A must redeem the stock for cash or other
assets. The preferred stock contains an automatic
conversion feature under which the preferred stock
is exchanged for A’s shares of common stock upon an
IPO. The conversion rate has both a fixed and
variable component; upon any conversion, A must
deliver a fixed number of shares, subject to a floor
on the fair value of the shares delivered that is
equal to $1,000 as of the date of conversion. Thus,
if the fair value of the fixed number of shares that
is required to be delivered upon a conversion is
less than $1,000, A must deliver an additional
number of shares so that the aggregate fair value of
the shares delivered equals $1,000. Under ASC 480, A
must determine at inception whether it is more
likely than not that it would deliver a variable
number of shares worth a fixed monetary amount of
$1,000 if a conversion were to occur at any time
before the stated redemption date. In other words, A
would assess whether its obligation to deliver a
variable number of shares worth a fixed monetary
amount is predominant (see Section
6.1.1.3), assuming that an automatic
conversion occurred because of an IPO. Entity A
would classify the preferred stock as a liability
under ASC 480 only if the obligation to deliver
shares worth a fixed monetary amount was
predominant, assuming that an IPO were to occur.
6.2.5.2 Instruments Other Than Outstanding Shares
ASC 480-10
55-49 If exercisability of a
feature into a fixed or variable number of shares is
contingent on both the occurrence or nonoccurrence
of a specified event and the issuer’s share price, a
financial instrument settleable in a number of
shares that can vary should be analyzed following
the same method as for the examples in paragraphs
480–10–55–45 and 480-10-55-50 to consider all
possibilities. In some cases, it may be determined
that the instrument may not be within the scope of
paragraph 480-10-25-14 and thus not a liability
under this Subtopic. That determination depends on
whether the obligation to deliver a variable number
of shares, with a monetary value based on either a
fixed monetary amount known at inception or an
inverse relationship with the share price, is
predominant at inception.
55-52 Entity F has a
share-settleable puttable warrant that provides that
the put feature is exercisable only if Entity F
fails to accomplish an operational plan (for
example, failure to complete a building within two
years). If at inception the possibility that both
the building will not be completed in two years and
the put will be exercised is judged to be
predominant, the put warrant would be recognized as
a liability under paragraph
480-10-25-14(a).
If a financial instrument other than an outstanding share
contains more than one obligation, and one of those obligations is
contingent on the occurrence or nonoccurrence of a specified event as well
as the issuer’s stock price, the analysis of whether ASC 480-10-25-14
applies is similar to that for other instruments that embody multiple
obligations (see Section
6.2.4). In assessing whether a contingent obligation to
deliver a variable number of shares whose monetary value is based on one of
the factors in ASC 480-10-25-14 is predominant, the issuer would consider
the contingency’s likelihood of being met by assessing it separately from
any other factors that may affect the settlement outcome. If the issuer
determines that ASC 480-10 does not apply, the contract would be evaluated
under ASC 815-40.
6.2.6 Obligations With Settlement Alternatives
Some obligations give one of the parties the choice of whether
the obligation will be settled by the issuer’s transfer of assets or by its
issuance of shares. In these circumstances, the issuer should determine whether
ASC 480-10-25-4, ASC 480-10-25-8, or ASC 480-10-25-14 takes precedence in the
assessment of whether the contract must be accounted for outside of equity.
6.2.6.1 Issuer Choice
If a financial instrument in the form of a share embodies an
unconditional redemption obligation, and the issuer has a choice of settling
the obligation by either transferring assets or delivering a variable number
of nonredeemable shares of equal value, the instrument should be assessed as
a variable-share obligation under ASC 480-10-25-14 rather than as a
mandatorily redeemable financial instrument under ASC 480-10-25-4. Such an
instrument does not meet the definition of a mandatorily redeemable
financial instrument because the issuer has no unconditional obligation to
transfer assets.
Example 6-7
Redeemable Preferred Share — Issuer Choice to
Settle in Cash or Shares
An outstanding preferred share contains an unconditional obligation that
requires the issuer to redeem the share for a fixed
monetary amount (e.g., $100,000) on a specified
date. The issuer has the option to settle the
obligation by either transferring cash or delivering
a variable number of equity shares equal in value to
the fixed monetary amount on the settlement date.
The share would be evaluated under ASC 480-10-25-14
rather than ASC 815-40-25-4 because the issuer does
not have an unconditional obligation to transfer
assets. In this example, the instrument is a
liability under ASC 480 even though it does not
represent a mandatorily redeemable financial
instrument. If, however, the obligation involving
the delivery of a variable number of shares was not
solely or predominantly based on a fixed monetary
amount, on variations in something other than the
fair value of the issuer’s equity shares, or on
variations inversely related to changes in the fair
value of the issuer’s equity shares, classification
of the instrument as a liability under ASC 480 would
not be required.
If a financial instrument other than an outstanding share
embodies a conditional or unconditional obligation to repurchase shares (or
is indexed to such an obligation), and the issuer has a choice of settling
the obligation by either transferring assets or delivering a variable number
of nonredeemable equity shares of equal value, the instrument should be
assessed as a variable-share obligation under ASC 480-10-25-14 rather than
as an obligation to repurchase shares by transferring assets under ASC
480-10-25-8. However, the instrument would still be a liability under ASC
480-10-25-14 because the monetary value of the shares delivered on
settlement is based on variations that are inversely related to changes in
the fair value of the issuer's equity shares.
Paragraph B48 of the Background Information and Basis for Conclusions of FASB Statement 150 states:
Certain financial instruments embody obligations
that permit the issuer to determine whether it will settle
the obligation by transferring assets or by issuing equity shares.
Because those obligations provide the issuer with discretion to
avoid a transfer of assets, the Board concluded that those
obligations should be treated like obligations that require
settlement by issuance of equity shares. That is, the Board
concluded that this Statement should require liability
classification of obligations that provide the issuer with the
discretion to determine how the obligations will be settled if, and
only if, the conditions in [ASC 480-10-25-14] related to changes in
monetary value are met.
If a financial instrument embodying an obligation to
repurchase shares gives the issuer a choice of settling the obligation by
transferring either assets or a fixed number of nonredeemable equity shares,
the instrument is outside the scope of ASC 480-10 because it embodies
neither an obligation to transfer assets nor an obligation to deliver a
variable number of shares.
6.2.6.2 Counterparty Choice
If a financial instrument in the form of a share embodies an
unconditional redemption obligation, and the holder has a choice of
requiring the issuer to settle the redemption obligation by transferring
either assets or a variable number of shares of equal value, the instrument
should be assessed as a variable-share obligation under ASC 480-10-25-14
rather than as a mandatorily redeemable financial instrument because the
issuer does not have an unconditional obligation to transfer assets. In
accordance with ASC 480-10-55-28, such a share would be classified as a
liability under ASC 480-10 if the issuer has an unconditional obligation
that may require the issuance of a variable number of shares on the basis of
one of the factors in ASC 480-10-25-14.
If the share instead gave the holder a choice of requiring
the issuer to repurchase the share by transferring either assets or a fixed
number of equity shares, the share would fall outside the scope of ASC
480-10 because it embodies neither an unconditional obligation to transfer
assets nor an obligation to deliver a variable number of shares.
If a financial instrument other than an outstanding share
embodies a conditional or unconditional obligation to repurchase shares (or
is indexed to such an obligation), and the holder has the choice of
requiring the issuer to settle the redemption obligation by transferring
either assets or a variable number of shares of equal value, the issuer
should assess the contract under ASC 480-10-25-8. Such a contract would not
be analyzed as a variable-share obligation under ASC 480-10-25-14 because
the issuer could be forced to settle it by transferring assets depending on
the holder’s settlement election. If the financial instrument instead gave
the holder a choice of assets or a fixed number of shares, the instrument
would still be assessed under ASC 480-10-25-8 because it embodies an
obligation that may require the entity to transfer assets.
6.2.6.3 Summary
The following table summarizes the analysis under ASC 480-10
of financial instruments embodying obligations to repurchase shares that
give either the issuer or the holder a choice of settlement in assets or
nonredeemable equity shares.
Issuer Choice | Counterparty Choice | |
---|---|---|
Settlement
Alternatives — Transfer of Assets or Variable Number
of Nonredeemable Equity Shares | ||
Outstanding share | Evaluate as variable-share obligation under ASC
480-10-25-14 | Evaluate as variable-share obligation under ASC
480-10-25-14 |
Financial instrument other than an outstanding
share | Evaluate as variable-share obligation under ASC
480-10-25-14 | Evaluate as an obligation to repurchase shares by
transferring assets under ASC
480-10-25-8 |
Settlement
Alternatives — Transfer of Assets or Fixed Number of
Nonredeemable Equity Shares | ||
Outstanding share | Outside scope of ASC 480-10 | Outside scope of ASC 480-10-25 |
Financial instrument other than an outstanding
share | Outside scope of ASC 480-10 | Evaluate as an obligation to repurchase shares by
transferring assets under ASC
480-10-25-8 |
6.2.6.4 Illustration
ASC 480-10
55-27 Some instruments do not
require the issuer to transfer assets to settle the
obligation but, instead, unconditionally require the
issuer to settle the obligation either by
transferring assets or by issuing a variable number
of its equity shares. Because those instruments do
not require the issuer to settle by transfer of
assets, those instruments are not within the scope
of paragraphs 480-10-25-4 through 25-6. However,
those instruments may be classified as liabilities
under paragraph 480-10-25-14.
55-28 For example, an entity
may issue 1 million shares of cumulative preferred
stock for cash equal to the stock’s liquidation
preference of $25 per share. The entity is required
either to redeem the shares on the fifth anniversary
of issuance for the issuance price plus any accrued
but unpaid dividends in cash or to settle by issuing
sufficient shares of its common stock to be worth
$25 per share. Preferred stockholders are entitled
to a mandatory dividend, payable quarterly at a rate
of 6 percent per annum based on the $25 per share
liquidation preference ($1.50 per share annually).
The dividend is cumulative and is payable in cash or
in a sufficient number of additional shares of the
preferred stock based on the liquidation preference
of $25 per share. That obligation does not represent
an unconditional obligation to transfer assets and,
therefore, is not a mandatorily redeemable financial
instrument subject to paragraph 480-10-25-4. But it
is still a liability, under paragraph
480-10-25-14(a), because the preferred shares embody
an unconditional obligation that the issuer may
settle by issuing a variable number of its equity
shares with a monetary value that is fixed and known
at inception. Because the preferred shares are
liabilities, payments to holders are reported as
interest cost, and accrued but not-yet-paid payments
are part of the liability for the shares.
6.2.7 Financial Instruments That Embody Both Rights and Obligations
ASC
480-10
55-26 . . . A net written or
net purchased option or a zero-cost collar similar to
the examples in paragraphs 480-10-55-18 through 55-20
that must or may be net share settled is classified as a
liability (or asset) under paragraph 480-10-25-14(c),
because the monetary value of the issuer’s obligation to
deliver a variable number of shares under the written
put option varies inversely in relation to changes in
the fair value of the issuer’s share price. The
purchased call option element of that freestanding
instrument does not embody an obligation to deliver a
variable number of shares and does not affect the
classification of the entire instrument when applying
that paragraph. In addition, a freestanding purchased
call option is not within the scope of this Subtopic
because it does not embody an obligation.
In assessing whether ASC 480-10-25-14 applies, an issuer
considers only terms and features that represent obligations (e.g., forward
obligations and written options). Issuer rights that could not require the
transfer of assets or equity shares do not affect the accounting analysis.
Accordingly, an issuer does not assess predominance among the potential
settlement outcomes for a share-settled instrument that embodies only one
obligation, even if the instrument has other potential settlement outcomes that
could result in the issuer’s receipt of assets or equity shares because of
issuer rights.
For a freestanding financial instrument such as a
net-share-settled collar that contains both a purchased call option that could
result in the issuer’s receipt of assets or equity shares and a written put
option that could result in the issuer’s delivery of assets or equity shares,
the purchased call option component does not affect the analysis under ASC
480-10-25-14. Instead, the written put option component causes the entire
instrument to be classified as a liability (or as an asset in some
circumstances) under ASC 480-10-25-14. Such accounting applies even if the fair
value of the purchased option component equals or exceeds the written option
component so that the collar represents a zero-cost collar or a net-purchased
option on the issuer’s own stock.
6.3 Accounting
ASC 480-10
30-7 All other financial instruments recognized under the guidance in Section 480-10-25 shall be measured initially at fair value.
35-1 Financial instruments within the scope of Topic 815 shall be measured subsequently as required by the provisions of that Topic.
35-4A Contingent consideration issued in a business combination that is classified as a liability in accordance with the requirements of this Topic shall be subsequently measured at fair value in accordance with 805-30-35-1.
35-5 All other financial instruments recognized under the guidance in Section 480-10-25 shall be measured subsequently at fair value with changes in fair value recognized in earnings, unless either this Subtopic or another Subtopic specifies another measurement attribute.
55-17 In contrast to forward
purchase contracts that require physical settlement in
exchange for cash, forward purchase contracts that require
or permit net cash settlement, require or permit net share
settlement, or require physical settlement in exchange for
specified quantities of assets other than cash are measured
initially and subsequently at fair value, as provided in
paragraphs 480-10-30-2, 480-10-30-7, 480-10-35-1, and
480-10-35-5 (as applicable), and classified as assets or
liabilities depending on the fair value of the contracts on
the reporting date.
A financial instrument that must be accounted for as an asset or a liability
under ASC 480-10-25-14 is initially and subsequently measured at fair value, with
changes in fair value recognized in earnings unless a different accounting treatment
is permitted or required by other GAAP (e.g., share-settled debt that is accounted
for at amortized cost by using the interest method in accordance with ASC
835-30).
Unless the fair value option in ASC 825-10 is elected, share-settled debt1 whose monetary value represents a fixed or predominantly fixed monetary amount should be accounted for at amortized cost in accordance with the interest method in ASC 835-30. As noted in paragraph B13 of the Background Information and Basis for Conclusions of FASB Statement 150, “a financial instrument that requires settlement
by issuance of $100,000 worth of equity shares establishes something more akin to a
debtor-creditor relationship than to an ownership relationship.” Further, the last
sentence of ASC 480-10-55-22 (i.e., upon “issuance of the shares to settle the
obligation, equity is increased by the amount of the liability and no gain or loss
is recognized for the difference between the average and the ending market price”)
implicitly acknowledges that a fixed-monetary-value share-settled debt arrangement
is not required to be measured at fair value through earnings. The paragraph
provides guidance on whether a gain or loss should be recognized related to the
difference between the average and ending market price upon the settlement of a
share-settled debt arrangement for which the number of shares that will be delivered
is determined on the basis of an average stock price as opposed to the ending stock
price. Had the instrument in ASC 480-10-55-22 been measured on an ongoing basis at
fair value (i.e., on the basis of a current stock price), there should have been no
difference to address at settlement after the issuer had updated its prior fair
value estimate.
Example 6-8
Variable-Share-Settled Obligation — Fixed Monetary
Amount
In October 20X0, Issuer T issued an obligation to deliver a variable number of its equity shares to Entity K, which can elect to require settlement of the obligation at any time starting in January 20X1. The obligation is not in the form of an outstanding share. Upon settlement, T will issue a variable number of shares of its common stock that has a fair value equal to $20 million. The fair value of common stock will be determined on the basis of the weighted average price of the common stock for the 20 consecutive trading days preceding settlement. The obligation is classified as a liability under ASC 480-10-25-14 because the monetary value of its settlement amount is predominantly fixed and the obligation is not in the form of an outstanding share. Company T determines that it would be appropriate to account for the obligation as share-settled debt at amortized cost since the obligation is repayable on demand at a predominantly fixed monetary amount.
