9.5 Measurement | DART – Deloitte Accounting Research Tool

9.5.1 Initial Measurement

SEC Staff Accounting Bulletins

SAB Topic 3.C, Redeemable Preferred Stock [Reproduced in ASC 480-10-S99-2]

Facts: Rule 5-02.27 of Regulation S-X states that redeemable preferred stocks are not to be included in amounts reported as stockholders’ equity, and that their redemption amounts are to be shown on the face of the balance sheet. However, the Commission’s rules and regulations do not address the carrying amount at which redeemable preferred stock should be reported, or how changes in its carrying amount should be treated in calculations of earnings per share . . . .

Question 1: How should the carrying amount of redeemable preferred stock be determined?

Interpretive Response: The initial carrying amount of redeemable preferred stock should be its fair value at date of issue. . . .

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: FN12 . . . .

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FN12 SAB Topic 3C, Redeemable Preferred Stock, states that the initial carrying amount of redeemable preferred stock should be its fair value at date of issue. The SEC staff believes this guidance should also be applied to other similar redeemable equity instruments. Consistent with Paragraph 820-10-30-3, the transaction price will generally represent the initial fair value of the equity instrument when the issuance occurs in an arm’s-length transaction with an unrelated party and there are no other unstated rights or privileges.

When an equity instrument subject to the temporary equity guidance is first recognized, it is initially measured at its fair value at issuance unless an exception applies. This measurement requirement applies irrespective of whether the redemption value is higher or lower than fair value. ASC 820 contains guidance on measuring fair value. In many cases, the transaction price (the proceeds received at issuance) will equal the initial fair value (see ASC 820-10-30-2 through 30-6). ASC 820-10-30-3A discusses circumstances in which the transaction price might not equal fair value at initial recognition (e.g., related-party transactions and forced transactions).

For example, an entity may issue a preferred stock instrument for net proceeds of $1,000, which equals its issuance-date fair value. If the instrument contains a redemption feature that permits the holder to put the instrument to the issuer at any time for cash of $950, the amount initially presented in temporary equity is $1,000 even though the redemption value is $950.

Exceptions to the requirement to measure an instrument classified as temporary equity initially at fair value include the following:

An equity host that remains after the bifurcation of an embedded derivative (see Section 9.5.6).
Equity-classified components of convertible debt (see Section 9.5.7).
An equity instrument issued with another freestanding financial instrument (see Section 9.5.9).
Noncontrolling interests (see Section 9.5.10).
Equity securities held by ESOPs (see Section 9.5.11).
Share-based payment arrangements (see Section 9.5.12).

Further, it would generally be appropriate for an entity to deduct, from the related proceeds, specific incremental costs that are directly attributable to the issuance of an instrument classified in temporary equity when the entity initially measures the instrument at fair value, because SAB Topic 5.A (reproduced in ASC 340-10-S99-1) states, in part:

Specific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering.

Further, AICPA Technical Q&As Section 4110.01 states, in part:

Direct costs of obtaining capital by issuing stock should be deducted from the related proceeds, and the net amount recorded as contributed stockholders’ equity. . . . Such costs should be limited to the direct cost of issuing the security. Thus, there should be no allocation of officers’ salaries, and care should be taken that legal and accounting fees do not include any fees that would have been incurred in the absence of such issuance.

See Section 3.3.4.4 for further discussion of what qualifies as an issuance cost.

9.5.2 Subsequent Measurement

9.5.2.1 Overview

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(13) Subsequent measurement. The SEC staff’s views regarding the subsequent measurement of a redeemable equity instrument that is subject to ASR 268 are included in paragraphs 14–16. Paragraphs 14 and 15 discuss the general views regarding subsequent measurement. Paragraph 16 discusses the application of those general views in the context of certain types of redeemable equity instruments.

S99-3A(14) If an equity instrument subject to ASR 268 is currently redeemable (for example, at the option of the holder), it should be adjusted to its maximum redemption amount at the balance sheet date. . . .

S99-3A(15) If an equity instrument subject to ASR 268 is not currently redeemable (for example, a contingency has not been met), subsequent adjustment of the amount presented in temporary equity is unnecessary if it is not probable that the instrument will become redeemable. If it is probable that the equity instrument will become redeemable (for example, when the redemption depends solely on the passage of time), the SEC staff will not object to either of the following measurement methods provided the method is applied consistently:

Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.

S99-3A(17) Application of the fair value option. Measurement of a redeemable equity instrument (or host contract) subject to ASR 268 at fair value through earnings in lieu of the measurement guidance provided in paragraphs 14–16 is not appropriate.FN16

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FN16 Paragraph 825-10-15-5(f) prohibits the election of the fair value option for financial instruments that are, in whole or in part, classified in stockholder’s equity (including temporary equity).

While the probability that an instrument will become redeemable does not affect its classification as temporary equity (see Section 9.4.1), such probability may affect the instrument’s subsequent measurement. Unless an exception applies, the measurement of an instrument classified as temporary equity after initial recognition differs depending on whether, as of the balance sheet date, (1) the instrument is currently redeemable or, if it is not currently redeemable, (2) it is probable that the instrument will become redeemable. The table below provides an overview of the subsequent measurement requirements that apply in each circumstance.

Circumstance	Subsequent Measurement
The instrument is currently redeemable.	Maximum redemption amount (i.e., the current redemption value) subject to a floor equal to the initial carrying amount.
The instrument is not currently redeemable, but it is probable that the instrument will become redeemable in the future (e.g., as a result of the passage of time).	Accounting policy choice between (1) accreted redemption value and (2) current redemption value. In both cases, the measurement is subject to a floor equal to the initial carrying amount.
The instrument is not currently redeemable, and it is not probable that the instrument will become redeemable in the future.	Not required to be remeasured.

As of each balance sheet date and on an ongoing basis, the issuer reassesses whether the instrument is currently redeemable or it is probable that it will become redeemable. The issuer may need to exercise significant judgment in determining whether it is probable that the security will become redeemable and must consider all relevant information. See Section 9.5.4 for additional discussion of the assessment of whether it is probable that a security will become redeemable.

If the instrument is not currently redeemable, but it is probable that the instrument will become redeemable, the SEC staff expects consistent application of the accounting method selected (i.e., measurement either at the accreted redemption value or the current redemption value), along with appropriate disclosure of the selected policy in the footnotes to the financial statements. In addition, entities that elect to “accrete changes in the redemption amount” over the period from the date of issuance to the earliest redemption date must disclose the “redemption amount of the equity instrument as if it were currently redeemable” (see Section 9.8.2).

Adjustments to the carrying amount of instruments classified as temporary equity are recognized as a deemed dividend against retained earnings or, in the absence of retained earnings, paid-in capital (see Section 9.5.5). Special considerations apply to preferred stock with a stated dividend rate that increases over time (see Section 9.5.2.6).

Exceptions to the subsequent-measurement guidance apply to:

Equity-classified components of convertible debt (see Section 9.5.7).
Noncontrolling interests (see Section 9.5.10).
Equity securities held by ESOPs (see Section 9.5.11).
Share-based payment arrangements (see Section 9.5.12).

