Deloitte's Roadmap: Distinguishing Liabilities From Equity

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 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 and is therefore evaluated under other GAAP (e.g., ASC 815-40; see Section 3.2.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

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.

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. 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.

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.

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:

The stock does not meet the definition of a mandatorily redeemable financial instrument under ASC 480 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).

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 since the issuer has an unconditional obligation to transfer cash or other assets in exchange for the par amount.

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.

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.

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.

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).

Company U, an SEC registrant, issued, for $33 million, a 6.5 percent convertible preferred stock with an embedded put option. If exercised, the put option requires U to repurchase the shares for $33 million. Because U’s repurchase of the shares is conditioned upon exercise of the put option, the shares do not meet the definition of a mandatorily redeemable financial instrument in ASC 480 (see Chapter 4). Further, the issuer has determined that the put option is not required to be bifurcated as a derivative instrument under ASC 815-15. Because the redemption of the shares of preferred stock is outside the issuer’s control, these shares must be classified as temporary rather than permanent equity. Note that classification of the convertible preferred stock in temporary equity would also have been required even if the put option had been separated as an embedded derivative under ASC 815-15.

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.

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.

Entity D issues preferred stock that is only redeemable, at the option of the holders, upon (1) a merger or consolidation for which D is a constituent party (a “merger”) or (2) a sale of all or substantially all of D’s assets (an “asset sale”). Both a merger and an asset sale can occur only with approval of D’s board of directors. The preferred security is not redeemable upon what is often referred to in practice as a “change of control” (which is generally outside an entity’s control) because any redemption can occur only with approval of D’s board of directors.

The holders of the preferred stock do not currently control (1) D’s board of directors through direct representation or other rights or (2) the vote on matters submitted to D’s stockholders. Furthermore, in accordance with the terms of the preferred stock, the holders do not have the ability to obtain control of D’s board of directors or the vote of D’s stockholders. The holders of the preferred stock could only possibly obtain control over D’s board of directors or the vote of D’s stockholders by acquiring D’s common shares from third-party holders (i.e., by purchasing shares from other common stockholders that do not own the preferred stock).

The preferred stock does not have to be classified in temporary equity on the basis that D may be unable to prevent the preferred stockholders from obtaining control over D’s board of directors or the vote of D’s stockholders by acquiring common shares of D from third-party investors (e.g., by acquiring a controlling interest in D’s common stock from third-party holders of common stock). Decisions that require approval of an entity’s board of directors are considered to be within the issuing entity’s control unless the holders of preferred stock (or other equity instruments that are being evaluated for temporary equity classification) currently control or could obtain control of the entity’s board of directors or vote of the entity’s stockholders through direct representation or other contractual rights that arise from the terms of the preferred stock instrument or any other instrument that the preferred stockholders otherwise own. For example, if the terms of the preferred stock allow the preferred stockholders to obtain control of the issuing entity’s board of directors if the entity fails to timely pay dividends on the preferred stock, the entity would not be able to conclude that decisions of its board of directors are within its control because it is outside an entity’s control to timely pay dividends. (In that circumstance, temporary equity classification is required.) However, an entity is not required to consider the possibility that holders of preferred stock (or other equity instruments) could seize control over the entity’s board of directors or vote of its stockholders by purchasing common stock or other securities from third-party investors. Such a view would result in the classification as temporary equity of all equity securities with any redemption feature (conditional or otherwise) that does not meet the limited exception in ASC 480-10-S99-3A(3)(f) for deemed liquidation events, which is inconsistent with the application of ASC 480-10-S99-3A in practice. This view is supported by ASC 480-10-S99-3A(7), (10), and (11).

While the above fact pattern involves preferred stock that is redeemable upon a merger or asset sale, which is considered to be within D’s control, the same conclusion would apply if the preferred stock was redeemable upon the occurrence of other events that are within D’s control, including:

• A call option that permits but does not require D to repurchase the instrument for cash.
• An equity conversion feature that D has the ability to settle in common shares but can elect to settle in cash.
• A redemption feature that requires D to redeem the instrument if D’s board of directors decides to undertake an IPO of common stock.

However, if the preferred stockholders currently own a majority of D’s common stock and thereby control the election of D’s board of directors, classification of the preferred stock in temporary equity would be required unless specific contractual provisions support a conclusion that such holders could not require the preferred stock to be redeemed (i.e., the decisions that would lead to any such redemption must be approved by independent common stockholders or directors appointed by those common stockholders).

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.

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).

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.

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.