On January 15, 20X1, K exercised its option to demand settlement. Company T issued 225,000 shares of common stock, which had a fair value of approximately $25 million measured on the basis of the current stock price on the settlement date. The excess of the fair value of the common stock over the $20 million carrying amount of the liability was the result of an increase in the common stock price during the averaging period. That is, the weighted average stock price for the 20 days in the averaging period was less than the current stock price at settlement. In a manner consistent with ASC 480-10-55-22, T should not recognize a loss for the excess of the current fair value of the common shares delivered at settlement over the $20 million carrying amount of the liability for the obligation.
Footnotes
1
In this Roadmap, the term “share-settled debt” is used to
describe a share-settled obligation that is not in the legal form of debt
but has the same economic payoff profile as debt. Financial instruments that
are in the legal form of debt are outside the scope of ASC 480-10 (see
Section
2.2.4).
6.4 Reassessment
Under ASC 480-10-25-14, an entity assesses whether an obligation has a monetary value that is based either solely or predominantly on a fixed monetary amount, on variations in something other than the fair value of the issuer’s equity shares, or on variations inversely related to changes in the fair value of the issuer’s equity shares. Such assessment is performed only at inception or upon a modification that is treated as a new instrument for accounting purposes (e.g., as a result of a modification or exchange that is accounted for as an extinguishment of the existing instrument; see ASC 470-50). There is no subsequent reassessment of whether the monetary value is based solely or predominantly on one of those factors. Further, as discussed in Section 3.2.1, the issuer does not reassess whether a feature is nonsubstantive or minimal after inception.
Example 6-9
Variable-Share-Settled Obligation — Number of Shares
Becomes Fixed
On January 1, 20X0, Issuer W issued an obligation to deliver
a variable number of its equity shares to Entity M.
Significant terms of the obligation are as follows:
- The number of shares to be issued depends on specified revenue targets achieved by a nonconsolidated joint venture that is owned equally by W and M.
- The number of shares issuable will be determined at the end of 20X2 on the basis of the revenue targets achieved for the two years ending December 31, 20X2, and W’s weighted average stock price for the 30-day period ending December 31, 20X2.
- Issuer W is obligated to issue the shares owed to M on December 31, 20X3. This delayed delivery exists as a result of a regulatory ownership restriction.
At the inception of the contract, W determined that it was
required to classify the share-issuance obligation as a
liability under ASC 480-10-25-14. Although the number of
shares issuable became fixed on December 31, 20X2, W is not
permitted to reclassify the liability amount into equity
because the monetary value of a variable-share settled
obligation may only be assessed at the contract’s inception.
Chapter 7 — Certain Option Combinations
Chapter 7 — Certain Option Combinations
This chapter discusses the special accounting requirements in ASC 480-10 related to certain option combinations involving noncontrolling interests (see Section 7.1) and the illustrations in ASC 480-10 of the application of its requirements to certain option combinations (see Section 7.2).
7.1 Certain Transactions Involving Noncontrolling Interests
ASC 480-10
55-53 A controlling majority owner (parent) holds 80 percent of a subsidiary’s equity shares. The remaining 20 percent (the noncontrolling interest) is owned by an unrelated entity (the noncontrolling interest holder). Simultaneous with the acquisition of the noncontrolling interest, the noncontrolling interest holder and the parent enter into a derivative instrument that is indexed to the subsidiary’s equity shares. The terms of the derivative instrument may be any of the following:
- The parent has a fixed-price forward contract to buy the other 20 percent at a stated future date. (Derivative 1)
- The parent has a call option to buy the other 20 percent at a fixed price at a stated future date, and the noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those same terms, that is, the fixed price of the call is equal to the fixed price of the put option. (Derivative 2)
- The parent and the noncontrolling interest holder enter into a total return swap. The parent will pay to the counterparty (initially the noncontrolling interest holder) an amount computed based on the London Interbank Offered Rate (LIBOR), plus an agreed spread, plus, at the termination date, any net depreciation of the fair value of the 20 percent interest since inception of the swap. The counterparty will pay to the parent an amount equal to dividends paid on the 20 percent interest and, at the termination date, any net appreciation of the fair value of the 20 percent interest since inception of the swap. At the termination date, the net change in the fair value of the 20 percent interest may be determined through an appraisal or the sale of the stock. (Derivative 3)
55-54 If the terms correspond with Derivative 1, the forward purchase contract that requires physical settlement by repurchase of a fixed number of shares (the noncontrolling interest) in exchange for cash is recognized as a liability, initially measured at the present value of the contract amount; the noncontrolling interest is correspondingly reduced. Subsequently, accrual to the contract amount and any amounts paid or to be paid to holders of those contracts are reflected as interest cost. In effect, the parent accounts for the transaction as a financing of the noncontrolling interest and, consequently, consolidates 100 percent of the subsidiary.
55-55 Depending on how
Derivative 2 was issued, one of three different accounting
methods applies. If Derivative 2 was issued as a single
freestanding instrument, under this Subtopic it would be
accounted for in its entirety as a liability (or an asset in
some circumstances), initially and subsequently measured at
fair value. If the written put option and the purchased call
option in Derivative 2 were issued as freestanding
instruments, the written put option would be accounted for
under this Subtopic as a liability measured at fair value,
and the purchased call option would be accounted for under
Subtopic 815-40. Under both of those situations, the
noncontrolling interest is accounted for separately from the
derivative instrument under applicable guidance. However, if
the written put option and purchased call option are
embedded in the shares (noncontrolling interest) and the
shares are not otherwise classified as liabilities under the
guidance in this Subtopic, the instrument shall be accounted
for as discussed in paragraph 480-10-55-59 with the parent
consolidating 100 percent of the subsidiary.
55-56 If the terms correspond with Derivative 3, the total return swap is indexed to an obligation to repurchase the issuer’s shares and may require the issuer to settle the obligation by transferring assets. Therefore it is in the scope of this Subtopic and is required to be accounted for as a liability (or asset in some circumstances), initially, and subsequently measured at fair value. The noncontrolling interest is accounted for separately from the total return swap.
55-57 In applying paragraphs 480-10-25-4 through 25-14 to determine classification, a freestanding financial instrument within this Subtopic’s scope is precluded from being combined with another freestanding financial instrument, unless combination is required under the provisions of Topic 815; therefore, unless under the particular facts and circumstances that Topic provides otherwise, freestanding derivative instruments in the scope of this Subtopic would not be combined with the noncontrolling interest.
55-58 This guidance is limited to circumstances in which the parent owns a majority of the subsidiary’s outstanding common stock and consolidates that subsidiary at inception of the derivative instrument. This guidance is limited to the specific derivative instruments described.
55-59 If the derivative
instrument in Derivative 2 is embedded in the shares
(noncontrolling interest) and the shares are not otherwise
classified as liabilities under the guidance in this
Subtopic, the combination of options should be viewed on a
combined basis with the noncontrolling interest and
accounted for as a financing of the parent’s purchase of the
noncontrolling interest.
55-60 Under that approach, the parent would consolidate 100 percent of the subsidiary and would attribute the stated yield earned under the combined derivative instrument and noncontrolling interest position to interest expense (that is, the financing would be accreted to the strike price of the forward or option over the period until settlement). No gain or loss would be recognized on the sale of the noncontrolling interest by the parent to the noncontrolling interest holder at the inception of the derivative instrument.
55-61 The risks and rewards of owning the noncontrolling interest have been retained by the parent during the period of the derivative instrument, notwithstanding the legal ownership of the noncontrolling interest by the counterparty. Combining the two transactions in this circumstance reflects the substance of the transactions; that the counterparty is financing the noncontrolling interest. Upon such combination, the resulting instrument is not a derivative instrument subject to Subtopic 815-10.
55-62 This accounting applies even if the exercise prices of the put and call options are not equal, as long as those exercise prices are not significantly different.
ASC 480-10 — Glossary
Noncontrolling Interest
The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.
7.1.1 Scenarios
ASC 480-10-55-53 through 55-62 contain multiple scenarios illustrating the
accounting for certain transactions that involve noncontrolling interests. Other than in
one scenario, the guidance in ASC 480-10-55-53 through 55-62 merely illustrates how to
apply ASC 480-10 and ASC 815-40. However, in the scenario in which an option combination
is embedded in the noncontrolling interest, ASC 480-10-55 contains unique requirements
that differ from other requirements in ASC 480-10 or ASC 815-40 (see Section 7.1.2).
The following table provides an overview of the scenarios in ASC 480-10-55-53 through 55-62. In each scenario, the parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary, and a third party holds the remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest). However, the parent is exposed to the risks and rewards associated with the noncontrolling interest through a forward, an option combination, or a total return swap on the noncontrolling interest that may require the issuer to pay cash.
Scenario | Parent’s Accounting |
---|---|
Derivative 1 — The parent has a fixed-price forward contract to buy the other 20 percent on a stated future date (ASC 480-10-55-53(a) and 55-54). |
|
Derivative 2 — The parent has a call option to buy the other 20 percent at a fixed price on a stated future date, and the noncontrolling interest holder has a put option to sell the other 20 percent to the parent under those same terms (ASC 480-10-55-53(b) and ASC 480-10-55-55). | The accounting depends on how Derivative 2 was structured. (see Section 7.1.2) |
Derivative 2 is issued as a single freestanding instrument (ASC 480-10-55-53(b) and ASC 480-10-55-55). |
|
The written put option and the purchased call option in Derivative 2 are issued as separate freestanding instruments (ASC 480-10-55-53(b) and ASC 480-10-55-55). |
|
The written put option and the purchased call option in Derivative 2 are embedded in the shares, and the shares are not mandatorily redeemable (ASC 480-10- 55-53(b), ASC 480-10-55-55, and ASC 480-10-55-59 through 55-62). |
|
Derivative 3 — The parent and the noncontrolling interest holder enter into a total return swap on the other 20 percent (ASC 480-10-55-53(b) and ASC 480-10-55-56). |
|
7.1.2 “Derivative 2”
7.1.2.1 Options Embedded in Noncontrolling Interest
The scenario described in ASC 480-10-55-53(b), ASC 480-10-55-55, and ASC 480-10-55-59 through 55-62 is as follows:
- The parent holds 80 percent of the subsidiary’s equity shares and consolidates the subsidiary.
- The remaining 20 percent of the subsidiary’s equity shares (the noncontrolling interest) are held by a third party.
- Simultaneously with the third party’s acquisition of the noncontrolling interest, the parent and the holder of the noncontrolling interest enter into the following option combination, which is labelled “Derivative 2” in ASC 480-10-55-53(b):
- The parent has a call option to purchase the noncontrolling interest at a fixed price on a stated future date.
- The noncontrolling interest holder has a put option to sell the noncontrolling interest to the parent under the same terms. (ASC 480-10-55-62 suggests that the exercise prices do not need to be equal as long as they are not significantly different.)
- The options are embedded in the shares representing the noncontrolling interest (i.e., they are not considered separate freestanding instruments).
- The noncontrolling interest shares do not meet the definition of a mandatorily redeemable financial instrument.
ASC 480-10-55-55 and ASC 480-10-55-59 through 55-62 require the embedded options and the noncontrolling interest in this scenario to be accounted for on a combined basis as a financing of the parent’s purchase of the noncontrolling interest. That is, the transaction is accounted for as a liability in a manner similar to a mandatorily redeemable financial instrument or a physically settled forward purchase contract on the issuer’s equity shares under ASC 480-10 even though redemption of the shares is conditional on the exercise of one or both of the options. Effectively, therefore, the guidance in ASC 480-10-55-55 and ASC 480-10-55-59 through 55-62 overrides that in ASC 480-10-55-38 through 55-40 under which shares that embed a written put option and a purchased call option with the same terms are not considered mandatorily redeemable (see Section 4.2.1).
The guidance in ASC 480-10-55-55 and ASC 480-10-55-59 through 55-62 applies
irrespective of whether the noncontrolling interest is in the form of common
stock or preferred stock. Further, it applies even if the relative ownership
interests of the parent and the holder of the noncontrolling interest differ
from the levels assumed in the scenario described in ASC 480-10 (i.e., 80
percent and 20 percent) provided that the parent owns a majority of the
subsidiary’s outstanding common stock and consolidates the subsidiary at the
inception of the arrangement (see ASC 480-10-55-58).
The liability accounting required by ASC 480-10-55-59 through 55-62 applies only to the combination of a call option and a put option on a noncontrolling interest when the options (1) are exercisable on the same future date and (2) have either the same fixed price or, as discussed in ASC 480-10-55-62, exercise prices that are not significantly different. Entities may be required to use significant judgment to determine whether the call and put options have the same fixed price. For example, if the call and put options each have an exercise price with the same fixed amount and the same adjustment for an interest component such as LIBOR, the call and put options would be considered to have the same fixed price.
However, the liability classification guidance in ASC 480-10-55-59 through 55-62
does not apply if (1) the option exercise prices are based on a formula
(e.g., EBITDA) that is not simply an indexation to interest rates or (2) the
options are contingent on the satisfaction of certain conditions. ASC
480-10- 55-61 discusses the FASB’s rationale for the liability accounting
required under ASC 480-10-55-59 through 55-62 and states, in part:
The risks and rewards of owning the noncontrolling
interest have been retained by the parent during the period of the
derivative instrument, notwithstanding the legal ownership of the
noncontrolling interest by the counterparty. Combining the two
transactions in this circumstance reflects the substance of the
transactions; that the counterparty is financing the noncontrolling
interest.
For options that have an exercise price based on EBITDA, the substance of the
transaction does not represent the parent’s financing of the purchase of the
noncontrolling interest because the purchase price continues to vary on the
basis of the subsidiary’s operating performance.
If the liability classification in ASC 480-10-55-59 through 55-62 does not apply solely because the option exercise prices are based on a formula that is not simply an indexation to interest rates, the noncontrolling interest is not considered a mandatorily redeemable financial instrument under ASC 480-10-25-4 (see Chapter 4) and is not subject to liability classification under the other provisions of ASC 480-10. Accordingly, the parent would classify the noncontrolling interest as an equity instrument. However, if the parent is an SEC registrant, the noncontrolling interest would be subject to classification and measurement in temporary equity in accordance with ASC 480-10-S99-3A (see Chapter 9).
7.1.2.2 Freestanding Options
If a parent and the holder of a noncontrolling interest
enter into put and call options on the noncontrolling interest, and either
the option combination or each option is considered to be a freestanding
financial instrument (see Section 3.3) that is separate from the noncontrolling
interest, the noncontrolling interest and the options would not be accounted
for on a combined basis as a financing of the parent’s purchase of the
noncontrolling interest. Instead, the accounting for the options depends on
whether they represent a single freestanding financial instrument (in which
case the option combination is accounted for as an asset or a liability
under ASC 480-10-25-8) or two separate freestanding financial instruments
(in which case the put option is accounted for as a liability under ASC
480-10-25-8, and the call option is evaluated under ASC 815-40). Either way,
the accounting differs from that on noncontrolling interests with embedded
options in ASC 480-10-55-59 through 55-62 because the noncontrolling
interest would be reflected in equity by the parent.
7.2 Illustrations of the Application of ASC 480-10 to Certain Option Combinations
The application of the scope provisions and the accounting requirements in ASC 480-10 depends on how an issuer’s contractual rights and obligations are aggregated or disaggregated into units of account (see Section 3.3). The guidance in ASC 480-10-55-19 and 55-20 and in ASC 480-10-55-34 through 55-37 illustrates the application of ASC 480-10 to sets of options that involve the same counterparty and are executed contemporaneously. Each freestanding financial instrument is assessed separately under ASC 480-10, whereas a freestanding financial instrument that includes multiple components is analyzed in its entirety.