In accordance with ASC 480-10-S99-3A(17) and ASC 825-10-15-5(f), an issuer may not elect to measure an instrument presented in temporary equity at fair value with changes in fair value recognized in earnings.

9.5.2.2 Current Redemption Value

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(14) If an equity instrument subject to ASR 268 is currently redeemable (for example, at the option of the holder), it should be adjusted to its maximum redemption amount at the balance sheet date. If the maximum redemption amount is contingent on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure). The redemption amount at each balance sheet date should also include amounts representing dividends not currently declared or paid but which will be payable under the redemption features or for which ultimate payment is not solely within the control of the registrant (for example, dividends that will be payable out of future earnings).FN13

S99-3A(15) . . . If it is probable that the equity instrument will become redeemable (for example, when the redemption depends solely on the passage of time), the SEC staff will not object to . . . the following measurement [method] provided the method is applied consistently: . . .

b. Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.

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FN13 See also Section 260-10-45.

Subsequent measurement at the current redemption value (subject to a floor equal to the initial carrying amount) is required if the instrument is currently redeemable. If it is probable that the instrument will become redeemable, however, such subsequent measurement is elective (as one of two permissible accounting policy options).

The current redemption value is the maximum amount payable if redemption were to occur as of the balance sheet date (see Section 9.5.6 for a discussion of how to adjust the measurement for any host contract classified as temporary equity with a bifurcated derivative). The current redemption value includes any currently accumulated, undeclared dividends that the issuer would be required to pay upon a redemption; however, it excludes discretionary, undeclared dividends irrespective of whether the issuer expects or intends to pay them.

If the instrument is not currently redeemable (e.g., because the redemption feature is contingent and, although the contingency has not been met, it is probable that it will be met in the future, or the instrument will become redeemable on a specified date in the future), the current redemption value is measured as if the instrument were redeemable at the end of the reporting period (i.e., the balance sheet date). That is, the end of the reporting period is viewed “as if it were also the redemption date for the instrument.”

If the redemption amount fluctuates on the basis of a market price or index (e.g., the current stock price or the most recent EBITDA), the current redemption value is determined on the basis of the current market price or index level as of the balance sheet date. This measurement applies even if the ability to redeem the instrument is contingent on the attainment of a specific market price or index level. If the index used for redemptions is updated periodically (e.g., October 31 of each year), the issuer should use the most recently calculated index amount for measurements as of the balance sheet date (e.g., it should use the October 31 index amount for the year ending on December 31 even if the index has changed from October 31 to December 31 because any redemptions are contractually based on the index as of October 31). The issuer should not seek to project what the index level will be for future redemptions (e.g., based on a trailing or rolling metric).

If a conversion feature causes an instrument to be classified as temporary equity (e.g., the issuer could be forced to cash settle the feature in accordance with ASC 815-40-25; see Section 9.4.6), the current redemption value would reflect the current conversion value (i.e., the amount of cash the issuer would be assumed to have to deliver upon a conversion).

Example 9-9

Preferred Stock That Is Redeemable on the Basis of the Common Stock Price

Entity X issues a perpetual preferred stock instrument for $100 at the beginning of the reporting period, when the stock price was $100. The instrument is redeemable at an amount equal to the quoted market price of X’s common stock one year after the end of the reporting period. At the beginning of the reporting period, X elected to subsequently measure the instrument at its current redemption value. If the quoted market price of the common stock at the end of the reporting period is $150, the current redemption value is $150 even though (1) the instrument is not currently redeemable and (2) the expected future redemption amount (based on the future market price of the common stock) if the instrument is redeemed may be different from $150. Therefore, X would adjust the carrying amount of the instrument from $100 to $150.

9.5.2.3 Accreted Redemption Value

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(15) . . . If it is probable that the equity instrument will become redeemable (for example, when the redemption depends solely on the passage of time), the SEC staff will not object to . . . the following measurement [method] provided the method is applied consistently:

Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates. . . .

SEC Staff Accounting Bulletins

SAB Topic 3.C, Redeemable Preferred Stock [Reproduced in ASC 480-10-S99-2]

Facts: Rule 5-02.27 of Regulation S-X states that redeemable preferred stocks are not to be included in amounts reported as stockholders’ equity, and that their redemption amounts are to be shown on the face of the balance sheet. However, the Commission’s rules and regulations do not address the carrying amount at which redeemable preferred stock should be reported, or how changes in its carrying amount should be treated in calculations of earnings per share . . . .

Question 1: How should the carrying amount of redeemable preferred stock be determined?

Interpretive Response: The initial carrying amount of redeemable preferred stock should be its fair value at date of issue. Where fair value at date of issue is less than the mandatory redemption amount, the carrying amount shall be increased by periodic accretions, using the interest method, so that the carrying amount will equal the mandatory redemption amount at the mandatory redemption date. The carrying amount shall be further periodically increased by amounts representing dividends not currently declared or paid, but which will be payable under the mandatory redemption features, or for which ultimate payment is not solely within the control of the registrant (e. g., dividends that will be payable out of future earnings). Each type of increase in carrying amount shall be effected by charges against retained earnings or, in the absence of retained earnings, by charges against paid-in capital.

The accounting described in the preceding paragraph would apply irrespective of whether the redeemable preferred stock may be voluntarily redeemed by the issuer prior to the mandatory redemption date, or whether it may be converted into another class of securities by the holder. Companies also should consider the guidance in FASB ASC paragraph 480-10-S99-3A (Distinguishing Liabilities from Equity Topic).

Subsequent measurement at the accreted redemption value (subject to a floor equal to the initial carrying amount) is one of two permitted accounting policy options if the instrument is not currently redeemable but it is probable that it will become redeemable. The issuer determines the accreted redemption value on the basis of periodic accretions of any difference between the initial carrying amount and the future redemption amount (including dividends not currently declared or paid, but payable upon redemption) over the period from the date of issuance (or the date on which it becomes probable that the instrument is redeemable, if later) to the earliest redemption date. If the redemption amount fluctuates on the basis of a market price or index (e.g., the current stock price or the most recent EBITDA), the future redemption amount is determined on the basis of the current market price or index level as of the balance sheet date. Projections of future changes (e.g., in fair value for an instrument redeemable at fair value) are not permitted.

The issuer uses an appropriate method (i.e., the interest method) to calculate the periodic accretion under which the accreted redemption value equals the redemption amount on the earliest redemption date. As stated in ASC 835-30-35-2, under the interest method, the issuer amortizes the difference between the present value and the redemption value to the earliest redemption date “in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period.” The accretion calculation under the interest method should include all dividends that will be payable on the redemption date. Special considerations apply to preferred stock with an increasing dividend rate (see Section 9.5.2.6).

