On the Radar
Contracts on an Entityʼs Own
Equity
Entities raising capital must apply the highly complex, rules-based
guidance in U.S. GAAP to determine whether (1) freestanding contracts such as
warrants, options, and forwards to sell equity shares are classified as liabilities
or equity instruments and (2) convertible instruments contain embedded equity
features that require separate accounting as derivative liabilities. To reach the
proper accounting conclusion, they must consider the following key questions:
All entities are capitalized with debt or equity. The nature and 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.
ASC 815-40 provides guidance on the
reporting entity’s accounting for contracts that are potentially indexed to, and
potentially settled in, an entity’s own equity (also known as equity-linked
financial instruments). The following are examples of the types of instruments that
are within the scope of ASC 815-40:
Freestanding Equity-Linked Financial Instruments
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Embedded Equity-Linked Financial Instruments
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An equity-linked financial instrument can be classified in equity
only if it (1) is indexed to the entity’s own stock and (2) meets all other
conditions for equity classification. If an equity-linked financial instrument
either is not indexed to the entity’s own stock or does not meet the other
conditions for equity classification, it is classified as an asset or a liability.
Under the indexation and equity classification guidance, all terms of a contract
must be analyzed regardless of their significance or likelihood of becoming
applicable. Seemingly inconsequential features in a contract can cause it to fail to
qualify for equity classification.
An equity-linked financial instrument’s classification on the
balance sheet will affect how returns on the instrument are reflected in an entity’s
income statement. Returns on asset- and liability-classified instruments are
reflected in net income because they are subsequently measured at fair value, with
changes in fair value reported in earnings, whereas returns on equity-classified
instruments are generally reflected in equity, without affecting net income.
In addition to the effect on net income and earnings per share,
entities often seek to avoid classifying freestanding or embedded equity-linked
financial instruments as liabilities for other reasons, including:
- The effect of the classification on the entity’s credit rating and stock price.
- Regulatory capital requirements.
- Debt covenant requirements (e.g., leverage or capital ratios).
The SEC staff closely
scrutinizes the appropriate balance sheet classification
of freestanding and embedded equity-linked financial
instruments. This is evident in comment letters on
registrants’ filings and the number of restatements
arising from inappropriate classification.
Balance Sheet Classification
ASC 815-40 applies to each freestanding equity-linked financial
instrument regardless of whether it meets the ASC 815 definition of a derivative
instrument. In addition, ASC 815-40 applies to embedded equity-linked financial
instruments in hybrid financial instruments such as convertible debt and
convertible preferred stock unless (1) the embedded feature is clearly and
closely related to the host contract; (2) the hybrid financial instrument is
measured at fair value, with changes in fair value reported in earnings; or (3)
the equity-linked financial instrument does not, on a stand-alone basis, meet
the definition of a derivative instrument.
In some cases, equity-linked contracts 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 account (e.g., preferred stock is
issued with detachable warrants). When an entity enters into a financing
transaction that includes equity-linked items that can be legally detached and
exercised separately, those items are separate freestanding financial
instruments and ASC 815-40 must be applied to them individually.
Equity-linked features may be embedded in hybrid financial instruments. If so, an
entity often needs to use judgment to determine the unit of account for the
embedded feature that must be evaluated under ASC 815-40.
Unless a freestanding or embedded equity-linked financial
instrument is considered indexed to the entity’s stock, it must be classified as
an asset or a liability. To be considered indexed to the entity’s stock, the
instrument’s exercise and settlement provisions must meet certain conditions.
While contingent exercise provisions often do not disqualify an instrument from
being indexed to an entity’s stock, the instrument’s settlement terms may
contain adjustments to the exercise price or settlement amount that can result
in the arrangement’s failure to be considered indexed to the entity’s stock. Any
input that could potentially affect an instrument’s exercise price or settlement
amount (i.e., number of shares) that is not an input into the pricing of a
fixed-for-fixed forward or option on equity shares will result in the
instrument’s failure to be considered indexed to the entity’s stock.
At the 2024 AICPA & CIMA Conference on Current SEC
and PCAOB Developments, the SEC staff commented on
the complexities that issuers face when evaluating
whether a financial instrument should be classified
as a liability or equity and, more specifically,
whether a warrant instrument may be considered
indexed to an entity’s own stock in accordance with
relevant guidance. The SEC staff described certain
provisions commonly observed in warrant agreements
and observed that because an entity must use
significant judgment when applying the relevant
guidance, widespread diversity in practice exists
related to the determination of whether such
provisions would preclude an instrument from being
indexed to the entity’s own equity.
The SEC staff articulated its belief
that standard setting related to ASC 815-40 would
improve consistency and provide necessary clarity on
how to classify equity-linked contracts, and it
encouraged stakeholder input on this topic as part
of the FASB’s upcoming agenda consultation. As of
the date of this publication, no formal project has
been added to the FASB’s agenda, but entries with
equity-linked contracts should monitor the
Board’s Web site for
potential standard-setting developments.
A number of equity classification conditions must be met for
freestanding or embedded equity-linked financial instruments that are indexed to
the entity’s stock to be classified as equity instruments. The general principle
is that if net cash settlement could be required for any event that is not
within the entity’s control, the contract should be classified as an asset or a
liability rather than as equity.
Earnings per Share
ASC 260 addresses the EPS accounting for contracts within the scope of ASC 815-40.
Special considerations are necessary for contracts that may be settled in stock or
cash.
Under ASC 260, an entity may not overcome
the presumption of share settlement for a contract that
may be settled in stock or cash. Therefore, the shares
potentially issuable under such a contract must be
included in the denominator of diluted EPS.
Deloitte’s Roadmap Contracts on
an Entity’s Own Equity provides a
comprehensive discussion of the classification, initial and
subsequent measurement, and presentation and disclosure of
equity-linked financial instruments. Entities should also
consider Deloitte’s Roadmap Distinguishing Liabilities
From Equity for guidance on
equity-linked financial instruments as well as Deloitte’s
Roadmap Earnings per
Share for guidance on basic and diluted
EPS.
Contacts
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Ashley Carpenter
Audit &
Assurance
Partner
Deloitte &
Touche LLP
+1 203 761
3197
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For information about Deloitte’s
financial instruments service offerings, please contact:
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Will Braeutigam
Audit &
Assurance
Partner
Deloitte &
Touche LLP
+1 713 982
3436
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