ASC 480-10
Combination of Written Put Option and Purchased Call Option Issued as a Freestanding Instrument
55-18 If a freestanding financial instrument consists solely of a written put option to repurchase the issuer’s equity shares and another option, that freestanding financial instrument in its entirety is subjected to paragraphs 480-10-25-4 through 25-14 to determine if it meets the requirements to be classified as a liability.
55-19 For example, an entity may enter into a contract that requires it to purchase 100 shares of its own stock on a specified date for $20 if the stock price falls below $20 and entitles the entity to purchase 100 shares on that date for $21 if the stock price is greater than $21. That contract shall be analyzed as the combination of a written put option and a purchased call option and not as a forward contract. The written put option on 100 shares has a strike price of $20, and the purchased call option on 100 shares has a strike price of $21. If at issuance the fair value of the written put option exceeds the fair value of the purchased call option, the issuer receives cash and the contract is a net written option — a liability. If required to be physically settled, that contract is a liability under the provisions in paragraphs 480-10-25-8 through 25-12 because it embodies an obligation that may require repurchase of the issuer’s equity shares and settlement by a transfer of assets. If the issuer must or can net cash settle the contract, the contract is a liability under the provisions of those paragraphs because it embodies an obligation that is indexed to an obligation to repurchase the issuer’s equity shares and may require settlement by a transfer of assets. If the issuer must or can net share settle the contract, that contract is a liability under the provisions in paragraph 480-10-25-14(c), because the monetary value of the obligation varies inversely in relation to changes in the fair value of the issuer’s equity shares.
55-20 If, in this example, the fair value of the purchased call option at issuance exceeds the fair value of the written put option, the issuer pays out cash and the contract is a net purchased option, to be initially classified as an asset under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c). If the fair values of the two options are equal and opposite at issuance, the financial instrument has an initial fair value of zero, and is commonly called a zero-cost collar. Thereafter, if the fair value of the instrument changes, the instrument is classified as an asset or a liability and measured subsequently at fair value.
Three Freestanding Instruments
55-34 An issuer has the following three freestanding instruments with the same counterparty, entered into contemporaneously:
- A written put option on its equity shares
- A purchased call option on its equity shares
- Outstanding shares of stock.
55-35 Under this Subtopic those three contracts would be separately evaluated. The written put option is reported as a liability under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c) (depending on the form of settlement) and is measured at fair value. The purchased call option does not embody an obligation and, therefore, is not within the scope of this Subtopic. The outstanding shares of stock also are not within the scope of this Subtopic, because the shares do not embody an obligation for the issuer. Under paragraph 480-10-25-15, neither the purchased call option nor the shares of stock are to be combined with the written put option in applying paragraphs 480-10-25-4 through 25-14 unless otherwise required by Topic 815. If that Topic required the freestanding written put option and purchased call option to be combined and viewed as a unit, the unit would be accounted for as a combination of options, following the guidance in paragraphs 480-10-55-18 through 55-20.
Two Freestanding Instruments
55-36 An issuer has the following two freestanding instruments with the same counterparty entered into contemporaneously:
- A contract that combines a written put option at one strike price and a purchased call option at another strike price on its equity shares
- Outstanding shares of stock.
55-37 As required by paragraph 480-10-25-1, paragraphs 480-10-25-4 through 25-14 are applied to the entire freestanding instrument that comprises both a put option and a call option. Because the put option element of the contract embodies an obligation to repurchase the issuer’s equity shares, the freestanding instrument that comprises a put option and a call option is reported as a liability (or asset) under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c) (depending on the form of settlement) and is measured at fair value. Under paragraphs 480-10-15-3 through 15-4 and 480-10-25-1, that freestanding financial instrument is within the scope of this Subtopic regardless of whether at current prices it is a net written, net purchased, or zero-cost collar option and regardless of the form of settlement. The outstanding shares of stock are not within the scope of this Subtopic and, under paragraph 480-10-25-15, are not combined with the freestanding written put and purchased call option. (Some outstanding shares of stock are within the scope of this Subtopic, for example, mandatorily redeemable shares or shares subject to a physically settled forward purchase contract in exchange for cash.)
ASC 480-10-55-19 and 55-20, and ASC 480-10-55-35 and 55-36 contain two similar
examples of a freestanding financial instrument that consists of a combination of a
written put option and a purchased call option on own stock. The accounting analysis
of this option combination under ASC 480-10 depends on whether the issuer could be
required to settle its obligation under the written put option component by
transferring assets or may settle it by transferring a variable number of equity
shares. If the issuer could be required to settle the obligation by transferring
assets (either in a physical settlement or net in cash), the instrument is
classified as a liability (or as an asset in some circumstances) under ASC
480-10-25-8 because it is not an outstanding share and it embodies an obligation to
repurchase the issuer’s equity shares or is indexed to such an obligation (see
Chapter 5). If the
issuer must or can elect to settle the obligation by delivering a variable number of
shares, the instrument is classified as a liability (or as an asset in some
circumstances) under ASC 480-10-25-14(c) because (1) it is a financial instrument
other than an outstanding share that embodies a conditional obligation that the
issuer must or may settle by issuing a variable number of shares and (2) its
monetary value is inversely related to the issuer’s stock price (see Chapter 6). In either case,
the instrument is classified outside of equity because of the written put option
component. The purchased call option does not affect the analysis of the appropriate
classification of the instrument because the call option does not represent an
obligation of the issuer.
Although the classification analysis in these two examples focuses on the written put option component, the option combination is accounted for in its entirety since it represents a single freestanding financial instrument. For example, in the fair value measurement of the instrument, both the written put option and the purchased call option components are considered. Note, however, that the purchased call option component of the combination would have been outside the scope of ASC 480-10 had it been issued as a freestanding instrument that is separate from the written put option, as illustrated in ASC 480-10-55-34 and 55-35, since it (1) would have represented a unit of account that is separate from the written put option and (2) embodies no obligation of the issuer. Similarly, outstanding shares of stock that are freestanding financial instruments and separate from the put and call options are analyzed independently of the options, as illustrated in ASC 480-10-55-34 through 55-37.
Chapter 8 — Presentation and Disclosure
Chapter 8 — Presentation and Disclosure
This chapter discusses the presentation and disclosure of instruments that are classified outside of equity under ASC 480-10-25 (see Sections 8.1 and 8.2). ASC 480-10 contains special presentation and disclosure requirements for entities that have issued mandatorily redeemable shares but have no equity-classified shares outstanding (see Section 8.3). Further, ASC 480-10 requires certain adjustments to EPS calculations (see Section 8.4).
8.1 Presentation
ASC 480-10
45-1 Items within the scope of this Subtopic shall be presented as liabilities (or assets in some circumstances). Those items shall not be presented between the liabilities section and the equity section of the statement of financial position.
Instruments that do not qualify as equity under ASC 480-10-25 must be presented as either assets or liabilities. Unlike securities with redemption features outside the control of the issuer (e.g., puttable shares) that are subject to ASC 480-10-S99-3A (see Chapter 9), such instruments cannot be presented in a mezzanine section between liabilities and equity.
Mandatorily redeemable financial instruments, which are one of the three classes of freestanding financial instruments that must be classified outside of equity under ASC 480-10, are always classified as liabilities. Freestanding financial instruments in the other two classes are either assets or liabilities depending on whether their fair value is positive or negative. For example, a forward contract or collar on equity shares may be in either a gain or loss position for the issuer.
An issuer that has no equity-classified instruments outstanding presents liability-classified shares that are subject to mandatory redemption, and related payments and accruals, separately from other liabilities in the issuer’s financial statements (see Section 8.3).
8.2 Disclosure
ASC 480-10
50-1 Entities that issue financial instruments recognized under the guidance in Section 480-10-25 shall disclose both of the following:
- The nature and terms of the financial instruments
- The rights and obligations embodied in those instruments, including both:
- Settlement alternatives, if any, in the contract
- The entity that controls the settlement alternatives.
50-2 Additionally, for all outstanding financial instruments recognized under the guidance in Section 480-10-25 and for each settlement alternative, issuers shall disclose all of the following:
- The amount that would be paid, or the number of shares that would be issued and their fair value, determined under the conditions specified in the contract if the settlement were to occur at the reporting date
- How changes in the fair value of the issuer’s equity shares would affect those settlement amounts (for example, “the issuer is obligated to issue an additional X shares or pay an additional Y dollars in cash for each $1 decrease in the fair value of one share”)
- The maximum amount that the issuer could be required to pay to redeem the instrument by physical settlement, if applicable
- The maximum number of shares that could be required to be issued, if applicable
- That a contract does not limit the amount that the issuer could be required to pay or the number of shares that the issuer could be required to issue, if applicable
- For a forward contract or an option indexed to the issuer’s equity shares, all of the following:
- The forward price or option strike price
- The number of issuer’s shares to which the contract is indexed
- The settlement date or dates of the contract, as applicable.
50-3 Paragraph 505-10-50-3 requires additional disclosures for actual issuances and settlements that occurred during the accounting period.
The disclosure requirements in ASC 480-10 supplement those in ASC 505-10-50 related to an entity’s capital structure and those in other GAAP related to an entity’s liability and equity instruments. Notably, ASC 505-10-50-3 requires disclosure of the pertinent rights and privileges of securities outstanding, and ASC 505-10-50-11 requires disclosure of the amount of redemption requirements associated with stock that is redeemable at fixed or determinable prices on fixed or determinable dates in each of the five years after the date of the latest statement of financial position presented.
The disclosures entities must provide under ASC 480-10 are similar to those
required by ASC 815-40 for contracts on an entity’s own equity. Note that while ASU
2020-06 amended the disclosure requirements in ASC 815-40, it did not amend those in
ASC 480-10.
8.3 Entities That Have No Equity-Classified Shares
8.3.1 Separate Presentation and Disclosure
ASC 480-10
45-2 Entities that have no equity instruments outstanding but have financial instruments issued in the form of shares, all of which are mandatorily redeemable financial instruments required to be classified as liabilities, shall describe those instruments as shares subject to mandatory redemption in statements of financial position to distinguish those instruments from other liabilities. Similarly, payments to holders of such instruments and related accruals shall be presented separately from payments to and interest due to other creditors in statements of cash flows and income.
50-4 Some entities have no equity instruments outstanding but have financial instruments in the form of shares, all of which are mandatorily redeemable financial instruments required to be classified as liabilities. Those entities shall disclose the components of the liability that would otherwise be related to shareholders’ interest and other comprehensive income (if any) subject to the redemption feature (for example, par value and other paid-in amounts of mandatorily redeemable instruments shall be disclosed separately from the amount of retained earnings or accumulated deficit).
If an entity determines that none of its financial instruments qualify as equity
under ASC 480-10 because all of its shares meet the definition of a mandatorily
redeemable financial instrument in ASC 480-10, special presentation and
disclosure requirements apply. The liability-classified shares are presented
separately from other liabilities and described as “shares subject to mandatory
redemption” in the statement of financial position. Further, payments and
accruals on such instruments are presented separately in the statement of cash
flows and the statement of financial performance. Moreover, an entity discloses
the components of the liability that would otherwise be related to shareholders’
interest and other comprehensive income (e.g., par value, APIC, retained
earnings or accumulated deficit, and accumulated other comprehensive income
attributable to those shares).
Paragraph B60 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
For entities that have financial instruments in the form of shares that are all mandatorily redeemable, the Board decided that, in addition to separate presentation, a related disclosure is needed that displays the nature and composition of the mandatorily redeemable instruments. For example, such an entity would disclose the event triggering the redemption, the number of shares issued and outstanding, the value associated with those financial instruments, and any retained earnings or accumulated other comprehensive income that would be distributed on redemption . . . . The Board concluded that for those entities that have financial instruments in the form of shares that are all mandatorily redeemable, disclosure will assist financial statement users in assessing the amount and timing of redemptions.
In ASC 480-10-55-64 below, the FASB provides an example of stock that must be redeemed upon the death of the holder.
ASC 480-10
Example 1: Mandatorily Redeemable Financial Instruments — Stock to Be Redeemed Upon Death of the Holder
55-64 This Example illustrates the application of the guidance in this Subtopic to stock to be redeemed upon the death of the holder. An entity may issue shares of stock that are required to be redeemed upon the death of the holder for a proportionate share of the book value of the entity. The death of the holder is an event that is certain to occur. Therefore, the stock is classified as a liability. (An insurance contract that would cover the cost of the redemption does not affect the classification of the stock as a liability.) If the stock represents the only shares in the entity, the entity reports those instruments in the liabilities section of its statement of financial position and describes them as shares subject to mandatory redemption so as to distinguish the instruments from other financial statement liabilities. The issuer presents interest cost and payments to holders of such instruments separately, apart from interest and payments to other creditors, in statements of income and cash flows. The entity also discloses that the instruments are mandatorily redeemable upon the death of the holders. The following presentation is an example of the required presentation and disclosure for entities that have no equity instruments outstanding but have shares, all of which are mandatorily redeemable financial instruments classified as liabilities.
8.3.2 Difference Between Redemption Price and Book Value
ASC 480-10
45-2A Some entities have outstanding shares, all of which are subject to mandatory redemption on the occurrence of events that are certain to occur. The redemption price may be a fixed amount or may vary based on specified conditions. If all of an entity’s shares are subject to mandatory redemption and the entity is not subject to the deferral in paragraphs 480-10-15-7A through 15-7F, an excess of the redemption price of the shares over the entity’s equity balance shall be reported as an excess of liabilities over assets (a deficit), even though the mandatorily redeemable shares are reported as a liability. If the redemption price of the mandatorily redeemable shares is less than the book value of those shares, the entity should report the excess of that book value over the liability reported for the mandatorily redeemable shares as an excess of assets over liabilities (equity).
The measurement of a mandatorily redeemable financial instrument under ASC 480-10-35-3 is based not on the holder’s interest in the net book value of the entity but on the amount to be paid on settlement of the instrument (i.e., the redemption value). Therefore, the carrying amount may differ from the net book value attributable to an instrument, in which case ASC 480-10-45 requires the excess or deficit to be presented separately. If the carrying amount of mandatorily redeemable financial instruments exceeds their net book value, the excess is reported as an “excess of liabilities over assets (a deficit).” If the net book value exceeds the carrying amount, the surplus is reported as “excess of assets over liabilities (equity).”
When all of an entity’s shares are mandatorily redeemable financial instruments and contractually must be redeemed at their book value, the entity generally would report no net income after deducting interest cost on those shares. When all of an entity’s shares are mandatorily redeemable financial instruments and contractually must be redeemed at an amount other than their net book value, however, changes in the carrying amount of the liability-classified mandatorily redeemable financial instruments could be greater or less than net income before interest cost on those shares is deducted.
FASB Staff Position FAS 150-2 (superseded as a result of the Codification) contains two examples of an entity’s transition to FASB Statement 150 and its post-transition accounting when all shares are mandatorily redeemable and the redemption value differs from the entity’s book value. Except for the entries related to transition, those examples continue to be relevant and are reproduced below (the transition entries have been removed).
FASB Staff Position FAS 150-2
Illustrations of
Accounting for Mandatorily Redeemable Shares With a
Redemption Value That Differs From the Company’s
Book Value [footnote omitted]
Example
1
Assume . . . that the fair value (which
equals the redemption value) of the mandatorily
redeemable shares is $20 million and the book value of
those shares is $15 million, of which $10 million is
paid-in capital. [In this case,] the company would
recognize a liability of $20 million . . . .
Subsequently, net income attributable to the mandatorily
redeemable shares is $1 million for the year 20XX and
the fair value of those shares at the reporting date of
December 31, 20XX, is $21.2 million. Also assume that
the company did not pay any cash dividends.