Calculating the accreted redemption value by using the interest method tends to be straightforward when the timing and amount of the future cash flows (including the redemption amount) are fixed. If the timing or amount of the future cash flows varies, determining the accreted redemption value and the associated accretion pattern is more complex. If the redemption value varies on the basis of an index or other similar variable (e.g., fair value), the amortization schedule of periodic accretions needs to be updated regularly to reflect periodic changes in the redemption value. Similarly, the accretion pattern needs to be adjusted if the earliest redemption date changes (e.g., on the basis of estimates of when it is probable that an exercise contingency will be met). As the redemption value changes over time, the issuer adjusts the accretion pattern by using an appropriate method (e.g., a retrospective or prospective interest method). An entity should select one method as its accounting policy and apply it consistently to similar instruments. If an entity applies a retrospective interest method (similar to that under ASC 310-20-35-26 or ASC 320-10-35-41), the impact of the recalculation of the effective interest on the carrying amount of the instrument is recognized in the current period; prior-period financial statements are not restated.

A policy of measuring an instrument for which the timing or amount of redemption varies at its accreted redemption value may mitigate some of the volatility in the carrying amount associated with measuring the instrument at its current redemption value, since changes in the redemption value are amortized over the period until the earliest redemption date under the accreted redemption value method but recognized immediately under the current redemption value method. To avoid some of the complexity associated with measuring such instruments at their accreted redemption value, however, the issuer may instead elect an accounting policy under which the instruments are measured at their current redemption value.

If an instrument is not currently redeemable, nor is it probable that the instrument will become redeemable, the issuer is not required to accrete a difference between the current carrying amount and the redemption amount even if the redemption amount exceeds the current carrying amount.

Example 9-10

Accounting for a Change in Redemption Amount — Prospective Method

Entity Y issues a perpetual preferred stock instrument at the beginning of the annual reporting period for $100.00, when the stock price was $133.10. The instrument is redeemable at an amount equal to the quoted market price of the issuer’s common stock two years after the end of the annual reporting period. The stock price remained constant at $133.10 during the year until the end of the annual reporting period, when it increased to $177.80. At the beginning of the annual reporting period, Y elected to subsequently measure the instrument at its accreted redemption value and to use a prospective interest method to reflect subsequent changes in the timing and amount of future cash flows. To amortize the difference between $100.00 and $133.10 over three years, Y prepared an amortization schedule that uses an effective interest rate of 10 percent. After one year, therefore, the accreted redemption value before adjustment for the changes in the redemption value is $110.00 (= $100 + [10% × $100]). Because the stock price increased to $177.80 at the end of the reporting period, however, Y would update its accretion pattern for the remaining two years. Under the prospective interest method and in accordance with the revised amortization schedule prepared at the end of the reporting period, the difference between the current carrying amount of $110.00 and the current redemption value of $177.80 would be amortized over the remaining two years (i.e., the new effective interest rate is 25 percent).

9.5.2.4 Multiple Redemption Features

The measurement of the redemption value (whether the instrument is measured at its current redemption value or its accreted redemption value) reflects the amount that would be payable under redemption features that both (1) cause the instrument to be classified in temporary equity (e.g., holder redemption options or redemption features outside the control of the issuer) and (2) require it to be remeasured (i.e., features that cause the instrument to be considered currently redeemable or will probably cause it to become redeemable). Redemption features that do not cause the instrument to be classified as temporary equity (e.g., redemption features solely within the control of the issuer or upon ordinary liquidation events) are not reflected in the measurement of the redemption value.

Example 9-11

Preferred Stock That Is Callable and Puttable at Different Amounts

An equity instrument includes a holder put option exercisable at $90 and an issuer call option exercisable at $110. The redemption value is $90 (provided that the holder cannot direct the issuer to exercise the call option) even though the redemption amount would be higher should the issuer elect to exercise its call option. The call option does not affect the measurement of the redemption value because it does not result in a requirement to classify the equity instrument in temporary equity (only the put option does).

Similarly, redemption features that do not require the instrument to be remeasured (i.e., features that do not cause the instrument to be considered currently redeemable or do not cause its redeemability to become probable) do not affect the measurement of the redemption value.

Example 9-12

Preferred Stock With Contingent and Noncontingent Redemption Features

Entity Z issues an instrument that includes the following two redemption features: (1) upon a change of control (which is not probable), the instrument will be mandatorily redeemed for $120 and (2) the holder has a noncontingent put option with an exercise price of $100 that will become exercisable on a specified date in the future. In measuring the redemption value, Z takes into account the put option, but not the contingent redemption feature, because it is not probable that the instrument will become redeemable under the contingent redemption feature.

If an instrument contains more than one redemption feature that (1) causes the instrument to be classified as temporary equity and (2) is currently exercisable or will probably become exercisable, the redemption value reflects the maximum amount that the issuer might have to pay under those features.

Example 9-13

Preferred Stock With Two Contingent Redemption Features

An equity-classified instrument includes a contingent put option with an exercise price of $100 and another contingent put option with an exercise price of $110. If it is probable that each feature will become exercisable, the redemption value is the higher of $100 and $110 (i.e., $110).

9.5.2.5 Limit on Reductions to the Carrying Amount

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

e. For a redeemable equity instrument other than those discussed in (a), (b), and (d) of this paragraph, regardless of the accounting method applied in paragraphs 14 and 15, the amount presented in temporary equity should be no less than the initial amount reported in temporary equity for the instrument. That is, reductions in the carrying amount of a redeemable equity instrument from the application of paragraphs 14 and 16 are appropriate only to the extent that the registrant has previously recorded increases in the carrying amount of the redeemable equity instrument from the application of paragraphs 14 and 15.

In accordance with ASC 480-10-S99-3A(16)(e), an issuer is not permitted to reduce the carrying amount of an instrument classified as temporary equity below its initial carrying amount except for share-based payment arrangements, ESOPs, and convertible debt instruments with a separated equity component (for which special measurement guidance applies). For example, if the current redemption value of a currently redeemable instrument is $100 (e.g., the instrument can be put by the investor to the issuer for $100) and the initial fair value of the instrument was $105, the issuer is not permitted to reduce the amount presented for the instrument in temporary equity below $105 even though the carrying amount exceeds the redemption value.

9.5.2.6 Increasing-Rate Preferred Stock

In accordance with SAB Topic 5.Q, the SEC staff believes that an entity must use the interest method to recognize dividends on increasing-rate preferred stock. Although SAB Topic 5.Q specifically discusses nonconvertible preferred stock issued at a discount to its liquidation preference, with stated dividends that increase over time, the guidance also applies to (1) preferred stock issued at its liquidation preference that contains a stated dividend rate that increases over time and (2) convertible preferred stock that contains a stated dividend rate that increases over time.

Connecting the Dots

An issuer cannot avoid applying the SEC’s guidance on increasing-rate preferred stock on the basis that the holder may convert a preferred stock instrument into the issuer’s common shares before the stated dividend rate increases. The issuer does not control the ability to require the instrument to be converted into common stock and therefore does not have the unilateral ability to avoid an increase in the dividend rate. The same conclusion applies to a convertible preferred stock instrument that is mandatorily convertible into the issuer’s common shares if the issuer’s stock price increases to a stated amount per share.

