4.1 Overview
ASC 815-40
15-7 An entity shall evaluate
whether an equity-linked financial instrument (or embedded
feature), as discussed in paragraphs 815-40-15-5 through
15-8 is considered indexed to its own stock within the
meaning of this Subtopic and paragraph 815-10-15-74(a) using
the following two-step approach:
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Evaluate the instrument’s contingent exercise provisions, if any.
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Evaluate the instrument’s settlement provisions.
15-8 Examples 2–21 (see paragraphs 815-40-55-26 through 55-48) illustrate the application of the guidance in paragraphs 815-40-15-5 through 15-7. These examples do not address whether an instrument (or embedded feature) is classified in equity (or would be classified in equity if freestanding). These examples also do not address whether the instrument is within the scope of Topic 480 or whether the instrument would be subject to the two-class method under Topic 260.
55-25A The Examples in paragraphs
815-40-55-26 through 55-48 illustrate the application of the
guidance beginning in paragraph 815-40-15-5.
One of the conditions that must be met for an equity-linked instrument to
qualify as equity is that the instrument is considered indexed to the entity’s own
stock in accordance with ASC 815-40-15. This condition must be met because:
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If a freestanding equity-linked instrument is not considered indexed to the entity’s own equity, it cannot be accounted for in equity but must be accounted for as an asset or a liability (irrespective of whether it meets the definition of a derivative).
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If a freestanding or embedded equity-linked instrument that meets the definition of a derivative is not considered indexed to the entity’s own equity, it does not qualify for the own-equity scope exception to the derivative accounting guidance in ASC 815-10-15-74(a).
To determine whether an equity-linked instrument is considered indexed to the
issuer’s own equity, an entity performs a two-step analysis:
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Step 1 — Evaluate whether the instrument contains any exercise contingencies and, if so, whether they disqualify the instrument from being classified as equity (see Section 4.2).
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Step 2 — Assess whether the settlement terms are consistent with equity classification (see Section 4.3).
If an entity concludes that an equity-linked instrument is considered indexed to
its own stock under ASC 815-40-15, the entity would also need to determine whether
the equity classification conditions in ASC 815-40-25 are met (see Chapter 5).
Contracts on an entity’s own equity that are prepared in accordance with
standard ISDA documentation often include adjustments and termination events defined
by reference to ISDA standard terms and definitions (see Section 3.1.3). When the EITF developed the
indexation guidance that was later incorporated into ASC 815-40-15, the Task Force
was mindful of such ISDA terms and definitions (e.g., ISDA’s 2002 equity derivatives
definitions). Nevertheless, without analyzing the contract’s terms, an entity cannot
assume that a contract prepared in accordance with standard ISDA documentation meets
the indexation guidance in ASC 815-40-15. For example, an entity should assess
whether the contract specifies any alterations to the ISDA definitions.
Example 4-1
ASR Adjustments
An ASR agreement may give the counterparty (e.g., an investment bank) the right to early terminate the ASR if certain contingent events occur that are defined by reference to ISDA’s equity derivatives definitions. Examples of termination events defined by ISDA include merger events, tender offers, nationalization, insolvency, delisting, change in law, insolvency filing, hedging disruption, increased cost of hedging, loss of stock borrow, and increased cost of stock borrow. The ASR may also specify additional termination events, for example, if the entity (1) declares an extraordinary cash dividend or a regular quarterly dividend in an amount greater than that specified in the agreement or (2) issues securities or share capital of another entity acquired or owned (directly or indirectly) by the entity as a result of a spin-off or other similar transaction — or any other type of securities (other than shares), rights, or warrants or other assets — for payment (cash or other consideration) at less than the prevailing market price.