The following illustrates the statement
of position at January 1, 20XX, and December 31, 20XX,
and the statement of income for the year ended December
31, 20XX (income tax considerations have been
disregarded):
Example
2
Assume the same facts as in Example 1
except that the shares are to be redeemed at an amount
($11 million) that is less than their book value. . .
.
The following illustrates the statement
of position at January 1, 20XX:
8.4 Earnings per Share
ASC 480-10 does not comprehensively address how to determine EPS for instruments
within its scope. Instead, an entity applies ASC 260 except as specified in ASC
480-10-45-4, which requires the entity to make certain adjustments to the EPS
calculation performed under ASC 260 for (1) mandatorily redeemable financial
instruments and (2) forward contracts that require physical settlement by repurchase
of a fixed number of equity shares of common stock in exchange for cash (see
Section 8.4.1). For
other contracts within the scope of ASC 480-10, an entity applies ASC 260, including
to other forward contracts and written put options on common stock (see Section 8.4.2) and
share-settled debt (see Section
8.4.3). Special considerations are necessary for contracts that may
be settled in stock or cash. For a detailed discussion of the computation of EPS,
see Deloitte’s Roadmap Earnings
per Share.
Changing Lanes
ASC 260 contains specific guidance on diluted EPS that applies to contracts
that may be settled in stock or cash. This guidance applies whether the
option to elect the form of settlement is controlled by the entity or the
counterparty to the contract. ASC 260-10-45-45, as amended by ASU 2020-06,
states:
The effect of potential share settlement shall be included in
the diluted EPS calculation (if the effect is more dilutive) for an
otherwise cash-settleable instrument that contains a provision that
requires or permits share settlement (regardless of whether the election
is at the option of an entity or the holder, or the entity has a history
or policy of cash settlement). An example of such a contract accounted
for in accordance with this paragraph and paragraph 260-10-45-46 is a
written call option that gives the holder a choice of settling in common
stock or in cash. An election to share settle an instrument, for
purposes of applying the guidance in this paragraph, does not include
circumstances in which share settlement is contingent upon the
occurrence of a specified event or circumstance (such as contingently
issuable shares). In those circumstances (other than if the contingency
is an entity’s own share price), the guidance on contingently issuable
shares should first be applied, and, if the contingency would be
considered met, then the guidance in this paragraph should be applied.
Share-based payment arrangements that are payable in common stock or in
cash at the election of either the entity or the grantee shall be
accounted for pursuant to this paragraph and paragraph 260-10-45-46,
unless the share-based payment arrangement is classified as a liability
because of the requirements in paragraph 718-10-25-15 (see paragraph
260-10-45-45A for guidance for those instruments). If the payment of
cash is required only upon the final liquidation of an entity, then the
entity shall include the effect of potential share settlement in the
diluted EPS calculation until the liquidation occurs.
Before the adoption of ASU 2020-06, if certain conditions were met, an entity
could overcome the presumption of share settlement for contracts that may be
settled in stock or cash. In such cases, the entity would not include the
dilutive effect of such contracts in the denominator of diluted EPS.
However, after the ASU’s adoption, except for certain share-based payment
arrangements, an entity must assume that in the calculation of diluted
EPS, any contract that allows for settlement in shares will be settled
in shares. As a result, the entity would include potential common
shares in the denominator of diluted EPS by using the treasury stock,
reverse treasury stock, if-converted, or contingently issuable share method,
as applicable. In some situations, the entity may also need to adjust the
numerator in the calculation of diluted EPS.
Arrangements that commonly allow for settlement in stock or
cash include convertible instruments and warrants on common stock. However,
ASC 260-10-45-45 applies to all contracts that allow
for settlement in stock or cash at the option of the entity or the
counterparty. Therefore, other contracts, such as redeemable equity
securities — including but not limited to redeemable noncontrolling
interests (see Chapter
9) — that may be settled in parent shares are also subject to
this guidance.
Even if share settlement is unlikely, the guidance in ASC 260-10-45-45
applies. That is, the intent of the party that may elect the form of
settlement is not relevant in the application of this guidance. Therefore,
to comply with ASC 260-10-45-45, an entity will need to inventory all of its
contracts that allow for settlement in shares.
For more information about for the accounting for diluted EPS for contracts
that may be settled in stock or cash, see Section
4.7 of Deloitte’s Roadmap Earnings per Share.
8.4.1 Mandatorily Redeemable Financial Instruments and Physically Settled Forward Contracts to Repurchase Common Stock
ASC 480-10
45-4 Entities that have issued mandatorily redeemable shares of common stock or entered into forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock in exchange for cash shall exclude the common shares that are to be redeemed or repurchased in calculating basic and diluted earnings per share (EPS). Any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to shares that are to be redeemed or repurchased that have not been recognized as interest costs in accordance with paragraph 480-10-35-3 shall be deducted in computing income available to common shareholders (the numerator of the EPS calculation), consistently with the two-class method set forth in paragraphs 260-10-45-60 through 45-70.
ASC 480-10-45-4 requires an entity to make the following adjustments to the EPS calculation for (1) mandatorily redeemable financial instruments and (2) forward contracts that require physical settlement by repurchase of a fixed number of equity shares of common stock in exchange for cash:
-
Numerator (i.e., the amount of income available to common stockholders) — The entity uses the two-class method to adjust the numerator for any amounts attributable to such shares that have not been accounted for as interest cost. Under the two-class method, the entity reduces the numerator for the amount of undistributed earnings that are allocable to the shares subject to repurchase.
- Denominator (i.e., the number of shares outstanding) — In calculating basic and diluted EPS, the entity excludes from the denominator shares of common stock that will be repurchased (i.e., it treats those shares as retired).
Paragraph B68 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
The Board decided that the number of outstanding shares associated with physically settled forward purchase contracts measured at the present value of the contract amount should be removed from the denominator in computing basic and diluted earnings per share in the same way as required for mandatorily redeemable shares classified as liabilities. The Board reasoned that, because the accounting for physically settled forward contracts reduces equity, even though the shares are still outstanding, they are effectively accounted for as if retired. Like mandatorily redeemable shares accounted for as liabilities, shares subject to physically settled forward contracts should not be treated as outstanding in earnings per share calculations. The Board noted that amounts paid to holders are interest costs reflected in earnings available to common shareholders, the numerator in calculating earnings per share.
Connecting the Dots
Questions often arise related to whether it is appropriate to reduce the denominator in the calculation of basic EPS when an entity has a forward contract to repurchase a variable number of shares that must be physically settled. Although the EPS guidance in ASC 480-10-45-4 refers to contracts in which a fixed number of shares must be physically settled, it is generally appropriate to reduce the denominator by the minimum number of shares of common stock that will be repurchased, but only if the contract specifies a contractual minimum. In these circumstances, the entity should apply a method akin to the two-class method for the number of shares removed from the denominator if those shares are entitled to dividends during the period of the forward contract and the holder is not obligated to return those dividends to the entity.
According to ASC 260-10-45-60 and ASC 260-10-45-60B, the two-class method is an earnings-allocation formula under which:
- Net income is “reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends . . . that must be paid for the current period (for example, unpaid cumulative dividends).”
- The “remaining earnings [are] allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed.”
- The “total earnings allocated to each security [are] divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.”
While the outstanding common shares are excluded from the denominator in the
calculations of EPS, if the counterparty that owns the common shares has a
contractual right to participate in dividends declared by the entity before the
common shares are retired, the entity must treat the excluded common shares as
participating securities under ASC 260. This is the case even if the issuing
entity does not regularly declare or pay dividends. Under the two-class method,
an entity adjusts the numerator for any dividends declared or paid and
undistributed earnings, but only to the extent that these amounts have not been
accounted for as interest cost.
Because ASC 480-10-45-3 requires entities to reflect in interest cost “[a]ny
amounts paid or to be paid to holders of [forward purchase] contracts . . . in
excess of the initial measurement amount,” the numerator is not adjusted for
such amounts under the two-class method. For example, accrued cumulative
dividends should be recognized as interest cost, even if they are not declared,
as long as the holder is entitled to such dividends during the life of the
contract or at settlement. Generally, therefore, no distributed earnings will be
allocated to these participating securities because the dividends will have been
recognized in earnings as interest cost; reflecting the distributed earnings
under the two-class method would result in “double-counting” the impact on EPS.
However, undistributed earnings must be allocated to these participating
securities in accordance with ASC 260-10-45-60 through 45-70.
Other amounts attributable to the shares under the two-class method, however,
might not have been recognized as interest cost. For example, the holder of a
mandatorily redeemable financial instrument may have a participation right in 10
percent of dividends paid on common shares if or when they are declared. An
amount may therefore be allocable to the shares subject to repurchase because
all earnings for the period are assumed to have been distributed under the
two-class method. However, this amount may not have been recognized as interest
cost under ASC 480-10 if the holder is not entitled to it during the life of the
contract or at settlement unless the issuer elects to declare a dividend on
common stock. As discussed in Section 3.2.4.3.1 of Deloitte’s Roadmap Earnings per
Share, the impact on EPS of treating the common shares as
participating securities will often be the same as including the common shares
in the denominator in the EPS calculations when an entity has undistributed
earnings. If, however, a forward purchase contract on a fixed number of common
shares contains fixed adjustments to the forward price that are based on
anticipated dividends, the guidance in Section 5.3.3.5.2 of that Roadmap applies
and the forward purchase contract is not a participating security.
Example 8-1
Basic EPS — Forward Contract to Repurchase
Shares
Company A, a public business entity, has 1,000 outstanding common shares. On January 1, A enters into a forward contract that must be physically settled on December 31 by the repurchase of 100 shares in exchange for the fixed amount of $500. The forward contract does not provide for any subsequent adjustment of the repurchase price on the basis of the amount of actual dividends paid. Like other common shares, the 100 shares to be repurchased under the forward contract continue to be entitled to receive any dividends declared on common shares until the repurchase date. However, A declares no dividends during the year.
In calculating basic EPS for the year, A excludes from the denominator the 100
shares that are to be repurchased in accordance with ASC
480-10-45-4. Company A’s earnings for the year are
$20,000. In the absence of the forward contract, basic
EPS for the year would have been $20 ($20,000 ÷
1,000).
ASC 480-10-45-4 also requires that A deduct from income available to common stockholders any amounts (including participation rights in undistributed earnings) attributable to shares that are to be repurchased. This is consistent with the two-class method described in ASC 260 (except to the extent that such amounts have already been recognized as interest cost under ASC 480-10-35-3). Because the forward contract in this situation does not return to A the actual dividends paid on the 100 shares to be repurchased, A deducts $2,000 from the EPS numerator to reflect the participation rights in undistributed earnings attributable to the 100 shares being repurchased ($20,000 × [100 ÷ 1,000]). Accordingly, the EPS numerator is $18,000 ($20,000 – $2,000). Because the EPS denominator is 900, basic EPS for the period is still $20 ($18,000 ÷ 900).
The SEC staff has indicated that if an equity-classified preferred stock is
subsequently reclassified as a liability (e.g., a preferred share that was
conditionally redeemable becomes mandatorily redeemable), the reclassification
should be treated as a redemption of equity by issuance of a debt instrument in
the calculation of EPS (see ASC 260-10-S99-2 and Section 3.2.2.8 of Deloitte’s Roadmap
Earnings per
Share). Further, ASC 480-10-30-2 requires an entity to
initially measure the instrument at fair value upon reclassification, with an
offset to equity and no gain or loss recognized. For EPS purposes, however, the
numerator is adjusted for any change in the carrying amount. For example, if the
new carrying amount under ASC 480-10 exceeds the carrying amount previously
recorded in equity, that difference reduces the EPS numerator (i.e., the change
is treated as a distribution to the holder of the instrument).
8.4.2 Other Forward Purchase Contracts and Written Put Options on Common Stock
ASC 260-10
Written Put Options and the Reverse Treasury Stock Method
45-35
Contracts that require that the reporting entity
repurchase its own stock, such as written put options
and forward purchase contracts other than forward
purchase contracts accounted for under paragraphs
480-10- 30-3 through 30-5 and 480-10-35-3, shall be
reflected in the computation of diluted EPS if the
effect is dilutive. If those contracts are in the money
during the reporting period (the exercise price is above
the average market price for that period), the potential
dilutive effect on EPS shall be computed using the
reverse treasury stock method. . . .
The reverse treasury stock method applies in the computation of diluted EPS to contracts that require an entity to repurchase its common stock. Such contracts include the following:
- Written put options (common stock) — Options written by an entity under which the counterparty has the right, but not the obligation, to sell a specified quantity or amount of common stock to the entity at a fixed or otherwise determinable price.
- Forward purchase contracts (common stock) — Contracts that require the entity to purchase a specified quantity or amount of common stock from the counterparty at a future date at a fixed or otherwise determinable price.
An entity should not apply the reverse treasury stock method to a contract
listed above in the following four situations:
-
The contract represents a forward contract to repurchase common stock that is within the scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 8.4.1).
-
The contract must be net settled in cash (i.e., no common shares are purchased upon settlement).
-
The contract may be settled in cash or stock at the election of the entity, and the entity has overcome the presumption of share settlement. As discussed in Chapter 1, ASU 2020-06 affects an entity’s ability to overcome the presumption of share settlement of a contract that may be settled in cash or stock.
-
The contract is a participating security, and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.
The reverse treasury stock method represents a method of determining the dilutive effect of a contract that obligates an entity to purchase its common shares. Under this method, it is assumed that the entity raises the proceeds necessary to satisfy its obligation under the share purchase contract by issuing its common shares to market participants at the average market price during the period. The excess of the common shares assumed issued over the common shares purchased under the contract represents the incremental common shares under the reverse treasury stock method.
Although contracts subject to the reverse treasury stock method
must be classified as liabilities (or as assets in some circumstances) for
accounting purposes, it is still assumed that they are classified as equity
instruments under this method of calculating diluted EPS. Therefore, along with
adding incremental shares to the denominator under the reverse treasury stock
method, an entity must adjust the numerator to reflect the change in net income
that would have occurred during the reporting period if the contract had been
classified in equity. Since contracts subject to the reverse treasury stock
method are typically subsequently measured at fair value, with changes in fair
value recognized in earnings, and contracts classified as equity instruments are
typically not subsequently remeasured, the adjustment to the numerator will
reflect a reversal of the mark-to-market adjustment recognized on the contract
during the reporting period, net of any associated income tax effects. However,
the numerator adjustment should not be made, and the incremental shares should
not be added to the denominator, if either (1) the contract is a written put
option and is out-of-the-money on the basis of a comparison of the exercise
price with the average market price (see below) or (2) the aggregate effect of
the two adjustments is antidilutive on the basis of the antidilution sequencing
requirements in ASC 260. See Section 4.7 of Deloitte’s Roadmap Earnings per Share for further
discussion of the diluted EPS accounting for contracts subject to the reverse
treasury stock method.
Like the treasury stock method (see discussion in Section 4.2.2.1 of Deloitte’s Roadmap
Earnings per
Share), the reverse treasury stock method is only applied to
written put options that are in-the-money from the perspective of the
counterparty. This determination is based on a comparison of the exercise price
with the average market price of the entity’s common stock. The reverse treasury
stock method should not be applied to an out-of-the-money written put option
that would be dilutive to EPS because of the adjustment made to the numerator to
reverse the mark-to-market amount recognized on the contract during the
reporting period. However, because forward purchase contracts must be settled
regardless of whether they are in-the-money or out-of-the-money, the reverse
treasury stock method should be applied to forward contracts if such contracts
are dilutive. An entity would determine whether a forward purchase contract is
dilutive to EPS on the basis of the aggregate effect of the numerator adjustment
and the incremental common shares to be included in the denominator under the
reverse treasury stock method.