Although ASC 480-10-S99-3A(15) gives an entity the option of recognizing redemption-amount measurement adjustments related to redeemable preferred stock by using one of two methods when preferred stock is not redeemable on the balance sheet date but it is probable that it will become redeemable (see Section 9.5.2.1), the entity must apply the effective yield method when SAB Topic 5.Q applies. Under SAB Topic 5.Q, it is not appropriate to immediately recognize the entire discount between the issuance price and the liquidation preference related to increasing-rate preferred stock. Rather, an entity applies the SEC’s guidance on increasing-rate preferred stock independently from the guidance on redeemable equity securities. However, some preferred stock instruments may be subject to both sets of requirements.

For further discussion of the scope and application of SAB Topic 5.Q, see Section 3.2.2.3 of Deloitte’s Roadmap Earnings per Share.

9.5.3 Assessment of Whether an Instrument Is Currently Redeemable

If a holder of an instrument classified as temporary equity currently has the right to exercise a redemption feature (e.g., a put right) and no conditions need to be met (or those conditions are currently met) to effect a redemption, the instrument is considered currently redeemable. An instrument would not be considered currently redeemable if the redemption feature cannot be exercised by the holder on the balance sheet date (e.g., if it can only be exercised on a specified future date [or dates] or if a redemption would require the satisfaction of conditions outside the holder’s control that are not met as of the balance sheet date).

If a condition needs to be met for the holder to exercise a redemption feature, and the holder controls whether the condition is met as of the balance sheet date, the instrument should be considered currently redeemable even if the condition was not met as of the balance sheet date (i.e., the condition is not substantive in the analysis). For example, an equity instrument is redeemable at the option of the holder upon the holder’s voluntary decision to terminate employment with the issuer. In such a case, the instrument is considered currently redeemable as of the balance sheet date even if the holder has made no decision to terminate employment, because the holder controls whether the condition is satisfied as of the balance sheet date. Similarly, if an instrument is redeemable upon a vote by a majority of the holders of the outstanding instrument, the instrument would be considered currently redeemable, because the holder (as a class) controls whether the condition is met as of the balance sheet date (i.e., the shareholder vote is not a substantive contingency, but an exercise of a current redemption right).

The issuer’s option to redeem the instrument as of the balance sheet date does not affect the assessment of whether the instrument is currently redeemable unless the holder has the power to control the issuer’s decision to exercise the redemption feature (see Section 9.4.4). If the holder has the power to direct the issuer to exercise the call option as of the balance sheet date, however, the instrument would be considered currently redeemable, because the option is not contingent.

When an instrument is redeemable upon a change of control, merger, consolidation, sale of substantially all assets, or other similar deemed liquidation event, and the holder controls the issuer’s board of directors, it is acceptable, but not required, to view the instrument as currently redeemable. Some view the deemed liquidation condition as nonsubstantive (i.e., the instrument should be viewed as currently redeemable) because the holder has the power to direct the issuer’s actions through its control of the issuer’s board of directors. Others view the same condition as substantive (i.e., the instrument should be viewed as not currently redeemable) because redemption is contingent on the identification of a market participant willing to purchase the assets for consideration in an amount sufficient to distribute the redemption amount to the holders of the redeemable equity instruments (see Section 9.5.4.5).

9.5.4 Assessing Whether It Is Probable That an Instrument Will Become Redeemable

9.5.4.1 Overview

The measurement of a redeemable equity instrument that is not currently redeemable depends on whether it is probable that the instrument will become redeemable. The ASC master glossary defines “probable” as the “future event or events are likely to occur” (i.e., probable is a higher threshold than “reasonably possible” or “more likely than not,” but near certainty is not required).

In evaluating whether it is probable that an instrument will become redeemable, an entity does not assess the likelihood that the instrument will be redeemed. Even if an instrument’s redemption is not probable, the instrument’s becoming redeemable may be probable. For example, an equity share may contain (1) a noncontingent redemption feature that permits the holder to put the instrument to the issuer for cash two years from the reporting date and (2) no other feature relevant to the analysis. On the basis of its contractual terms, the instrument is certain to become redeemable with the passage of time irrespective of whether it is probable that the holder will exercise its put option. Similarly, it is probable that an equity share that contains a put feature that will become exercisable upon the occurrence of an uncertain future event (e.g., a project milestone) will become redeemable if it is probable that the event will occur even if the put option is not expected to be exercised if or when it becomes exercisable. Further, it is probable that an equity share that will, on the basis of the passage of time, become redeemable by the holder unless an uncertain future event occurs will become redeemable unless there is a more than remote chance that the event will occur that will negate the holder’s ability to redeem the instrument (irrespective of the likelihood of the holder’s exercise of the contingent redemption right).

The table below provides an overview of the evaluation of whether it is probable that various features will become redeemable.

Probable That Feature Will Become Redeemable	Not Probable That Feature Will Become Redeemable
Redeemable at the option of the holder on a specified date in the future Redeemable at the option of the holder upon the occurrence of an event that is probable of occurring Automatically redeemed upon the occurrence of an event whose occurrence is probable Redeemable at the option of the holder on a specified date in the future unless an event that has a remote chance of occurring before that date happens Automatically redeemed on a specified date in the future unless an event that has a remote chance of occurring before that date happens	Redeemable at the option of the holder upon the occurrence of an event whose occurrence is not probable (e.g., an event that is reasonably possible) Automatically redeemed upon the occurrence of an event whose occurrence is not probable Redeemable at the option of the holder on a specified date in the future unless an event that has a more than remote chance of occurring before that date happens Automatically redeemed on a specified date in the future unless an event that has a more than remote chance of occurring before that date happens

Probable That Feature Will Become Redeemable

Not Probable That Feature Will Become Redeemable

Redeemable at the option of the holder on a specified date in the future
Redeemable at the option of the holder upon the occurrence of an event that is probable of occurring
Automatically redeemed upon the occurrence of an event whose occurrence is probable
Redeemable at the option of the holder on a specified date in the future unless an event that has a remote chance of occurring before that date happens
Automatically redeemed on a specified date in the future unless an event that has a remote chance of occurring before that date happens

Redeemable at the option of the holder upon the occurrence of an event whose occurrence is not probable (e.g., an event that is reasonably possible)
Automatically redeemed upon the occurrence of an event whose occurrence is not probable
Redeemable at the option of the holder on a specified date in the future unless an event that has a more than remote chance of occurring before that date happens
Automatically redeemed on a specified date in the future unless an event that has a more than remote chance of occurring before that date happens

Because of the uncertainties associated with the completion of a business combination (including, e.g., the completion of due diligence and the obtaining of any necessary shareholder or regulatory approval), the occurrence of a business combination generally would not be considered probable until it has been consummated. Similarly, the successful completion of an IPO or the completion of an IPO at a targeted stock price generally would not be considered probable until the IPO is effective and the stock target price is reached. Further, it is typically not probable that a change of control or sale of all or substantially all of an entity’s assets will occur until the transaction has been consummated, because such transactions require the agreement of a third party that is willing to acquire the entity or all or substantially all of its assets, and there are typically substantive contingencies associated with the transactions before their closing, as discussed above.

If an entity does not remeasure an instrument presented in temporary equity because it is not probable that it will become redeemable, the entity should disclose “the reasons why it is not probable that the instrument will become redeemable” (see Section 9.8.2).

