5.6 Liabilities, Equity, and Temporary Equity

The SEC historically has focused on the classification of financial instruments as liabilities or equity in the balance sheet when those financial instruments have redemption provisions or possess characteristics of both liabilities and equity. For example, the classification of embedded features within convertible debt instruments and freestanding warrants is often scrutinized since they may contain both liability and equity components under U.S. GAAP.4

At the time they are approaching a potential IPO, prospective registrants may have outstanding financial instruments with characteristics of both liabilities and equity, or in connection with a potential IPO, an entity may issue new financial instruments. Even if certain instruments are already outstanding before an IPO, when public financial statements are initially issued, it may be appropriate for a financial instrument to be classified as temporary equity (e.g., outside of permanent equity) in accordance with SEC rules even if it was acceptable for the financial instrument to be classified as permanent equity before the IPO. In accordance with 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 outside of permanent equity if it is redeemable for cash or other assets in any of the following circumstances: 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. The SEC’s guidance on temporary equity applies to SEC registrants’ financial statements that are prepared in accordance with Regulation S-X. Nonpublic entities are not required to apply this guidance but may elect to do so. Accordingly, an entity undertaking an IPO that has not previously elected to apply the SEC’s guidance on temporary equity would need to reassess its classification conclusion for equity-classified instruments. For equity-classified instruments (e.g., preferred stock) that must be treated as temporary equity, specific balance sheet presentation and disclosure would be required. In subsequently measuring an instrument classified in temporary equity, an entity must also assess whether (1) the instrument is currently redeemable or (2) it is probable that the instrument will become redeemable in the future. The SEC staff closely scrutinizes whether registrants’ balance sheet classification of capital securities is appropriate, as demonstrated in recent comment letters on registrants’ filings and the number of restatements associated with inappropriate classification. Given the extent of the SEC’s scrutiny on proper classification of capital securities as liabilities, temporary equity, or permanent equity, entities are encouraged to consult with their independent registered public accounting firms on the appropriate application of GAAP.

For more information about the classification of liabilities and equity, see Deloitte’s Roadmap Distinguishing Liabilities From Equity.

5.6.1 Distributions to Owners Under SAB Topic 1.B.3

While planning for an IPO, entities may make distributions to pre-IPO owners as compensation or as a return of capital. The SEC provides explicit guidance on reporting planned distributions to owners at or before the closing of an IPO.

Distributions are generally paid out of earnings. However, if the planned distribution exceeds earnings for the previous 12-month period, the amount of the distribution in excess of current earnings is deemed to be paid out of the proceeds of the offering.

Regardless of the source from which the planned distributions will be made to owners, if such planned distributions are not reflected in the latest balance sheet and the amount is significant in relation to reported equity, an entity should provide pro forma disclosures that reflect an accrual for the planned distribution and its impact on reported equity without giving effect to the offering proceeds (see paragraph 3420.1 of the FRM). Historically, this pro forma information was presented alongside the historical balance sheet or in an appropriate footnote disclosure. However, SEC Final Rule 33-10786, which amends Regulation S-X, Rule 11-02(a)(12), states that a registrant must not “[p]resent pro forma financial information on the face of the registrant’s historical financial statements or in the accompanying notes, except where such presentation is required by U.S. GAAP or IFRS-IASB, as applicable.” Accordingly, registrants should determine the appropriate location of the pro forma information, which might include summary financial information, the capitalization table, or separate unaudited pro forma financial information.

In addition, if a planned or actual distribution to owners is deemed to be paid out of proceeds of the offering rather than from the current year’s earnings, pro forma per-share data (pro forma EPS) should be presented for the latest fiscal year and interim period only. Pro forma EPS should be calculated by including an incremental number of shares, not to exceed the number of shares being offered in the IPO that, on the basis of the offering price, would be needed to pay the portion of the distribution that exceeds earnings for the previous 12-month period.