See Section 4.3.2
of Deloitte’s Roadmap Earnings per Share for further discussion of the
application of the reverse treasury stock method to potential common shares
within its scope that are not participating securities. For example, see that
Roadmap's guidance on special issues that arise when:
-
The number of common shares to be repurchased is variable (Section 4.3.2.1.1).
-
The exercise price or the forward price is variable (Section 4.3.2.1.2.1).
-
The contract is issued, exercised, forfeited, or canceled, or it expires, during a financial reporting period (Section 4.3.2.1.3.1).
-
The contract permits net share settlement (Section 4.3.2.2.2).
-
The contract has multiple settlement alternatives (Sections 4.3.2.2.3 and 4.6).
If a potential common share is a participating security, an entity is required
to apply the more dilutive of the reverse treasury stock method or the two-class
method of calculating diluted EPS (see Section 5.5.4 of Deloitte’s Roadmap
Earnings per
Share).
If a contract can be settled in common stock or cash at the option of the
issuer, it is presumed that it will be settled in common stock. Before the
adoption of ASU 2020-06, ASC 260-10-45-46 and ASC 260-10-55-36 imply that the
presumption may be overcome if past experience or a stated policy provides a
reasonable basis for an entity to conclude that the contract will be paid
partially or wholly in cash unless the counterparty controls the means of
settlement (see Section
4.3.2.2.1 of Deloitte’s Roadmap Earnings per Share).
The reverse treasury stock method is not applied if the contract must be cash
settled (i.e., no common shares are purchased on settlement) or, before the
adoption of ASU 2020-06, the contract may be settled in cash or stock at the
election of the entity, and the entity has overcome the presumption of share
settlement. Any dilutive impact of the contract is reflected through the
mark-to-market adjustment recognized in earnings on the contract through the
application of other GAAP. Since share settlement is not assumed in the
calculation of diluted EPS, and because the contract has already been marked to
market through net earnings in accordance with the subsequent-measurement
guidance in ASC 480, no additional adjustments are needed in the calculation of
diluted EPS. The reverse treasury stock method is applied in all other
circumstances if its application is dilutive. Other circumstances may include
those in which (1) the contract must be share settled, (2) the counterparty is
permitted to require the entity to settle the contract in cash or by purchasing
common shares, or (3) before the adoption of ASU 2020-06, the entity is
permitted to settle the contract in cash or by purchasing common shares and does
not overcome the presumption of share settlement.
Changing Lanes
ASU
2020-06 removes an entity’s ability to overcome the
presumption of share settlement for the contracts discussed above. As a
result, entities would be unable to assume cash settlement for any such
contract that permits settlement in shares at either party’s election.
See Chapter
1 for additional details.
8.4.3 Certain Variable-Share Obligations
8.4.3.1 General
For a holder of financial instruments issued in the form of
shares that embody an unconditional obligation that the issuing entity must
settle by issuing a variable number of common shares that are classified as
liabilities under ASC 480-10-25-14 (see Chapter 6), there may not be any
potential “upside” from increases in the issuing entity’s common stock.
Nevertheless, such instruments meet the definition of a convertible
security; therefore, the if-converted method of calculating diluted EPS must
be applied to them. See Section 4.4 of Deloitte’s Roadmap Earnings per Share for detailed
discussion of the application of the if-converted method.
In the discussion that follows, it is assumed that the
if-converted method of calculating diluted EPS applies to a liability under
ASC 480-10-25-14. For financial instruments not issued in the form of shares
that are liabilities under ASC 480-10-25-14, the if-converted method may not
apply to the calculation of diluted EPS.
8.4.3.2 Accounting for the Effect of Variability in the Number of Shares That Must Be Issued on Settlement
Because the settlement of liabilities under ASC 480-10-25-14
involves the issuance of a variable number of the issuer’s equity shares,
special considerations apply when diluted EPS is calculated by using the
if-converted method.
If the number of common shares issuable upon settlement of a
liability under ASC 480-10-25-14 varies solely on the basis of the issuer’s
share price (e.g., a preferred share that must be settled in a variable
number of common shares equal to a fixed monetary amount), an entity that
has not adopted ASU 2020-06 can apply any of the three methods discussed
below (i.e., View A, B, or C).
Changing Lanes
ASU 2020-06 adds new
guidance to ASC 260 on the calculation of EPS when changes in an
entity’s share price affect the conversion price or the number of
shares that would be issued to settle a financial instrument that is
subject to the if-converted method. ASC 260-10-45-21A (added by ASU
2020-06) states:
Changes in an entity’s share price may affect the exercise
price of a financial instrument or the number of shares that
would be used to settle the financial instrument. For
example, when the principal of a convertible debt instrument
is required to be settled in cash but the conversion premium
is required to (or may) be settled in shares, the number of
shares to be included in the diluted EPS denominator is
affected by the entity’s share price. In applying both the
treasury stock method and the if-converted method of
calculating diluted EPS, the average market price shall be
used for purposes of calculating the denominator for diluted
EPS when the number of shares that may be issued is
variable, except for contingently issuable shares within the
scope of the guidance in paragraphs 260-10-45-48 through
45-57. See paragraphs 260-10-55-4 through 55-5 for
implementation guidance on determining an average market
price.
Upon the adoption of ASU 2020-06, for a financial
instrument issued in the form of a share that embodies an
unconditional obligation that must be settled by issuing a variable
number of common shares equal to a fixed monetary amount (i.e.,
share-settled debt), the issuing entity should use the average
market price to determine the number of shares to add to the
denominator under the if-converted method.
On the basis of informal discussions with the FASB
staff, we understand that the above guidance was not intended to
broadly address the diluted EPS accounting under the if-converted
method when the conversion price or the number of shares issuable
upon settlement varies on the basis of an underlying other than just
share price. Rather, the guidance was only intended to address the
diluted EPS accounting under the if-converted method when the
variability in the settlement terms results solely from changes in
the entity’s share price. Therefore, an entity that has adopted ASU
2020-06 does not have to apply the guidance in ASC 260-10-45-21A
(although doing so would be acceptable, as discussed below) if the
variability in the number of shares issuable upon settlement of a
liability under ASC 480-10-25-14 results from changes in an
underlying other than just the entity’s share price. Furthermore,
ASC 260-10-45-21A should not be applied when diluted EPS must be
calculated by using the contingently issuable share method. Rather,
in a manner consistent with ASC 260-10-45-21A, when the contingently
issuable share method applies, so does the relevant guidance in ASC
260-10 on diluted EPS calculations for contingently issuable share
arrangements. In practice, entities must exercise judgment to
determine whether the contingently issuable share method is
required. During our informal discussions, the FASB staff
acknowledged the difficulty of making this determination.
Accordingly, entities are encouraged to consult with their
independent accounting advisers.
ASC 260 does not specifically address how to apply the if-converted method
when the number of common shares issuable upon settlement of a liability
under ASC 480-10-25-14 varies on the basis of a specified rate, price,
index, or other variable besides just the entity’s share price. Therefore,
in such circumstances, an entity may reasonably interpret ASC 260 in one of
three ways:
-
View A: The number of common shares issuable upon settlement reflects the number of shares that would be issuable at the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Under that guidance, it is assumed that the contingency (in this case, the number of shares issuable to settle the instrument) is resolved as of the end of the reporting period. Thus, an entity applies the if-converted method on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 of Deloitte’s Roadmap Earnings per Share for additional discussion of the contingently issuable share method.
-
View B: The number of common shares issuable upon settlement is based on the highest number of common shares available to the counterparty during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires diluted EPS to be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the settlement prices applicable for the entire time during the reporting period in which the instrument was outstanding and should use the settlement assumption that is least advantageous to the entity and produces the highest number of common shares for the investor. The entity should not project future settlement prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The number of common shares issuable upon settlement is based on the average of the specified rate, price, index, or other variable during the financial reporting period — This view is consistent with ASC 260-10-45-23, which requires an entity to assume that the proceeds from exercise or settlement of a contract subject to the treasury stock method are used to purchase common stock at the average market price during the period. This approach is also consistent with the FASB’s acknowledgment in paragraph BC115 of ASU 2020-06 that entities applied this method in practice before adopting the guidance in ASC 260-10-45-21A.
These three approaches are acceptable regardless of whether
the entity or counterparty controls the timing of settlement (since neither
party ultimately controls the rate, price, index, or other variable that
affects settlement). The approach selected is considered an accounting
policy election that must be applied consistently and disclosed.
If the instrument or any embedded feature in the instrument
is classified as a liability and recognized at fair value, with changes in
fair value reported in earnings (which may be required because of the
variable terms of the contract), an entity must also adjust the numerator in
calculating diluted EPS. See Section 4.4.2.2.3 of Deloitte’s
Roadmap Earnings per
Share for more information.
It is not acceptable to apply the if-converted method on the
basis of the specified rate, price, index, or other variable at the
beginning of the reporting period because there is no basis in ASC 260 for
the use of this approach.
For additional discussion of this topic, see Section 4.4.2.3 of Deloitte’s Roadmap Earnings per Share.
Chapter 9 — The SEC's Guidance on Temporary Equity
Chapter 9 — The SEC’s Guidance on Temporary Equity
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
Footnotes
1
From remarks by then SEC Professional
Accounting Fellow Dominick J. Ragone III before the
2000 AICPA Conference on Current SEC
Developments.
9.1 Sources of Guidance
9.1.1 Overview
The SEC has issued various types of guidance on the separate presentation and disclosure of certain redeemable equity instruments, including:
- Rules and policies:
- Regulation S-X, Rule 5-02.27.
- Accounting Series Release No. 268 (ASR 268).
- Codification of Financial Reporting Policies, Section 211 (CFRP 211; also known as CFRR 211 or FRR 211).
- Staff Accounting Bulletins (SABs):
- SAB Topic 3.C.
- SAB Topic 14.E.
- Staff announcements and observer comments at EITF meetings:
- Classification and Measurement of Redeemable Securities (announcement).
- Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan (observer comment).
Further, when applying the SEC’s temporary equity guidance, registrants should
consider 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 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. Some practitioners continue to refer to this announcement as EITF Topic D-98 because that document contained an earlier version of the announcement. However, they should no longer rely on the text of EITF Topic D-98 because the SEC has since revised the original announcement.
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). These observer comments are also contained in EITF Issue 89-11, which was superseded by the
Codification.
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 (including the SEC staff announcement
in ASC 480-10- S99-3A) 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). Thus, paragraph 17.24 of AICPA Audit
and Accounting Guide Depository and Lending Institutions: Banks and Savings
Institutions, Credit Unions, Finance Companies, and Mortgage Companies
(AAG-DEP), July 1, 2020, states, in part:
Regulation S-X, [Rule 5-02.27,] states that mandatory
redeemable preferred stock is not to be included in amounts reported as
stockholders’ equity. Although nonpublic companies are not required to
follow Regulation S-X, it would be appropriate for them to do so in most
cases.
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 480-10 (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 because they are not considered indexed to the entity’s own stock under ASC 815-40-15 or because the issuer could be forced to settle them in cash in accordance with ASC 815-40-25. (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 480-10 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 not qualify as equity under GAAP before
the adoption of ASU 2020-06. ASC 480-10 and ASC 815-40 generally preclude equity
classification for a contract (other than an outstanding share) that the issuer
might be forced to settle in cash or other assets. Accordingly, to qualify as
equity under ASC 480-10 and ASC 815-40 before the adoption of ASU 2020-06, a
contract other than an outstanding share cannot contain a redemption feature
that would have resulted in temporary equity classification under ASC
480-10-S99-3A. Therefore, the temporary equity guidance does not apply to
freestanding contracts on the entity’s own equity that are accounted for as
equity under ASC 815-40 before the adoption of ASU 2020-06.
Changing Lanes
ASU
2020-06 amends ASC 815-40 to eliminate the following
three conditions in ASC 815-40-25 that must be met for an equity-linked
instrument to be classified in stockholders’ equity:
-
The contract permits the entity to settle it in unregistered shares (ASC 815-40-25-11 through 25-16).
-
No counterparty rights rank higher than shareholder rights (ASC 815-40-25-31 through 25-34).
- There is no requirement in the contract for the issuing entity to post collateral at any point for any reason (ASC 815-40-25-35).
After an entity’s adoption of ASU 2020-06, an instrument
may meet the equity classification conditions in ASC 815-40-25 when the
above three conditions are not met. Such a contract would generally need
to be classified in temporary equity under ASC 480-10-S99-3A. On the
basis of informal discussions with the staff of the SEC’s Office of the
Chief Accountant, we understand that it is unclear whether ASC
480-10-S99-3A will be amended to address the issue. In the absence of
preclearance with the SEC, an entity should classify as temporary equity
a contract that would have been classified as a liability before ASU
2020-06's amendments to ASC 815-40-25. See Chapter 1 for additional details
about ASU 2020-06.
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:
- Before the adoption of ASU 2020-06, convertible debt subject to the cash conversion guidance in ASC 470-20. That guidance applies to the issuer’s accounting for certain convertible debt instruments that by their stated terms may be settled in cash (including partial cash settlement) or other assets upon conversion. The issuer allocates to the liability component an amount of the proceeds equal to the fair value of a similar liability that does not have an associated equity component, and it allocates the remaining amount of the proceeds to the equity component.
- Before the adoption of ASU 2020-06, convertible debt that contains a beneficial conversion feature (BCF) at issuance (see ASC 470-20-25-5). The BCF is “recognized separately at issuance by allocating a portion of the proceeds equal to the intrinsic value of that feature to [APIC].”
- Before the adoption of ASU 2020-06, convertible debt for which a contingent BCF has been triggered (see ASC 470-20-25-6). The issuer recognizes a contingent BCF when the contingency is resolved (e.g., an IPO) by debiting the debt (typically a debt discount) and crediting equity (APIC) for the amount of the BCF.
- Convertible debt issued at a substantial premium (see ASC 470-20-25-13). There is a presumption that such premium should be separately presented in equity.
- 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). The “increase in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange)” reduces the carrying amount of the debt instrument with an offsetting entry to equity (APIC).
- Convertible debt with an embedded conversion option that no longer meets the bifurcation criteria in ASC 815-15-25-1. The issuer reclassifies to equity the carrying amount of the derivative liability (i.e., the fair value of the conversion option as of the date of reclassification; see ASC 815-15-35-4) and continues to amortize any remaining debt discount that was created by the original bifurcation).
Similarly, convertible preferred stock that is classified as a
liability under ASC 480-10 (see Chapters 4 and 6) may contain an equity component that
must be separated. For instance, a convertible preferred share that has a stated
redemption date and requires the issuer to settle the face amount in cash upon
conversion potentially would need to be separated into liability and equity
components under the cash conversion guidance in ASC 470-20 before the adoption
of ASU 2020-06 (see ASC 470-20-15-6 and ASC 470-20-55-70) provided that the
conversion option is not required to be bifurcated as an embedded derivative
under ASC 815-15. In a manner similar to its assessment of equity components in
convertible debt, the 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.
Changing Lanes
ASU 2020-06 eliminates the separation models in ASC
470-20 for convertible debt instruments with a BCF or CCF. Therefore,
upon the adoption of ASU 2020-06, the temporary equity guidance in ASC
480-10-S99-3A will no longer apply to convertible debt instruments that
would have previously been subject to such guidance because of a BCF or
CCF. Rather, those convertible debt instruments will be classified
entirely as liabilities (i.e., there will be no separate equity
component to evaluate for classification in temporary equity). However,
convertible debt instruments will continue to 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, or (3) an
embedded conversion option no longer meets the bifurcation criteria in
ASC 815-15-25-1. In these situations, the temporary equity guidance in
ASC 480-10-S99-3A on convertible debt instruments with separately
recognized equity components is still relevant. See Chapter 1 for
additional details about ASU 2020-06.
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. (Subtopic 470-20 provides guidance on accounting for convertible instruments with contingently adjustable conversion ratios.)