Example 9-14

Assessment of the Probability That an Equity Instrument Will Become Redeemable

Company A, an SEC registrant, owns and operates supermarkets in Alaska. On January 1, 20X4, A issues 100,000 shares of redeemable convertible preferred stock for $1,000 per share, with the following terms:

Written put option — The preferred shares are redeemable by the holder any time after five years from issuance (i.e., on or after January 1, 20X9) for $1,100 per share if A has not opened 10 new supermarkets by January 1, 20X9.
Conversion option — The preferred shares are convertible by the holder, any time after issuance, into common shares of A at a conversion rate of 1:1.

Company A should assess whether it is probable that the preferred shares will become redeemable by considering whether it is probable that it will not open 10 new supermarkets by January 1, 20X9. (In its probability assessment, A would not take into account the fact that the holders of the preferred stock can exercise their option to convert the preferred shares into common shares at any time after issuance of the preferred shares.)

Company A might conclude that, at inception of the preferred stock, it is reasonably possible (but not probable) that it will not open 10 new supermarkets before January 1, 20X9, and that therefore it is not probable that the preferred shares will become redeemable. On the basis of that conclusion, A would initially record the preferred stock at fair value (i.e., $1,000) and would not need to adjust that amount subsequently until it determines that it is probable that 10 new supermarkets will not be opened by January 1, 20X9. Company A should disclose the reasons why it believes that it is not probable that the preferred stock will become redeemable.

If at some point A concludes that it is probable that it will not open 10 new supermarkets by January 1, 20X9, and thus that it is probable that the shares will become redeemable, A should either (1) use the interest method discussed in ASC 835-30 to accrete the carrying amount of the preferred stock to its redemption value over the remaining period (from the date on which A determines that it is probable that the shares will become redeemable to January 1, 20X9) or (2) immediately adjust the carrying amount of the preferred stock to its redemption value (i.e., $1,100). Company A should elect either method as its accounting policy and apply it consistently.

9.5.4.2 Mutually Exclusive Holder Options

If an instrument contains multiple mutually exclusive options (e.g., both conversion and redemption features) controlled by the holder, the probability assessment under ASC 480-10-S99-3A does not reflect the likelihood that the holder may exercise an option other than the redemption feature (e.g., a conversion option) before the redemption feature becomes exercisable. Thus, the probability that the holder will exercise a conversion feature before the instrument becomes redeemable is not relevant to the assessment of whether it is probable that the instrument will become redeemable.

In prepared remarks at the 2005 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Mark Northan stated the following:

The staff has become aware of questions in practice regarding the application of ASR 268 [footnote omitted] to equity securities with redemption features and other options. The question that I will address today concerns preferred securities that include multiple mutually exclusive options that are exercisable by the holder. In one example, the first option is a conversion option that is currently exercisable. This option gives the holder the right to convert the security into a fixed number of common shares. The second option, which is not currently exercisable, is a redemption option that gives the holder the right to redeem the shares for cash. The second option would become exercisable following the passage of a specified period of time.

Under the staff guidance in [ASC 480-10-S99-3A], these instruments are required to be classified outside of permanent equity because of the existence of a redemption feature.

The inquiries received by the staff concern the subsequent measurement of these securities following initial measurement at fair value. [ASC 480-10-S99-3A] has differing guidance on subsequent measurement for redeemable securities that depends upon whether the securities are currently redeemable, or whether it is probable or not that the security will become currently redeemable in the future.

When applying this guidance to a security with both a conversion option and a redemption option like the one described earlier, some have argued that it is not probable that the security will become currently redeemable because of the likelihood that the holder will exercise the conversion option first. We have objected to this view because the exercise of the conversion option was controlled entirely by the holder. Absent that action by the holder, the security will become redeemable following only the passage of time. The probability assessment that is required by [ASC 480-10-S99-3A] would not factor in the likelihood that other options held by the holder may or may not be exercised first. Thus, the instrument that I have described would be considered to be probable of becoming currently redeemable regardless of the likelihood of earlier conversion. As a result, the changes in the redemption values for this instrument would be recognized over the period from the date of issuance to the earliest possible redemption date using either of the two methods specified in [ASC 480-10-S99-3A].

9.5.4.3 Holder Option in Instrument With Mandatory Conversion Feature

Although the assessment of whether it is probable that an instrument will become redeemable does not take into account any holder option to convert an instrument before redemption (see Section 9.5.4.2), an entity would consider any feature that does not depend on the holder and could trigger conversion before the earliest redemption opportunity. It therefore would not necessarily be probable that an instrument that contains an option that permits the holder to redeem the instrument on a specified date (or dates) would become redeemable if it contains a mandatory conversion feature that requires the instrument to be converted into shares of common stock upon the occurrence of a specified event that is outside the holder’s control (such as a qualified IPO). In these circumstances, it would not be probable that the holder redemption option would become exercisable if it is more than remote that the specified event (such as the qualified IPO) will occur before the earliest redemption date. Accordingly, such an instrument would probably not become redeemable (and it would not be required to be remeasured under the temporary equity guidance) provided that the issuer controls the ability to share settle upon conversion (see Section 9.4.6).

In performing this assessment, the entity must consider the likelihood that the specified event (such as a qualified IPO as defined in the relevant agreements) would occur before the earliest redemption date as well as evaluate whether the entity controls the ability to share settle such conversion. The likelihood of the specified event and the entity’s ability to share settle the conversion feature should be reassessed as of each reporting date on the basis of the facts and circumstances as of that date (see Section 9.7.4). If an instrument becomes mandatorily convertible upon a qualified IPO as defined by reference to a specified monetary amount, it may be appropriate to involve valuation specialists in the evaluation of whether it is more than remote that such an IPO will occur. For a company that is just starting up, the likelihood that a qualified IPO will occur would not be expected to be more than remote.

It is probable that a redeemable equity instrument with a mandatory conversion feature will become redeemable if:

It is remote that the specified event (such as the qualified IPO) that would result in mandatory conversion into shares of common stock would occur before the earliest redemption date.
The issuer does not control the ability to share settle the mandatory conversion feature upon the specified event (so that the conversion feature would be analyzed for accounting purposes as a cash-settled redemption feature).
The holder has the ability to prevent the specified event triggering a mandatory conversion from occurring. (For instance, if mandatory conversion is required upon a qualified IPO and the holders control the entity, the holders can prevent the entity from undertaking a qualified IPO that would result in a mandatory conversion of the instrument.)
The holder has the choice to redeem the instrument or convert the instrument into shares of common stock upon the occurrence of the specified event.

In discussions with staff in the SEC’s Division of Corporation Finance, we have been made aware that the staff believes that the assessment of whether the occurrence of a qualified IPO is more than remote must be supported by an appropriate evaluation of all the relevant facts and circumstances on which the assessment is based. That is, the entity must have sufficiently persuasive information to support its conclusion that the occurrence of a qualified IPO is more than remote before an instrument otherwise becomes redeemable. In evaluating such likelihood, an entity must consider the manner in which “qualified IPO” is defined in the relevant agreements for the redeemable equity securities. If a qualified IPO is defined by reference to a minimum amount of securities sold in a public offering or a minimum price per security sold, the entity must consider that definition in its analysis. Further, if the entity has preliminary indications of the total offering or offering price, for example, on the basis of discussions with investment bankers, those preliminary indications must also be included in its analysis. In many situations, the entity will need to consult with its advisers for assistance in making these determinations.

