2.8 Financial Instruments
Because of the complexity associated with determining whether certain financial
instruments should be accounted for as derivatives, debt instruments, or equity, SEC
staff comments related to financial instruments have focused on (1) accounting for
embedded derivatives in hybrid instruments3 and (2) classification of financial instruments.
2.8.1 Embedded Derivatives in Hybrid Instruments
Examples of SEC Comments
- Please tell us in sufficient detail how you account for the €[X] million Dublin Convertible Preferred shareholder loans. In doing so, tell us how you analyzed the embedded conversion option and Stakeholder Warrants for derivatives and/or beneficial conversion features, how you account for the conversion option associated with dividends paid-in-kind, and where you classify the warrants on your balance sheet. Tell us the specific provisions of the conversion option and warrants, including the conversion price(s) of the loan principal, whether the warrants are legally detachable and separately exercisable, and how the “specified conversion price“ of the warrants is determined.
- We note that the conversion price of most of the convertible debentures is denominated in Canadian dollars while the conversion price of the convertible debentures issued [in July of the fiscal year] is denominated in US dollars. As such, it appears the conversion feature embedded in the debentures issued in July [of the fiscal year] is not indexed to your own stock and should be separated from the host contract and accounted for as a derivative pursuant to ASC 815. Please tell us how you accounted for the embedded conversion features and the basis in GAAP for your accounting.
The SEC staff may ask whether registrants have reached appropriate accounting
conclusions regarding whether embedded features in hybrid instruments should be bifurcated from the
host contract. ASC 815-15-25 provides guidance on whether an embedded feature should be separated
from the host contract and accounted for as a stand-alone derivative instrument in accordance with
ASC 815-10. If it is determined that an embedded feature is not clearly and closely related to the
host contract, the embedded feature may need to be bifurcated from the host contract depending
on whether certain other criteria are met and whether the embedded feature qualifies for any scope
exceptions. For example, if the features in a hybrid instrument are predominantly debt-like, the entity
would conclude that the host contract is more akin to debt; in such a case, an equity-like feature (e.g.,
a conversion option) would not be considered clearly and closely related to a debt host. Given the
complexity involved in determining whether a host contract is debt-like or equity-like, registrants can
expect the SEC staff to continue asking about the terms and features of convertible instruments to
determine whether the registrant has (1) properly determined the nature of the host contract and
(2) accounted for embedded features as stand-alone financial instruments when necessary. Registrants should consider the disclosure requirements of ASC 815-15 when making disclosures about the nature of the host contract.
2.8.2 Classification of Financial Instruments
Examples of SEC Comments
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You disclose that . . . you will be required to repurchase each share of [convertible preferred stock] that have not been converted into shares of common stock or automatically redeemed. Please tell us how you determined that your [convertible preferred stock] should be classified as mezzanine equity on your balance sheet and your consideration of the guidance in ASC 480-10-25-4.
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We note you have classified the . . . private placements warrants as equity. Please provide us with your analysis under ASC 815-40 to support your accounting treatment for these warrants. As part of your analysis, please address whether there are any terms or provisions in the warrant agreement that provide for potential changes to the settlement amounts that are dependent upon the characteristics of the holder of the warrant, and if so, how you analyzed those provisions in accordance with the guidance in ASC 815-40.
Entities should evaluate financial instruments that have both debt- and
equity-like characteristics to determine whether the instruments should be
classified as liabilities or equities in the financial statements. An entity
should first determine whether a financial instrument should be classified as a
liability in accordance with ASC 480. If the financial instrument is not
classified as a liability under ASC 480, the entity should analyze the financial
instrument under other accounting guidance, such as ASC 815. The SEC staff has
asked registrants to explain the basis for their determination of how financial
instruments should be classified, including the application of relevant
accounting literature. Such comments are especially common for SPACs or
companies that have merged with SPACs since complex financial instruments are
often issued to raise capital for SPACs and SPAC transactions.
Footnotes
3
The ASC master glossary defines a hybrid instrument as a
“contract that embodies both an embedded derivative and a host
contract.”