- 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).
Pending Content (Transition Guidance: ASC
815-40-65-1)
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
480-10, 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
480-10 (see Section
4.1.5) as follows:
- If the shares are exempt from the classification and measurement requirements in ASC 480-10, 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 480-10’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 480-10, 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
480-10]. In other words, if both the classification and measurement
guidance in [ASC 480-10] 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 480-10] 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
[Footnote omitted], 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 with employees 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 480-10 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).
9.4 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 480-10 (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 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. Note that
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 480-10 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.
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, note that 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 even if they
contain a deemed liquidation redemption feature.
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 480-10 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.
Note that 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 in accordance with the equity classification conditions in ASC 815-40-25. 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.)
This guidance is also consistent with the tentative conclusion reached by the EITF in paragraph 60 of EITF Issue 00-27 (this paragraph was not codified):
Issue 16(b) — Whether a convertible preferred stock
that has a conversion option within the scope of the [BCF guidance
in ASC 470-20] should be classified as either permanent or temporary
equity using the guidance in [ASC 815-40-25.]
The Task Force reached a tentative conclusion that the
guidance in [ASC 815-40-25] should be used to evaluate whether the
issuer controls the actions or events necessary to issue the number of
required shares under the conversion option if that conversion option is
exercised by the holder. If the issuer does not control settlement of
the conversion option’s exercise by delivering shares, cash settlement
of the instrument would be presumed and, if the issuer is an SEC
registrant, the convertible preferred stock would be classified as
temporary equity.
Before the adoption of ASU 2020-06, ASC 815-40-25-10 lists the following
conditions that must be met for an issuer to conclude that it cannot be forced
to cash settle a contract:
-
Settlement permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.
-
Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
-
Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
-
No required cash payment if entity fails to timely file. There are no required cash payments to the counterparty in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
-
No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
-
No counterparty rights rank higher than shareholder rights. There are no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.
-
No collateral required. There is no requirement in the contract to post collateral at any point or for any reason.
ASC 815-40-25 contains additional guidance (e.g., on applying the above
conditions) that the issuer should consider in determining whether it controls
settlement by delivery of its equity shares under ASC 480-10-S99-3A(6). See
Section 5.3 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a detailed
discussion of this guidance. 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.
The issuer should perform the assessment under ASC 815-40-25 irrespective of
whether a share-settled feature contractually 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
ASU
2020-06 amends ASC 815-40 to eliminate the following
three conditions in ASC 815-40-25 that must be met for an equity-linked
instrument to be classified in stockholders’ equity:
-
The contract permits the entity to settle it in unregistered shares (ASC 815-40-25-11 through 25-16).
-
No counterparty rights rank higher than shareholder rights (ASC 815-40-25-31 through 25-34).
-
There is no requirement in the contract for the issuing entity to post collateral at any point for any reason (ASC 815-40-25-35).
A contract that does not meet one of the above three
conditions 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. While ASU 2020-06 eliminates that condition from the equity
classification conditions in ASC 815-40-25, that does not mean an entity
controls the ability to issue registered shares. On the basis of
informal discussions with the staff of the SEC’s Office of the Chief
Accountant, it is unclear whether ASC 480-10-S99-3A will be amended to
address the issue. 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
removes. See Chapter
1 for additional details about ASU 2020-06.
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 instruments that are separated into liability and equity
components, such as certain convertible instruments that — before the adoption
of ASU 2020-06 — contain BCFs or CCFs (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).
Changing Lanes
ASU 2020-06 eliminates the separation models in ASC
470-20 for convertible debt instruments with a BCF or CCF. Therefore,
the temporary equity guidance in ASC 480-10-S99-3A will no longer apply
to convertible debt instruments that, because of a BCF or CCF, would
have been subject to such guidance. Rather, those convertible debt
instruments will be classified entirely as liabilities (i.e., there will
be no separate equity component to evaluate for classification in
temporary equity). However, convertible debt instruments will continue
to 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, or (3) an embedded conversion option no longer meets
the bifurcation criteria in ASC 815-15-25-1. In these situations, the
temporary equity guidance in ASC 480-10-S99-3A on convertible debt
instruments with separately recognized equity components is still
relevant. See Chapter
1 for additional details about ASU 2020-06
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. Note that this guidance has not yet been
updated to reflect ASU 2018-07, ASU 2019-08, or ASU
2020-06.]
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.FN79 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.FN80
SEC Accounting Series Release No. 268, Presentation in
Financial Statements of “Redeemable Preferred Stocks,”
FN81 (“ASR 268”) and related
guidanceFN82 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,FN83 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 with employees 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.FN84
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.
__________________________________
FN79 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.
FN80 FASB ASC paragraphs 718-10-25-6
through 718-10-25-19.
FN81 ASR 268, July 27, 1979, Rule
5-02.28 of Regulation S-X.
FN82 Related guidance includes FASB
ASC paragraph 480-10-S99-3A (Distinguishing
Liabilities from Equity Topic).
FN83 FASB ASC paragraph
718-10-35-13, states that an instrument ceases to
be subject to this Topic when “the rights conveyed
by the instrument to the holder are no longer
dependent on the holder being an employee of the
entity (that is, no longer dependent on providing
service).”
FN84 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, 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 from the classification 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. For such
arrangements, temporary equity classification is not required in the following
circumstances:
-
“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.” (As discussed in Section 9.4.6, a feature that requires or permits share settlement is normally treated as a cash-settled feature if the issuer might be forced to settle it in cash in accordance with the guidance in ASC 815-40-25.)
-
“A provision in an instrument for the direct or indirect repurchase of shares issued to an employee exists solely to satisfy the employer’s minimum statutory tax withholding requirements (as discussed in Paragraphs 718-10-25-18 through 25-19).”
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).
-
Before the adoption of ASU 2020-06, convertible preferred stock with a BCF (see Section 9.5.8).
-
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.
Changing Lanes
ASU
2020-06 eliminates the separation model in ASC
470-20 for convertible preferred stock with a BCF. See Section 9.5.8 for
more information.
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 recent 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 earnings per share).
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.
9.5.5.1 Paid-in-Kind Dividends
The terms of some redeemable equity instruments include a mandatory 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:4
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 |
As described above and in ASC 470-20-30-17(b), the following is one of the
conditions that must be satisfied for PIK dividend payments to be considered
nondiscretionary: “[i]f the original instrument or a portion thereof is
converted before accumulated dividends or interest are declared or accrued,
the holder will always receive the number of shares upon conversion as if
all accumulated dividends or interest have been paid in kind.” While the
wording of this condition is ambiguous, two acceptable interpretations of it
are generally applied in practice. An entity should select one 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 would 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 accrued (i.e., been earned to date) are paid in equity shares even if such dividends have not yet been contractually paid (i.e., if conversion occurs between contractual dividend payment dates). Thus, the frequency of contractual dividend payment dates has no impact on the number of equity shares that the holder will receive upon conversion because a holder that elects to convert the security in between contractual dividend payment dates will receive additional equity shares for the dividend that has accrued from the last contractual date.
In applying the above alternatives to a nonconvertible instrument, an entity
should substitute the “redemption date” for the “conversion date.”
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.
Although the approach described above is not codified in U.S. GAAP, it is consistent with the recommendation made in Discussion Document 3 (March 8, 2001) of the EITF 00-27 Working Group, comments previously made by the SEC
staff, and the accounting for stock dividends under ASC 505-20.
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 convertible instruments separated into
liability and equity components, such as certain convertible instruments that —
before the adoption of ASU 2020-06 — contain BCFs or CCFs (see Section 9.3.5), should be
evaluated under the temporary equity guidance only if the instruments are
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.)
Example 9-22
Subsequent Measurement of Convertible Debt Instrument
Subject to CCF Guidance
Before the adoption of ASU 2020-06, a convertible debt instrument that is
subject to the cash conversion guidance in ASC 470-20
was issued for net proceeds equal to its principal
amount of $100. The instrument includes a cash-settled
put option that permits the investor to put the
instrument back to the issuer at any time for $98. In
addition, the instrument is not currently convertible,
and the issuer has concluded that the put option is (1)
not required to be bifurcated and accounted for as a
derivative under ASC 815-15 and (2) considered
nonsubstantive under ASC 470-20 (and therefore does not
affect the amortization period for any recognized debt
discount). In accordance with the cash conversion
guidance in ASC 470-20, the issuer determines that the
carrying amount of the liability component is $90 and
the carrying amount of the equity component is $10. In
these circumstances, a portion of the equity component
is currently redeemable since the holder currently can
put the convertible debt instrument to the issuer for
$98, and the carrying amount of the liability component
is only $90. The amount reported in temporary equity is
the excess of the current redemption amount ($98) over
the current carrying amount of the liability component
($90) of the convertible debt; that is, $8. If, in this
example, the put option instead was exercisable only on
a future date or contingent on an event, and the
contingency is not met as of the reporting date, the
instrument would be outside the scope of the temporary
equity guidance (irrespective of whether it is probable
that the contingency will be met in the future). ASC
480-10-S99-3A only applies to convertible instruments
with a separately classified equity component if the
instrument is currently redeemable or convertible at the
reporting date.
The SEC provides 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 often causes 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 740-10. In practice, such basis differences
will usually result in the recognition of a deferred tax liability under ASC
740-10 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.
Example 9-23
Effect of Deferred Tax Liabilities on Subsequent
Measurement of an Equity Component in Convertible
Debt
A convertible debt instrument within the scope of the cash conversion guidance
in ASC 470-20 was issued for proceeds of $100. The tax
basis in the debt under the applicable taxation
requirements is the original issue price adjusted for
any original issue discount or premium before separation
of any equity component for accounting purposes (i.e.,
the tax basis is $100). Because of the application of
the cash conversion guidance in ASC 470-20, however, the
book basis in the debt (i.e., the carrying amount of the
liability component) is $90 after separation of an
equity component. If the issuer’s tax rate is 35
percent, the issuer will recognize a deferred tax
liability of $3.50 (= [$100 – $90] × 35%) with an
offsetting adjustment to equity (APIC). Accordingly, the
net amount credited to equity is $6.50. If the
instrument is currently redeemable for $98, the amount
of temporary equity is $8 rather than $6.50 because the
temporary equity guidance is applied to the carrying
amount of the equity-classified component before any
adjustment for the related tax effects.
Sometimes 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 determined in accordance with GAAP.
This scenario could occur, for example, if the fair value of any bifurcated
derivative instrument that is attributed to the liability component declines or
the initial amount of proceeds allocated to the convertible instrument as a
whole is less than its principal amount (where the principal amount equals the
redemption amount). ASC 480-10-S99-3A does not explicitly address whether “the
portion of the equity-classified component that is presented in temporary
equity” can exceed the amount allocated to the equity-classified component under
GAAP. Therefore, either of the following two approaches is acceptable provided
that it is applied consistently:
-
Limit the amount of temporary equity to the amount allocated to the equity-classified component in accordance with GAAP (e.g., ASC 470-20).
-
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.
Changing Lanes
ASU 2020-06 eliminates the separation models in ASC
470-20 for convertible debt instruments with a BCF or CCF. Therefore,
the initial and subsequent measurement guidance in ASC 480-10-S99-3A
will no longer apply to convertible debt instruments that, because of a
BCF or CCF, would have been subject to such guidance. Rather, those
convertible debt instruments will be classified entirely as liabilities
(i.e., there will be no separate equity component to evaluate for
classification in temporary equity). However, convertible debt
instruments will continue to 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, or (3) an embedded
conversion option no longer meets the bifurcation criteria in ASC
815-15-25-1. In these situations, the initial and subsequent measurement
guidance in ASC 480-10-S99-3A on convertible debt instruments with
separately recognized equity components is still relevant. See Chapter 1 for
additional details about ASU 2020-06.
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), that
guidance does not apply to equity-classified convertible stock with a separated
equity component (e.g., a BCF or an equity component that resulted from a
modification or exchange that affected the conversion option or a
reclassification of the embedded conversion option from a liability to equity).
As discussed in more detail in Section 3.2.5.2.4 of Deloitte’s Roadmap Earnings per
Share, before the adoption of ASU 2020-06, an entity can elect
one of 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.
Under both views, before the adoption of ASU 2020-06, an entity must consider
ASC 470-20-35-7, which states, in part:
All discounts retain their character such that a
discount resulting from the accounting for a beneficial conversion
option is amortized from the date of issuance to the earliest conversion
date. For SEC registrants, other discounts on perpetual preferred stock
that has no stated redemption date but that is required to be redeemed
if a future event that is outside the control of the issuer occurs (such
as a change in control) shall be accounted for in accordance with
Section 480-10-S99.
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.
Before the adoption of ASU 2020-06, if convertible stock with a CCF or BCF is
classified as a liability under ASC 480-10 (see Chapters 4 and 6 and Section 9.3.5), the issuer should apply
the measurement guidance for convertible debt with separated liability and
equity components (see Section
9.5.7) instead of this guidance.
Changing Lanes
ASU 2020-06 eliminates the separation model in ASC
470-20 for convertible preferred stock with a BCF. Therefore, the
temporary equity guidance discussed above will not apply to a
convertible preferred stock instrument that previously contained a
separate equity component because of a BCF. However, ASU 2020-06
contains new guidance that applies when a down-round feature in a
convertible preferred stock is triggered. ASC 260-10-30-1 (as amended by
ASU 2020-06) 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 (as amended by ASU 2020-06) 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 Office of the
Chief Accountant (OCA), we understand that the SEC will object if an
entity classifies the 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 (as amended by ASU
2020-06). 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.
See Chapter 1 for additional
details about ASU 2020-06.
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 BCF (before the
adoption of ASU 2020-06) (see Section 9.5.7) or 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-capitalFN85 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 intrinsicFN86 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.
__________________________________
FN85 Depending on the fact pattern,
this may be recorded as common stock and
additional paid in capital.
FN86 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.
4
This guidance is derived from ASC 470-20-30-17,
which addresses the commitment date for a PIK dividend in the
application of the BCF requirements. Although ASU 2020-06 eliminates
this guidance, it is still relevant to the initial measurement of
PIK dividends.
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 (e.g., a BCF or the equity component of a cash convertible under ASC 470-20) as temporary equity.
Changing Lanes
ASU 2020-06 eliminates the separation models in ASC
470-20 for convertible instruments with a BCF or CCF. The EPS guidance
in ASC 480-10-S99-3A(23) is still relevant to convertible debt
instruments that contain separate equity components for other reasons.
See Chapter
1 for additional details about ASU 2020-06.
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 any BCF 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 is recognized typically 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). If the old instrument contained a BCF, the same
accounting applies except that under ASC 470-20-40-1, any remaining
unamortized discount associated with the BCF on the date of conversion is
recognized as a deemed dividend.
Changing Lanes
ASU
2020-06 eliminates the separation model in ASC
470-20 for convertible instruments with a BCF. See Chapter 1 for
additional details about ASU 2020-06.
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
Office of the Chief Accountant, 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 computing 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 480-10 (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
480-10), 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 9-24
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 a contract 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 480-10.
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 825-10 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 825-10 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.
Chapter 10 — Differences Between U.S. GAAP and IFRS Accounting Standards
Chapter 10 — Differences Between U.S. GAAP and IFRS Accounting Standards
10.1 Background
10.1.1 IFRS Guidance
Under IFRS Accounting Standards, an issuer applies IAS 32 to determine whether
outstanding shares and other financial instruments should be
classified as liabilities (or, in some circumstances, assets) or
equity or be separated into liability and equity components. IAS 32
has a broader scope than does ASC 480-10. For example, IAS 32
addresses the accounting for convertible debt instruments, contracts
on the entity’s own equity that do not embody obligations of the
issuer (e.g., purchased put or call options on the entity’s own
equity), and contracts that embody obligations to transfer a fixed
number of the issuer’s equity shares but do not require the issuer to
transfer assets or a variable number of equity shares (e.g., written
call options, warrants, and forward sale contracts on the entity’s own
equity). The discussion of key differences below applies only to
contracts within the scope of ASC 480-10.