In addition, the SEC staff has expressed the view that the assessment of such likelihood must be performed as of each reporting date on the basis of the facts and circumstances existing as of that date. The incorporation of subsequent information that was not known or knowable as of the reporting date is inappropriate. For example, if an entity has issued financial statements that are included in a registration statement filed with the SEC for an IPO of common stock, the filing of the IPO is a factor supporting a conclusion that it is more than remote that a qualified IPO will occur before a redemption feature becomes exercisable. However, the SEC staff would not accept an evaluation as of the most recent balance sheet date in support of the entity’s assessment for prior balance sheet dates. Rather, the entity would need to perform an evaluation as of the prior balance sheet dates solely on the basis of the information that was known or knowable on those dates (i.e., the entity could not use the subsequent filing of a registration statement as support for its assessments as of prior balance sheet dates).

Since an entity evaluates, as of each financial reporting period, whether it is more than remote that a qualified IPO will occur before an instrument otherwise becomes redeemable, it is possible that the entity would be required to remeasure a redeemable equity security during some financial reporting periods and not be required to remeasure the security during other financial reporting periods. If an entity has previously remeasured a redeemable equity security and no longer is required to remeasure such a security, the entity should not reverse the prior measurement adjustments.

In the determination of whether the holders of redeemable equity securities control the ability to prevent an entity from consummating a qualified IPO, the relevant governance structure of the entity and the terms of the instrument must be considered. A conclusion that the holders do not control the entity’s board of directors or the voting of shareholders may not be sufficient. For example, if the holders have to consent to an IPO, they control the ability to prevent the entity from consummating a qualified IPO and therefore remeasurement of the redemption amount under ASC 480-10-S99-3A would be required. If the holders have provided any required consents, remeasurement would still be required if the holders are able to revoke such consents.

9.5.4.4 Issuer’s Redemption Option

Unless the holder has the power to control the issuer’s decision to exercise an option (see Section 9.4.4), the existence of an issuer option to redeem the instrument does not affect the assessment of whether it is probable that an instrument will become redeemable or the determination of the earliest redemption date in accordance with the temporary equity guidance. SAB Topic 3.C states that the accounting for redeemable preferred stock “would apply irrespective of whether the redeemable preferred stock may be voluntarily redeemed by the issuer prior to the mandatory redemption date.”

9.5.4.5 Deemed Liquidation Features

The consummation of a change of control, merger, consolidation, sale of substantially all assets, or other similar deemed liquidation event typically is not probable. Because an issuer is not required to remeasure instruments when they are not currently redeemable or when it is not probable that they will become redeemable, the issuer is generally not required to remeasure an instrument that is redeemable only upon the consummation of a deemed liquidation event that requires the involvement or action of a third party. This conclusion is acceptable even if the holders of the instrument have control over the entity. Even with such control, the redemption event may be viewed as contingent since redemption would require the agreement of a third party that is willing to acquire the entity or all or substantially all of its assets. It is typically not probable that a change of control or sale of all or substantially all of an entity’s assets will occur until the consummation of such transaction. Alternatively, it would be acceptable for a reporting entity to choose, as an accounting policy, to remeasure redeemable convertible preferred stock to its redemption amount when the redemption will occur only upon the consummation of a deemed liquidation and the holders of the redeemable convertible preferred stock have control over the entity (see Section 9.5.3).

9.5.4.6 Issuer Does Not Control Share Settlement

As discussed in Section 9.4.6, an entity may be required to classify an outstanding equity share in temporary equity because it does not control the ability to share settle a conversion of the instrument into other shares of the entity’s stock (e.g., preferred stock convertible into common stock). In these situations, subsequent measurement of the instrument to its redemption amount may not be required, although it would always be acceptable.

If the equity instrument is currently redeemable and the entity does not have a sufficient number of authorized and unissued shares to settle it on the balance sheet date, remeasurement to the redemption amount is always required. In other situations, the entity can evaluate the probability that there would be an insufficient number of shares available to settle the instrument. Such an evaluation should not take into account the likelihood that a holder would choose not to convert the instrument (i.e., it must be assumed that the holder will elect to convert the instrument). The equity instrument would need to be subsequently measured under ASC 480-10-S99-3A if it is probable that it would become redeemable for cash or other assets because of the inability of the issuer to share settle it. In making that determination, the entity would focus on the likelihood that it would have enough shares to settle a conversion on any date that the holder could elect to convert. If conversion itself is contingent, the evaluation would also take into account the likelihood that the instrument would become convertible. The examples in Section 9.5.4.6.1 illustrate the application of this guidance.

If the holder has the unilateral ability to convert the instrument and controls the entity’s board of directors or vote of its stockholders, subsequent measurement to the redemption amount is required if the entity would need to authorize additional shares to settle the instrument because the holder can prevent the entity from authorizing those shares. However, the mere fact that an entity is controlled by the holders of a convertible instrument (e.g., convertible preferred stock) does not mean that subsequent measurement to the redemption amount is always required. Determining whether such measurement is required depends on the facts and circumstances. The examples in Section 9.5.4.6.1 illustrate the application of this guidance.

An equity instrument may be redeemable for cash or other assets if the issuing entity does not complete an IPO of its stock by a stated date. If an IPO of stock occurs before the stated date, the instrument is automatically converted into common stock. If the entity does not control the ability to share settle such a conversion, it would be required to remeasure the instrument to its redemption amount (i.e., the amount of cash or other assets that would be owed if the IPO of stock did not occur). It is not appropriate for the entity to avoid such remeasurement on the basis that it is reasonably possible that a conversion would occur before the stated redemption date since the entity does not control the ability to share settle such conversion.4 Similarly, if the holders of the instrument control the entity’s board of directors, the entity would be required to subsequently measure the instrument to its redemption amount even if it controls the ability to share settle such a conversion because the holders can prevent the entity from completing an IPO of its stock. The examples in the next section illustrate the application of this guidance.

9.5.4.6.1 Examples

The three examples below illustrate the application of the guidance in Section 9.5.4.6 and are followed by a discussion of the rationale for each example’s conclusion. The examples do not address all situations that may affect whether an entity needs to subsequently measure a preferred stock instrument that is classified in temporary equity to its redemption amount. Significant judgment is often required, and consultation with an entity’s accounting advisers is recommended.

Example 9-15

Convertible Preferred Stock — Issuer Needs to Authorize Additional Shares to Settle a Conversion Option

An entity issues preferred stock that the holder may elect to convert into a fixed number of shares of common stock at any time after two years from the issuance date. Under the contractual terms of the instrument, any conversion must be settled in common shares. However, the instrument does not specifically state that in no circumstances would the issuer be required to settle a conversion in cash if the issuer does not have sufficient authorized and unissued shares of common stock. Any adjustments to the number of shares of common stock that must be issued upon conversion (e.g., stock splits, stock dividends) are within the issuer’s control. There are no redemption features in the convertible preferred stock (i.e., no other features in the instrument that could potentially require the issuer to settle the instrument in cash or other assets upon events or circumstances outside the issuer’s control).