5.6.2 Changes in Capitalization

Changes in an entity’s capitalization or revisions to the capital structure often occur before, or concurrently with, the effective date or closing of an IPO. Such changes are frequently associated with the complex equity structures of many pre-IPO entities and are made to ensure that the entity has an appropriate capital structure to go public.

Changes in capitalization take various forms, including amendments to an entity’s articles of incorporation, stock splits, redemptions of preferred stock, and conversions of preferred stock or debt into common stock. Some changes, such as stock splits, are reflected retrospectively in all periods presented in the financial statements. Most other changes, if they occurred after the latest balance sheet date, are only recorded prospectively and may not be reflected in the historical financial statements presented in an IPO filing. However, such changes in capitalization may need to be presented as part of pro forma information.

5.6.2.1 Stock Splits in Contemplation of the IPO

Stock splits (or reverse stock splits) may be declared during the pre-IPO process with the intent to be effected shortly before the effective date of the registration statement (i.e., just before the closing of the IPO). A stock split is often executed to establish an outstanding share count that will result in an offering price that is within a preferred range based on the estimated post-IPO valuation. If the stock split is both declared and effected before an amendment to the registration statement is filed, the impact must be retrospectively reflected in the historical financial statements. The related footnote disclosures should include:5

A description of the change.
The retroactive presentation.
The date the change became effective.

When a prospective stock split has been declared but is not yet effected, it is still typical to retrospectively reflect the stock split in the historical financial statements. Because the stock split is not yet effective as of the issuance of the financial statements, but those financial statements retroactively reflect the impact of the stock split, the registration statement must include a “to-be-issued” auditor’s report (i.e., a draft report in the form that will be issued at a future date). Such an auditor’s report would include a preface (or legend) signed by the auditor stating that it expects to be in a position to issue the report in the form presented when the stock split is legally effected. The highlights of the June 2014 CAQ SEC Regulations Committee joint meeting with the SEC staff discuss the following situations related to such a presentation:

In certain situations, a registrant’s financial statements included in a registration statement may reflect a transaction that has not yet occurred but (a) will occur just prior to or at effectiveness and (b) will be reflected retrospectively in the historical financial statements in accordance with US GAAP. Examples are a stock split or a legal reorganization. In those circumstances, the staff will commence a review of a registration statement that includes a “to-be-issued” audit report on financial statements that have already been revised to reflect the transaction retrospectively (see FRM Section 4710).

Note that the registration statement cannot be declared effective until the legend is removed and the auditor’s report is finalized. Entities are encouraged to consult with their independent registered public accounting firms if they believe they meet the requirements described above. See Section 3.8 for more information.

5.6.2.2 Redemption or Conversion of Preferred Stock to Common Stock and Conversion of Debt

In many instances, preferred stock or convertible debt will automatically convert to common stock upon an IPO. If the original terms of outstanding convertible preferred stock do not provide for automatic conversion into common stock upon an IPO, an entity may, before commencing the IPO process, seek to obtain the agreement of the preferred stockholders to convert their preferred stock into common stock at the time of the IPO or to modify existing provisions in organizational documents to incorporate an automatic conversion feature. As a result, a change in capitalization may occur after the date of the most recent balance sheet presented. Similarly, changes in capitalization can result from conversion of debt into equity after the date of the latest balance sheet presented.

Paragraph 3430.1 of the FRM points out that the historical financial statements, including EPS data, generally “should not be revised to reflect modifications of the terms of outstanding securities that become effective after the latest balance sheet date.” However, a registrant may need to provide pro forma information, as discussed further below.

5.6.2.3 Presentation of Pro Forma Information Related to Changes in Capitalization

The registration statement may need to include pro forma financial information related to changes in capitalization that occur around the same time as an IPO.