See Chapter 8 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity for
a discussion of key differences between U.S. GAAP and IFRS Accounting
Standards related to contracts on an entity’s own equity that are
within the scope of ASC 815-40.
10.1.2 Key Differences
The table below summarizes key differences between U.S. GAAP and IFRS Accounting
Standards in the accounting for outstanding equity shares and other
financial instruments that are within the scope of ASC 480-10
(including the SEC’s temporary equity guidance in ASC 480-10-S99-3A).
The table is followed by a detailed explanation of each
difference.
U.S. GAAP | IFRS Accounting Standards | |
---|---|---|
Redeemable equity securities | Financial instruments in the form of shares that embody an obligation to transfer assets are classified as liabilities only if the obligation is unconditional and the transfer of assets is therefore certain to occur. SEC registrants present equity-classified instruments that embody a conditional obligation to transfer assets as temporary equity. | Financial instruments in the form of shares that embody an obligation to transfer assets are classified as liabilities irrespective of whether the obligation is unconditional or conditional, with certain exceptions. |
Obligations to repurchase shares | Physically settled forward-purchase contracts that embody an obligation to
repurchase a fixed number of the issuer’s equity shares
for cash are accounted for at either the present value
of the redemption amount or the settlement value. Other
physically settled contracts that embody an obligation
to repurchase the issuer’s equity shares by transferring
assets (e.g., a physically settled written put option or
a forward purchase contract that provides the
counterparty with a right to require either physical or
net settlement) are accounted for at fair value. | Contracts that embody an obligation to repurchase the issuer’s equity shares by transferring assets are accounted for at the present value of the redemption amount if the issuer could be required to physically settle the contract by transferring assets in exchange for shares (e.g., a forward purchase or written put option contract that gives the counterparty the right to require either physical or net settlement). |
Obligations to issue a variable number of equity shares | A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by delivering a variable number of equity shares is classified as an asset or a liability if, at inception, the obligation’s monetary value is based either solely or predominantly on a fixed monetary amount, variations in something other than the fair value of the issuer’s equity shares, or variations inversely related to changes in the fair value of the issuer’s equity shares. | Contracts that will be settled in a variable number of shares are accounted for as assets or liabilities. |
10.2 Redeemable Equity Securities
Both U.S. GAAP and IFRS Accounting Standards require financial instruments
issued in the legal form of shares that embody an unconditional obligation that
requires the issuer to redeem the instrument by transferring its assets at a
specified or determinable date (or dates) or upon an event that is certain to occur
to be accounted for as liabilities (see Section 4.1 and paragraph 16 of IAS 32).
Under U.S. GAAP, financial instruments issued in the form of shares that embody
a conditional obligation that could require the issuer to redeem the instrument
generally are classified as equity because they are outside the scope of the
liability classification guidance in ASC 480-10. The definition of mandatorily
redeemable financial instruments (which must be classified as financial liabilities)
in ASC 480-10-20 is limited to unconditional obligations. Therefore, outstanding
shares that could be redeemed at the option of the holder,
or upon some contingent event, generally are not classified as financial liabilities
under ASC 480-10. Under U.S. GAAP, mandatorily redeemable equity securities that are
not certain to be redeemed (e.g., those containing an equity conversion option that
permits the securities to be converted into nonredeemable equity securities before
the mandatory redemption date) are also classified as equity. If redemption becomes
certain to occur, the securities would be reclassified, and accounted for, as a
liability. ASC 480-10-S99-3A indicates that when an equity instrument has a
redemption feature that is not solely within the control of the issuer, an SEC
registrant is required to present the instrument on the balance sheet between
permanent equity and liabilities in a section labeled “temporary equity” or
“mezzanine equity” (see Chapter
9).
Under IFRS Accounting Standards, an instrument should be accounted for as a
liability if it gives the holder the right to put the instrument back to the issuer
for cash or another financial asset (e.g., redeemable preferred shares) or is
automatically put back to the issuer upon the occurrence of an uncertain future
event (e.g., contingently mandatorily redeemable shares). Accordingly, there is no
concept of “temporary equity” under IFRS Accounting Standards. Paragraph 18(b) of
IAS 32 notes that the conditional redemption obligation creates a contractual
obligation for the issuer to deliver cash or another financial asset. Paragraph
19(b) of IAS 32 states that the fact that a contractual obligation is conditional
upon the holder’s exercising its right to require redemption does not negate the
existence of a financial liability since the issuer “does not have the unconditional
right to avoid delivering cash or another financial asset.”
Paragraph B79 of the Background Information and Basis for Conclusions of FASB Statement 150 notes:
IAS 32 requires the same accounting for conditionally redeemable instruments as for mandatorily redeemable instruments. [ASC 480-10] does not go that far. The Board acknowledges that the conditional obligation embedded in such shares may, if accounted for separately, meet the definition of a liability; however, the accounting for such compound instruments is beyond the scope of [ASC 480-10].
Under IAS 32, the issuer is exempt, in limited circumstances, from the liability classification requirement for puttable financial instruments. Specifically, IAS 32 requires that puttable instruments be presented as equity if the following four criteria are met:
- The holder is entitled “to a pro rata share of the entity’s net assets [at] liquidation.”
- “The instrument is in the class of instruments that is [the most] subordinate” and all instruments in that class are identical.
- The instrument has no other characteristics that would meet the definition of a financial liability.
- “The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity.”
Under IFRS Accounting Standards, instruments, or components of instruments, that
obligate the entity to deliver a pro rata share of the net assets of the entity only
on liquidation should be presented as equity if they meet criteria (1) and (2)
above. See paragraphs 16A through 16D of IAS 32 for additional information.
10.3 Obligations to Repurchase Shares
10.3.1 Forward Purchase Contracts on an Entity’s Own Equity
Under U.S. GAAP, a forward purchase contract on an entity’s own shares that is within the scope of ASC 480-10 is classified as a liability. If the forward contract requires physical settlement by repurchase of a fixed number of shares for cash, the contract is measured at the present value of the amount to be paid at settlement or settlement value (see Section 5.3.1). If the forward contract will be net share settled or net cash settled (or either party has the ability to elect net-cash or net-share settlement), however, the contract is accounted for at fair value, with changes in fair value recognized in earnings (see Sections 5.3.2 and 6.3).
Under IFRS Accounting Standards, paragraph 23 of IAS 32 requires a physically
settled forward-purchase contract on an entity’s
own shares to be accounted for as a liability at
the present value of the redemption amount. This
treatment applies if the issuer could be required
to settle the contract by a gross exchange of cash
for shares even if the holder has the right to
elect net-cash or net-share settlement (i.e., it
applies when the holder has the choice of settling
the contract gross by the exchange of either cash
or another financial asset for shares). This
guidance differs from that in ASC 480-10, under
which fair value accounting is required when an
ASC 480-10 liability may be net share settled or
net cash settled.
Paragraph B80 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
The difference between IAS 32 . . . and this Statement is that IAS 32 would define the class of instruments to be measured at the present value of the redemption amount more broadly. The Board views physically settled forward purchase contracts of an entity’s own shares in exchange for cash as being similar to financing a stock purchase or a treasury stock transaction and, therefore, would require the recognition of a liability for the future sacrifice of assets, but that view holds only if the obligation to purchase is unconditional and requires physical settlement in exchange for cash.
10.3.2 Written Put Options on an Entity’s Own Equity
Under U.S. GAAP, a written put option on an entity’s own shares is accounted for as a liability at fair value, with changes in fair value recognized in earnings (see Sections 5.3.1 and 6.3).
Under IFRS Accounting Standards, paragraph 23 of IAS 32 requires a physically
settled written put option on an entity’s own
shares to be accounted for in a manner similar to
a physically settled forward-purchase contract on
the entity’s own equity (see Section
10.3.1); that is, as a liability at the
present value of the redemption amount. This
treatment applies if the issuer could be required
to settle the contract by a gross exchange of cash
for shares even if the holder has the right to
elect net-cash or net-share settlement (i.e., it
applies when the holder has the choice of settling
the contract gross by the exchange of either cash
or another financial asset for shares).
Paragraph B80 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
The difference between IAS 32 . . . and this Statement is that IAS 32 would
define the class of instruments to be measured at the present value of
the redemption amount more broadly.
10.4 Obligations to Issue a Variable Number of Equity Shares
Under U.S. GAAP, a financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by delivering a variable number of equity shares is classified as an asset or a liability if, at inception, the obligation’s monetary value is based either solely or predominantly on a fixed monetary amount, variations in something other than the fair value of the issuer’s equity shares, or variations inversely related to changes in the fair value of the issuer’s equity shares (see Section 6.1). Obligations to issue a variable number of shares that do not meet the above conditions are typically accounted for as equity under U.S. GAAP.
Under IFRS Accounting Standards, paragraphs 21 and AG27(d) of IAS 32 require
contracts that will be settled in a variable number of shares to be accounted for as
assets or liabilities.
Paragraph B81 of the Background Information and Basis for Conclusions of FASB Statement 150 states, in part:
IAS 32 would require a liability to be recognized if an entity has a fixed monetary obligation or one that fluctuates in part or in full in response to changes in a variable other than the issuer’s own shares that can be settled with a number of shares that equals that obligation. [That guidance is] consistent with this [ASC 480-10] except for instruments with monetary values that fluctuate in part based on something other than changes in the fair value of the issuer’s shares and that are settled with a variable number of the issuer’s equity shares. [ASC 480-10] excludes from its scope share-settled “dual-indexed” financial instruments that are indexed (or have fair values that fluctuate) in part based on changes in the fair value of the issuer’s shares and in part based on one or more additional underlyings. . . . The Board notes that the accounting required for dual-indexed financial instruments that are within the scope of [ASC 815] is consistent with the accounting under . . . IAS 32.
Appendix A — Overview of Classification and Measurement Requirements in ASC 480-10
Appendix A — Overview of Classification and Measurement Requirements in ASC 480-10
A.1 Outstanding Shares
ASC 480-10 requires liability classification for
outstanding shares that fall into any of the following categories of
instruments:
Settlement Terms
|
Initial Measurement
|
Subsequent Measurement
| |
---|---|---|---|
Mandatorily redeemable financial instruments;
specifically, “shares that embody an unconditional
obligation requiring the issuer to redeem the instrument
by transferring its assets at a specified or
determinable date (or dates) or upon an event that is
certain to occur” (ASC 480-10-25-4 through 25-7; see
Sections 4.1
and 4.2)
|
Fixed settlement date and redemption amount
|
Fair value (see Section
4.3.1.1)
|
Present value of the settlement amount (see Section 4.3.1.2.1)
|
Variable settlement date or redemption amount
|
Fair value (see Section
4.3.1.1)
|
Amount of cash that would be paid if settlement occurred
on the reporting date (see Section 4.3.1.2.2)
| |
Outstanding shares that embody an
unconditional obligation that the issuer must or may
settle in a variable number of equity shares (see
Sections 6.1 and 6.2) if at inception the monetary value
of the obligation solely or predominantly has one of
three characteristics
|
The monetary value is fixed (see Section 6.1.2)
|
Fair value (see Section
6.3)
|
Amortized cost (see Section
6.3)
|
The monetary value is based on variations in something
other than the fair value of the issuer’s equity shares
(see Section
6.1.3)
|
Fair value (see Section
6.3)
|
Fair value (see Section
6.3)
| |
The monetary value is based on variations that are
inversely related to changes in the fair value of the
issuer’s equity shares (see Section 6.1.4)
|
Fair value (see Section
6.3)
|
Fair value (see Section
6.3)
| |
Noncontrolling interest with an embedded put and call
option combination that has certain characteristics (see
Section
7.1.2.1)
|
The options are exercisable on the same date and have
either the same fixed exercise price or prices that are
not significantly different.
|
Proceeds (see Section
7.1)
|
Present value of the strike price (see Section 7.1)
|
A.2 Financial Instruments Other Than Outstanding Shares
ASC 480-10 requires asset or liability
classification for financial instruments other than outstanding shares if they
fall into any of the following categories of instruments:
Settlement Terms
|
Initial Measurement
|
Subsequent Measurement
| |
---|---|---|---|
Forward contracts that require physical settlement by
repurchase of a fixed number of shares for cash (see
Sections 5.1
and 5.3.1.1)
|
Fixed settlement date and redemption amount
|
Fair value of the shares at inception or the present
value of settlement amount (see Section 5.3.1.2)
|
Present value of the settlement amount (see Section 5.3.1.3.1)
|
Variable settlement date or redemption amount
|
Fair value of the shares at inception or the amount of
cash that would be paid if the shares were repurchased
at inception (see Section
5.3.1.2)
|
Amount of cash that would be paid if settlement occurred
on the reporting date (see Section 5.3.1.3.2)
| |
Other instruments that are not an outstanding share and
both (1) embody an obligation to repurchase the issuer’s
equity shares or are indexed to such an obligation and
(2) require or may require the issuer to settle the
obligation by transferring assets (see Sections 5.1 and
5.2)
|
Fair value (see Section
5.3.2)
|
Fair value or amortized cost, as
appropriate (see Section 5.3.2)
| |
Instruments that are not an outstanding
share and embody an unconditional or conditional
obligation that the issuer must or may settle in a
variable number of equity shares (see Sections
6.1 and 6.2) if at
inception the monetary value of the obligation solely or
predominantly has one of three characteristics
|
The monetary value is fixed (see Section 6.1.2)
|
Fair value (see Section
6.3)
|
Fair value (see Section
6.3)
|
The monetary value is based on variations in something
other than the fair value of the issuer’s equity shares
(see Section
6.1.3)
|
Fair value (see Section
6.3)
|
Fair value (see Section
6.3)
| |
The monetary value is based on variations that are
inversely related to changes in the fair value of the
issuer’s equity shares (see Section 6.1.4)
|
Fair value (see Section
6.3)
|
Fair value (see Section
6.3)
|
Appendix B — Sources of SEC Guidance on Temporary Equity
Appendix B — Sources of SEC Guidance on Temporary Equity
The table below lists the main sources of the SEC’s temporary equity
guidance, most of which is reproduced in the SEC sections of the FASB Codification.
See Appendix D for a
list of the titles of other standards and literature referred to in this
Roadmap.
Title
|
SEC Reference or Type of Literature
|
FASB ASC Reference
|
Notes
|
---|---|---|---|
Commercial and Industrial Companies, Balance
Sheets, Preferred Stocks Subject to Mandatory Redemption
Requirements or Whose Redemption Is Outside the Control of
the Issuer
|
Rule 5-02.27 (also 17 CFR §210.5-02.27)
|
ASC 210-10-S99-1(27)
|
|
Bank Holding Companies, Balance Sheets,
Preferred Stocks Subject to Mandatory Redemption
Requirements or Whose Redemption Is Outside the Control of
the Issuer
|
Rule 5-02.27 (also 17 CFR §210.5-02.27)
|
ASC 942-210-S99-1(18)
|
Refers to 17 CFR §210.5-02.27 for
guidance
|
Insurance Companies, Balance Sheets,
Preferred Stocks Subject to Mandatory Redemption
Requirements or Whose Redemption Is Outside the Control of
the Issuer
|
Rule 7-03.20 (also 17 CFR §210.7-03.20)
|
ASC 944-210-S99-1(20)
|
States that 17 CFR §210.5-02.27 must be
followed
|
Presentation in Financial Statements of
“Redeemable Preferred Stocks”
|
ASR 268
|
|
Most of ASR 268 has been incorporated into
CFRP 211
|
Redeemable Preferred Stocks
|
|
ASC 480-10-S99-1
|
|
Redeemable Preferred Stock
|
SAB Topic 3.C
|
ASC 480-10-S99-2
|
|
FASB ASC Topic 718, Compensation — Stock
Compensation, and Certain Redeemable Financial
Instruments
|
SAB Topic 14.E
|
ASC 718-10-S99-1
|
|
Classification and Measurement of Redeemable
Securities
|
SEC Staff Announcement
|
ASC 480-10-S99-3A
|
Previously EITF Topic D-98
|
Sponsor’s Balance Sheet Classification of
Capital Stock With a Put Option Held by an Employee Stock
Ownership Plan
|
SEC Observer Comment
|
ASC 480-10-S99-4
|
Previously EITF Issue 89-11
|
Appendix C — Glossary of Selected Terms
Appendix C — Glossary of Selected Terms
Selected glossary terms in ASC 480-10-20 and the ASC master glossary are reproduced below.