The issuer does not currently have enough authorized and unissued common shares to settle conversion of the preferred stock into common stock, and authorization of the additional common shares needed to settle the conversion would have to be approved by the issuer’s board of directors and shareholders, which is outside of the issuer’s control. Therefore, the convertible preferred stock is classified in temporary equity. The holders of the convertible preferred stock do not control the issuer’s board of directors or the vote of its stockholders.

If the issuer intends to seek authorization for the additional common shares needed to settle conversion of the preferred stock and it is not probable that the issuer will not receive such authorization before the preferred stock becomes convertible, subsequent measurement of the convertible preferred stock to its redemption amount is not required. This is because it is not probable that the convertible preferred stock will become redeemable for cash or other assets. Such treatment is based on an interpretation of ASC 480-10-S99-3A(15); however, it would also be acceptable under that guidance to subsequently measure the convertible preferred stock to its redemption amount. An entity should consistently apply the approach it elects as an accounting policy.

For an issuer to be able to conclude that it is not probable that it will be unable to settle conversion of the convertible preferred stock in common shares, it would have to assess the likelihood of the events that could prevent the issuer’s ability to share settle a conversion. In this example, the issuer should consider factors including, but not limited to, other obligations that will require the issuance of shares and the likelihood that the board of directors and shareholders would reject an increase in the number of authorized and unissued shares. An entity’s past practice with similar situations may also be a relevant consideration.

Note that subsequent measurement to the redemption amount would be required in the following circumstances:

It is probable that the entity would be unable to authorize the additional common shares needed to satisfy conversion of the preferred stock before the instrument becomes convertible.
The instrument contains any other redemption feature that would require subsequent measurement to the redemption amount. For example, if the instrument was redeemable for cash at the option of the holder in the absence of an IPO of the issuer by a specified date, subsequent measurement to the redemption amount would be required even if the issuer believes that it is reasonably possible that an IPO would occur. This is because an entity cannot use a conversion feature for which it does not control the ability to settle in shares to avoid subsequent measurement of a convertible instrument that has another redemption feature that would require the instrument to be remeasured to its redemption amount.
The holders of the preferred stock control the issuer’s board of directors or the vote of its stockholders.
The instrument is convertible at the balance sheet date.

Example 9-16

Convertible Preferred Stock — Issuer May Need to Authorize Additional Shares to Settle a Share-Settled Redemption Option

An entity issues preferred stock that the holder may elect to convert into a variable number of shares of common stock equal to a fixed monetary amount at any time after two years from the issuance date (i.e., a share-settled conditional redemption option). Under the contractual terms of the instrument, any conversion must be settled in common shares. However, the instrument does not specifically state that in no circumstances would the issuer be required to settle a conversion in cash if the issuer does not have sufficient authorized and unissued shares of common stock. Any adjustments to the number of shares of common stock that must be issued upon conversion (e.g., stock splits, stock dividends) are within the issuer’s control. There are no other redemption features in the preferred stock (i.e., no other features in the instrument that could potentially require the issuer to settle the instrument in cash or other assets upon events or circumstances outside the issuer’s control).

The issuer currently has enough authorized and unissued common shares to settle conversion of the preferred stock into common stock. However, because the instrument does not have a cap on the number of shares that may need to be issued, it is possible that the issuer would not have enough authorized and unissued common shares to settle a conversion in the future. Therefore, the preferred stock is classified in temporary equity because the issuer would have to obtain the approval of its board of directors and shareholders to authorize the additional common shares that may be needed upon a conversion, which is outside the issuer’s control. The holders of the preferred stock do not control the issuer’s board of directors or the vote of its stockholders.

If the issuer concludes that it is not probable that it will be unable to share settle a conversion of the preferred stock because either (1) it is not probable that the number of shares issuable upon conversion would increase because of a drop in the entity’s common stock price or (2) it is not probable that it would be unable to authorize the additional common shares necessary to settle conversion of the preferred stock before the instrument becomes convertible, subsequent measurement of the preferred stock to its redemption amount is not required. This is because it is not probable that the preferred stock will become redeemable for cash or other assets. Such treatment is based on an interpretation of ASC 480-10-S99-3A(15); however, it would be acceptable under that guidance to subsequently measure the preferred stock to its redemption amount. An entity should consistently apply the approach it elects as an accounting policy.

For an issuer to be able to conclude that it is not probable that it will be unable to settle conversion of the preferred stock in common shares, it would have to assess the likelihood of the events that could result in the issuer’s inability to share settle a conversion. In this example, the issuer should consider factors including, but not limited to, the likelihood that its common share price would decrease in such a manner that it would no longer have enough authorized and unissued shares to settle a conversion, other obligations that will require shares to be issued during the term of the preferred stock, and the likelihood that the board of directors and shareholders would reject an increase in the number of authorized and unissued shares. An entity’s practice in similar situations may also be a relevant consideration.

Note that subsequent measurement to the redemption amount would be required in the following circumstances:

It is probable that (1) the entity would need additional common shares to settle a conversion because of a drop in the common stock price and (2) the issuer would be unable to obtain authorization to increase the number of issuable shares before the instrument becomes convertible.
The instrument contains any other redemption feature that would require subsequent measurement to the redemption amount. An entity cannot use a conversion feature for which it does not control the ability to settle in shares to avoid subsequent measurement of an instrument that has another redemption feature that would require the instrument to be remeasured to its redemption amount.
The holders of the preferred stock control the issuer’s board of directors or the vote of stockholders and it is probable that the issuer will need additional common shares to settle conversion of the preferred stock because of a drop in the common stock price.
The instrument is convertible as of the balance sheet date and the issuer does not have a sufficient number of authorized and unissued shares to settle a conversion.

Example 9-17

Convertible Preferred Stock — Adjustments to Conversion Terms

An entity issues preferred stock that the holder can elect to convert into a fixed number of shares of common stock. The entity concludes that it currently has enough authorized and unissued shares to settle a conversion of the preferred stock, and there are no other share issuance obligations of the issuer that could change this conclusion. The convertible preferred stock has no stated redemption features (call or put options, contingent or otherwise) that could require the issuer to settle the instrument in cash or other assets. Under the contractual terms of the instrument, the conversion price would be adjusted for standard antidilutive events (e.g., stock splits, stock dividends) and a down-round feature. However, the instrument does not specifically state that in no circumstances would the issuer be required to settle a conversion in cash if the issuer does not have sufficient authorized and unissued shares of common stock.

If the issuer had to authorize additional common shares to settle a conversion of the convertible preferred stock because of an adjustment to the conversion price, it would need the approval of the issuer’s board of directors and shareholders. The holders of the convertible preferred stock (as a group) control the entity’s board of directors. Therefore, because the issuer does not control the ability to avoid an adjustment to the conversion price and does not control the ability to authorize additional common shares, the convertible preferred stock is classified in temporary equity.