The SEC staff often asks registrants to present pro forma information when changes in capitalization will occur after the date of the latest balance sheet. Paragraph 3430.2 of the FRM indicates that when such changes (1) will “result in a material reduction of permanent equity” or (2) result from “redemption of a material amount of equity securities . . . in conjunction with the offering,” a pro forma balance sheet should be included in the filing that takes into account the change in capitalization but not the effects of the offering proceeds. As discussed in Section 5.6.1, SEC Final Rule 33-10786, which amended Rule 11-02(a)(12), states that a registrant must not “[p]resent pro forma financial information on the face of the registrant’s historical financial statements or in the accompanying notes, except where such presentation is required by U.S. GAAP or IFRS-IASB, as applicable.” Accordingly, registrants should determine the appropriate location of the pro forma information, which might include summary financial information, the capitalization table, or separate unaudited pro forma financial information.

The conversion of preferred stock to common stock in conjunction with an IPO is not a reduction of permanent equity and therefore does not need to be included in the pro forma balance sheet (see paragraph 3430.2 of the FRM). However, many entities choose to reflect such conversions in pro forma balance sheet information.

A prospective registrant should also present pro forma EPS when outstanding securities are or will be converted after the latest balance sheet date and this conversion will cause a material reduction in EPS (excluding the effects of the offering). The pro forma EPS should reflect the securities conversion but not the effects of the offering. Such pro forma EPS should be presented for the latest fiscal year and interim period presented in the registration statement.

5.6.3 SAB Topic 4.E, “Receivables From Sale of Stock”

ASC 505-10

45-2 An entity may receive a note, rather than cash, as a contribution to its equity. The transaction may be a sale of capital stock or a contribution to paid-in capital. Reporting the note as an asset is generally not appropriate, except in very limited circumstances in which there is substantial evidence of ability and intent to pay within a reasonably short period of time, for example, as discussed for public entities in paragraph 210-10-S99-1 (paragraphs 27 through 29), which requires a deduction of the receivable from equity. However, such notes may be recorded as an asset if collected in cash before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25).

Generally, receivables that result from the issuance of shares classified as permanent or mezzanine equity should be presented as a reduction of each respective class of stock (i.e., contra equity). That is, receivables that result from the issuance of shares classified as permanent equity generally should be presented as a reduction of permanent equity in accordance with ASC 505-10-45-2. Similarly, receivables that result from the issuance of shares classified as mezzanine equity should be presented as a reduction of mezzanine equity by analogy to the guidance in EITF Issue 89-11 (not codified), which states, in part, that “when 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.”

Under SAB Topic 4.E (codified in ASC 310-10-S99-2), outstanding receivables from officers or other employees related to the issuance of stock to officers or other employees must generally be presented as a deduction from stockholders’ equity rather than as an asset.

Asset classification of such receivables may be appropriate only when the receivable is fully repaid in cash before the financial statements are issued. The date of payment must be disclosed in the notes to the financial statements.

SAB Topic 4.E cautions, however, that the SEC staff would consider any subsequent return of cash to the officer or employee as potentially representing an effort “to evade the registration or reporting requirements of the securities laws.” Although the receivable may be settled before the effective date of the IPO, receivables of this nature must be disclosed separately, regardless of whether they are classified as an asset or as a deduction from equity.

In addition, an entity that allows an employee to finance the purchase of shares should consider whether recourse or nonrecourse notes have been tendered. Nonrecourse notes are not recognized because such financing is accounted for, in substance, as a stock option. See Section 3.11.2 of Deloitte’s Roadmap Share-Based Payment Awards for further guidance.

Connecting the Dots

Entities preparing to file a registration statement with the SEC should be particularly cognizant of the potential legal ramifications that may arise as a result of such loans and should address any issues with their legal counsel well in advance of becoming public. Section 402 of Sarbanes-Oxley generally precludes certain loans with officers and directors, and any prohibited loans must be settled before a registrant’s filing of a public registration statement. Before going public, prospective registrants should consult with legal counsel regarding potential settlement of such loans.

Footnotes

For more information about the classification of warrants issued in SPAC transactions, see Section D.6.

These disclosures are required by SAB Topic 4.C (codified as ASC 505-10-S99-4) as well as for changes in capital structure that involve a stock dividend.