ASC 480-10 Glossary and ASC Master Glossary
Down Round Feature
A feature in a financial instrument that reduces the strike
price of an issued financial instrument if the issuer sells
shares of its stock for an amount less than the currently
stated strike price of the issued financial instrument or
issues an equity-linked financial instrument with a strike
price below the currently stated strike price of the issued
financial instrument.
A down round feature may reduce the strike price of a
financial instrument to the current issuance price, or the
reduction may be limited by a floor or on the basis of a
formula that results in a price that is at a discount to the
original exercise price but above the new issuance price of
the shares, or may reduce the strike price to below the
current issuance price. A standard antidilution provision is
not considered a down round feature.
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.
Fair Value
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Financial Instrument
Cash, evidence of an ownership interest in an entity, or a contract that both:
- Imposes on one entity a contractual obligation either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term financial instrument in this definition is recursive (because the term financial instrument is included in it), though it is not circular. The definition requires a chain of contractual obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.
Contractual rights and contractual obligations encompass both those that are conditioned on the occurrence of a specified event and those that are not. All contractual rights (contractual obligations) that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets (liabilities) in financial statements — that is, they may be off-balance-sheet — because they fail to meet some other criterion for recognition.
For some financial instruments, the right is held by or the obligation is due from (or the obligation is owed to or by) a group of entities rather than a single entity.
Freestanding Financial Instrument
A financial instrument that meets either of the following conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Issuer
The entity that issued a financial instrument or may be required under the terms of a financial instrument to issue its equity shares.
Issuer’s Equity Shares
The equity shares of any entity whose financial statements are included in the consolidated financial statements.
Mandatorily Redeemable Financial Instrument
Any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.
Market Participants
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
- They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms
- They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary
- They are able to enter into a transaction for the asset or liability
- They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.
Monetary Value
A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain shares of stock with a current fair value equal to the gain.
Net Cash Settlement
A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain cash equal to the gain.
Net Share Settlement
A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain shares of stock with a current fair value equal to the gain.
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.
Obligation
A conditional or unconditional duty or responsibility to transfer assets or to issue equity shares. Because Topic 480 relates only to financial instruments and not to contracts to provide services and other types of contracts, but includes duties or responsibilities to issue equity shares, this definition of obligation differs from the definition found in FASB Concepts Statement No. 6, Elements of Financial Statements, and is applicable only for items in the scope of that Topic.
Orderly Transaction
A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
Parent
An entity that has a controlling financial interest in one or more subsidiaries. (Also, an entity that is the primary beneficiary of a variable interest entity.)
Physical Settlement
A form of settling a financial instrument under which both of the following conditions are met:
- The party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller.
- The seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
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).
Related Parties
Related parties include:
- Affiliates of the entity
- Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
- Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
- Principal owners of the entity and members of their immediate families
- Management of the entity and members of their immediate families
- Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
- Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
Securities and Exchange Commission Registrant
An entity (or an entity that is controlled by an entity) that meets any of the following criteria:
- It has issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
- It is required to file financial statements with the Securities and Exchange Commission (SEC).
- It provides financial statements for the purpose of issuing any class of securities in a public market.
Share-Based Payment Arrangements
An arrangement under which either of the following conditions is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity.
Also called share-based compensation arrangements.
Shares
Shares includes various forms of ownership that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. (Business entities have interest holders that are commonly known by specialized names, such as stockholders, partners, and proprietors, and by more general names, such as investors, but all are encompassed by the descriptive term owners. Equity of business entities is, thus, commonly known by several names, such as owners’ equity, stockholders’ equity, ownership, equity capital, partners’ capital, and proprietorship. Some entities [for example, mutual organizations] do not have stockholders, partners, or proprietors in the usual sense of those terms but do have participants whose interests are essentially ownership interests, residual interests, or both.)
Subsidiary
An entity, including an unincorporated entity such as a partnership or trust, in which another entity, known as its parent, holds a controlling financial interest. (Also, a variable interest entity that is consolidated by a primary beneficiary.)
Transfer
The term transfer is used in a broad sense consistent with its use in FASB Concepts Statement No. 6, Elements of Financial Statements (such as in paragraph 137), rather than in the narrow sense in which it is used in Subtopic 860-10.
Variable-Rate Forward Contracts
Variable-rate forward contracts are commonly used to effect equity forward transactions. The contract price on those forward contracts is not fixed at inception but varies based on changes in a specified index (for example, three-month U.S. London Interbank Offered Rate [LIBOR]) during the life of the contract.
Appendix D — Titles of Standards and Other Literature
Appendix D — Titles of Standards and Other Literature
The following are the titles of standards and
other literature mentioned in this publication other than the SEC’s principal
guidance on the presentation of temporary equity, which is listed in Appendix B:
AICPA Literature
Audit and Accounting Guide
Depository and Lending
Institutions: Banks and Savings Institutions, Credit Unions, Finance
Companies, and Mortgage Companies
Technical Questions and Answers
Section 4110, “Issuance of
Capital Stock”
FASB Literature
ASC Topics
ASC 105, Generally Accepted Accounting
Principles
ASC 205, Presentation of Financial Statements
ASC 210, Balance Sheet
ASC 220, Income Statement — Reporting Comprehensive Income
ASC 250, Accounting Changes and Error Corrections
ASC 260, Earnings per Share
ASC 310, Receivables
ASC 320, Investments — Debt Securities
ASC 321, Investments — Equity Securities
ASC 323, Investments — Equity Method and Joint
Ventures
ASC 340, Other Assets and Deferred Costs
ASC 450, Contingencies
ASC 460, Guarantees
ASC 470, Debt
ASC 480, Distinguishing Liabilities From Equity
ASC 505, Equity
ASC 606, Revenue From Contracts With Customers
ASC 718, Compensation — Stock Compensation
ASC 740, Income Taxes
ASC 805, Business Combinations
ASC 810, Consolidation
ASC 815, Derivatives and Hedging
ASC 820, Fair Value Measurement
ASC 825, Financial Instruments
ASC 830, Foreign Currency Matters
ASC 835, Interest
ASC 850, Related Party Disclosures
ASC 855, Subsequent Events
ASC 860, Transfers and Servicing
ASC 942, Financial Services — Depository and
Lending
ASC 944, Financial Services — Insurance
ASC 946, Financial Services — Investment
Companies
ASUs
ASU 2009-04, Accounting for Redeemable Equity Instruments
— Amendment to Section 480-10-S99
ASU 2016-19, Technical Corrections and
Improvements
ASU 2017-11, Earnings per Share (Topic 260);
Distinguishing Liabilities From Equity (Topic 480); Derivatives and
Hedging (Topic 815): Accounting for Certain Financial Instruments With
Down Round Features; Replacement of the Indefinite Deferral for
Mandatorily Redeemable Financial Instruments of Certain Nonpublic
Entities and Certain Mandatorily Redeemable Noncontrolling Interests
With a Scope Exception
ASU 2018-07, Compensation — Stock Compensation (Topic
718): Improvements to Nonemployee Share-Based Payment Accounting
ASU 2018-09, Codification Improvements
ASU 2019-08, Compensation — Stock Compensations (Topic
718) and Revenue From Contracts With Contracts (Topic 606): Codification
Improvements — Share-Based Consideration Payable to a Customer
ASU 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
Concepts Statement
No. 6, Elements of
Financial Statements
IFRS Literature
IAS 32, Financial
Instruments: Presentation
SEC Literature
Accounting Series Releases (ASRs)
No. 268 (FRR Section 211), Redeemable Preferred
Stocks
No. 280 (FRR Section 44), General Revision of Regulation
S-X
Financial Reporting Codification
CFRP 211, Redeemable Preferred Stocks
Regulation S-X
Rule 3-04, “Changes in Stockholders’ Equity and
Noncontrolling Interests”
Rule 4-07, “Discount on Shares”
Rule 4-08, “General Notes to Financial Statements”
Rule 5-02, “Commercial and Industrial Companies; Balance
Sheets”
Rule 7-03, “Insurance Companies; Balance Sheets”
Rule 9-03, “Bank Holding Companies; Balance Sheets”
(See Appendix B for additional references.)
SAB Topics
No. 2.A, “Business Combinations; Acquisition Method”
No. 3.C, “Senior Securities; Redeemable Preferred Stock”
No. 4.E, “Equity Accounts; Receivables From Sale of
Stock”
No. 5.A, “Miscellaneous Accounting; Expenses of
Offering”
No. 5.Q, “Miscellaneous Accounting; Increasing Rate
Preferred Stock”
No. 6.B, “Interpretations of Accounting Series Releases and
Financial Reporting Releases; Accounting Series Release 280 — General
Revision of Regulation S-X: Income or Loss Applicable to Common Stock”
No. 14.E, “Share-Based Payment; FASB ASC Topic 718,
Compensation — Stock Compensation, and Certain Redeemable Financial
Instruments”
Securities Exchange Act of 1934
Rule 14a-3, “Information to
Be Furnished to Security Holders”
Other Literature
The Division of
Corporation Finance: Frequently Requested Accounting and Financial
Reporting Interpretations and Guidance
Superseded Literature
Derivatives Implementation Group Issue
No. F6, “Fair Value Hedges:
Concurrent Offsetting Matching Swaps and Use of One as Hedging
Instrument”
EITF Abstracts
Issue No. 89-11, “Sponsor’s Balance Sheet Classification of
Capital Stock With a Put Option Held by an Employee Stock Ownership
Plan”
Issue No. 00-4, “Majority Owner’s Accounting for a Transaction in the Shares
of a Consolidated Subsidiary and a Derivative Indexed to the Noncontrolling
Interest in That Subsidiary”
Issue No. 00-27, “Application of Issue No. 98-5 to Certain
Convertible Instruments”
Issue No. 02-2, “When Certain Contracts That Meet the
Definition of Financial Instruments Should Be Combined for Accounting
Purposes”
Topic No. D-98,
“Classification and Measurement of Redeemable Securities”
FASB Staff Positions
FSP No. 150-2, Accounting for Mandatorily Redeemable Shares Requiring
Redemption by Payment of an Amount That Differs From the Book Value of
Those Shares Under FASB Statement No. 150
FSP No. 150-4, Issuers’ Accounting for Employee Stock Ownership Plans
Under FASB Statement No. 150
FSP No. 150-5, Issuer’s Accounting Under FASB Statement No. 150 for
Freestanding Warrants and Other Similar Instruments on Shares That Are
Redeemable
FASB Statement
Statement No. 150,
Accounting for Certain Financial Instruments With Characteristics of
Both Liabilities and Equity
FASB Technical Bulletin
No. 85-6, Accounting for a
Purchase of Treasury Shares at a Price Significantly in Excess of the
Current Market Price of the Shares and the Income Statement Classification
of Costs Incurred in Defending Against a Takeover Attempt
Appendix E — Abbreviations
Appendix E — Abbreviations
Abbreviation
|
Description
|
---|---|
AICPA
|
American Institute of Certified Public
Accountants
|
APIC
|
additional paid-in capital
|
ASC
|
FASB Accounting Standards Codification
|
ASR
|
Accounting Series Release
|
ASU
|
FASB Accounting Standards Update
|
BCF
|
beneficial conversion feature
|
CAQ
|
Center for Audit Quality
|
CCF
|
cash conversion feature
|
CEO
|
chief executive officer
|
CFR
|
Code of Federal Regulations
|
CFRP/CFRR
|
Codification of Financial Reporting
Policies
|
DECS
|
debt exchangeable for common stock
|
EBIT
|
earnings before interest and taxes
|
EBITDA
|
earnings before interest, taxes,
depreciation, and amortization
|
EITF
|
Emerging Issues Task Force
|
EPS
|
earnings per share
|
ERISA
|
Employee Retirement Income Security Act of 1974
|
ESOP
|
employee stock ownership plan
|
FASB
|
Financial Accounting Standards Board
|
FDA
|
Food and Drug Administration
|
FELINE
|
flexible equity-linked exchangeable
|
FRR
|
Financial Reporting Release
|
GAAP
|
generally accepted accounting principles
|
IAS
|
International Accounting Standard
|
IFRS
|
International Financial Reporting
Standard
|
IPO
|
initial public offering
|
IRC |
Internal Revenue Code
|
LIBOR
|
London Interbank Offered Rate
|
NAV
|
net asset value
|
OCA
|
SEC Office of the Chief Accountant
|
PCAOB
|
Public Company Accounting Oversight
Board
|
PEPS
|
premium exchangeable participating
securities
|
PIK
|
paid in kind
|
PRIDES
|
preferred redeemable increased dividend
equity securities
|
SAB
|
SEC Staff Accounting Bulletin
|
SAFE
|
simple agreement for future equity
|
SBIC
|
small business investment company
|
SEC
|
Securities and Exchange Commission
|
SPAC
|
special-purpose acquisition company
|
S&P 500
|
Standard & Poor’s 500 stock market
index
|
VSF
|
variable-share forward
|
VWAP
|
volume-weighted average price
|
ZCall
|
zero-strike call option
|
Appendix F — Roadmap Updates for 2023
Appendix F — Roadmap Updates for 2023
The table below summarizes the substantive changes made in the 2023
edition of this Roadmap.
Section
|
Title
|
Description
|
---|---|---|
Updated discussions of balance sheet
classification and the calculation of diluted EPS.
| ||
Put Warrants
|
Added guidance to clarify how put warrants
differ from net-cash-settled written call options.
| |
Initial Measurement
|
Added Connecting the
Dots to discuss the excise tax provision in
the Inflation Reduction Act of 2022.
| |
Reassessment
|
Added Example 6-9 to further
illustrate the reassessment guidance under ASC 480-10-25-14.
| |
Special Considerations When the Holder Has
the Ability to Control Issuer Decisions
|
Updated the list of features that would
require an equity instrument to be classified in temporary
equity.
| |
Limited Exception Applicable to Certain
Deemed Liquidation Provisions
|
Clarified the relationship between the
deemed liquidation exception in ASC 480-10-S99-3A(3)(f) and
the equity classification conditions in ASC 815-40-25. Also,
added Examples 9-6 and
9-7.
| |
Increasing-Rate Preferred Stock
|
Added guidance to clarify (1) the
application of SAB Topic 5.Q to convertible preferred stock
and (2) the relationship between SAB Topic 5.Q and the SEC’s
guidance on redeemable equity securities.
| |
Issuer Does Not Control Share Settlement
|
Added guidance on whether remeasurement is
required when the holders of a convertible instrument
control the issuer. Also added Section 9.5.4.6.1, which illustrates the
application of this guidance in Examples 9-15, 9-16, and 9-17.
| |
Extinguishments
|
Clarified that additional analysis is
necessary if the fair value of the consideration transferred
to redeem a preferred stock instrument does not reflect the
fair value of the instrument that is being redeemed.
|