If the issuer concludes that it is not probable that it will be unable to share settle the conversion feature, subsequent measurement of the convertible preferred stock to its redemption amount is not required. This conclusion is based on the following:

Convertible preferred stock agreements commonly contain adjustments to the conversion price in the event of an antidilutive event. Even though the holders of the convertible preferred stock control the issuer’s board of directors or the vote of stockholders, it is acceptable to evaluate the probability of the occurrence of this type of adjustment to the instrument. Such an approach is commonly applied in practice; otherwise, entities would be required to subsequently remeasure all convertible preferred stock instruments that are owned by a group that controls the issuer to their redemption amount. (Note that the evaluation of probability is only relevant to measurement; classification in temporary equity is still required regardless of the likelihood of redemption for cash or other assets.)
A third party (i.e., a purchaser of the issuer’s newly issued financial instruments) would need to be involved in the events that would have to occur for an issuer to no longer have enough authorized and unissued shares to settle a convertible preferred stock instrument as a result of a down-round feature. In a manner similar to its assessment of a deemed liquidation event (see Section 9.5.4.5), it is acceptable for an entity to evaluate the probability of the occurrence of a down-round feature.

While the entity in this example would not have to subsequently measure the convertible preferred stock instrument to its redemption amount, it would be acceptable for an entity to adopt an accounting policy under which such remeasurement is required.

Note that although there are no other redemption features in the convertible preferred stock discussed in this example, the conclusion would be the same if the convertible preferred stock was redeemable for cash or other assets only upon a deemed liquidation event for which the involvement of a third party was required provided that the occurrence of such an event was not considered probable (see further discussion in Section 9.5.4.5).

As the examples above demonstrate, entities will need to assess their facts and circumstances to determine whether the subsequent measurement of convertible preferred stock to its redemption amount is required when an issuer does not control the ability to share settle the instrument. This assessment would include whether the holders of the preferred stock control the issuer’s board of directors or the vote of its stockholders. While the conclusions related to subsequent measurement in the examples may differ when the preferred stockholders control the issuer, the supporting rationale for the conclusions is consistent. That is, if the issuer is controlled by the holders of the preferred stock, it cannot avoid subsequent measurement of that stock on the basis of an assessment of the likelihood of obtaining authorization to issue additional common shares.5 In each example, this principle is illustrated as follows:

Example 9-15 — In this example, the issuer needs to authorize additional common shares. That is, there is no condition or event that triggers the need for the additional common shares because they are already needed. If the holders of the convertible preferred stock control the issuer, subsequent measurement to the redemption amount is required because the holders can reject the issuer’s request for authorization of additional common shares.
Example 9-16 — In this example, the issuer would need to authorize additional common shares only if its share price dropped to such a level that the issuer would not be able to settle a conversion with the existing unissued shares available to be issued. The issuer first assesses whether it is probable that the share price would drop. If a price drop is not probable, subsequent measurement is not required. If a price drop is probable, subsequent measurement is required if the holders of the preferred stock control the issuer because the holders can reject the issuer’s request for authorization of additional common shares.
Example 9-17 — In this example, the issuer would need to authorize additional common shares only if (1) a conversion price adjustment occurs or the down-round feature is triggered and (2) the issuer no longer has sufficient authorized and unissued shares to settle a conversion of the convertible preferred stock. The probability assessment under which the issuer would be allowed to avoid subsequent measurement of the preferred stock to its redemption amount is related to a conversion price adjustment or the triggering of the down-round feature. It is therefore acceptable to evaluate the likelihood that such conditions would occur. If it is not probable that either event would occur, subsequent measurement to the redemption amount is not required. If it is probable that either event would occur, subsequent measurement to the redemption amount is required because the holders can reject the issuer’s request for authorization of additional common shares.

9.5.5 Recognition of Measurement Changes and Dividends

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(20) Preferred stock instruments issued by a parent (or single reporting entity). Regardless of the accounting method selected in paragraph 15 and the redemption terms (that is, fixed price or fair value), the resulting increases or decreases in the carrying amount of a redeemable instrument other than common stock should be treated in the same manner as dividends on nonredeemable stock and should be effected by charges against retained earnings or, in the absence of retained earnings, by charges against paid-in capital. . . .

S99-3A(21) Common stock instruments issued by a parent (or single reporting entity). Regardless of the accounting method selected in paragraph 15, the resulting increases or decreases in the carrying amount of redeemable common stock should be treated in the same manner as dividends on nonredeemable stock and should be effected by charges against retained earnings or, in the absence of retained earnings, by charges against paid-in capital. . . .

SEC Staff Accounting Bulletins

SAB Topic 3.C, Redeemable Preferred Stock [Reproduced in ASC 480-10-S99-2]

Facts: Rule 5-02.27 of Regulation S-X states that redeemable preferred stocks are not to be included in amounts reported as stockholders’ equity, and that their redemption amounts are to be shown on the face of the balance sheet. However, the Commission’s rules and regulations do not address the carrying amount at which redeemable preferred stock should be reported, or how changes in its carrying amount should be treated in calculations of earnings per share . . . .

Question 2: How should periodic increases in the carrying amount of redeemable preferred stock be treated in calculations of earnings per share . . . ?

Interpretive Response: Each type of increase in carrying amount described in the Interpretive Response to Question 1 should be treated in the same manner as dividends on nonredeemable preferred stock.

Because temporary equity represents equity, an issuer recognizes dividends, and changes in the carrying amount of a redeemable instrument classified as temporary equity, as equity transactions in a manner similar to the way it recognizes a dividend to the holder of a nonredeemable instrument; that is, it does not report them in net income or comprehensive income in its financial statements (see Section 9.6 for a discussion of how such changes affect the calculation of EPS).

Connecting the Dots

The redemption amount of redeemable stock may vary (e.g., it may be the fair value of the stock or it may be based on an index). In these situations, ASC 480-10-S99-3A allows an entity to reverse prior increases in the carrying amount of the stock that resulted from the application of the subsequent-measurement guidance in ASC 480-10-S99-3A (see Section 9.5.2.1). These increases would reverse the “deemed dividends” recorded in prior periods and would be treated as a “deemed contribution” by the stockholder. However, on a cumulative basis, adjustments to remeasure redeemable preferred stock to its redemption amount may not be negative. That is, decreases to the carrying amount that result from the application of ASC 480-10-S99-3A may only be recognized to the extent that such decreases reflect recoveries of previously recognized increases to the carrying amount as a result of the application of ASC 480-10-S99-3A (see Section 9.5.2.5).

To the extent that there are retained earnings, an entity recognizes against retained earnings dividends and changes in the carrying amount of an instrument classified as temporary equity. Thus, if the carrying amount increases, the entity would record the following entry:

Equity — retained earnings

Temporary equity

If there are no retained earnings, an entity recognizes against APIC the dividends and changes in the carrying amount. Thus, the following entry might be appropriate upon an increase in the carrying amount:

Equity — APIC

Temporary equity

If APIC is reduced to zero, an entity recognizes as an increase to the accumulated deficit the dividends and changes in the carrying amount. It would not be appropriate to measure APIC at a negative amount. Accordingly, the following entry might be appropriate upon an increase in the carrying amount when the issuer has a deficit:

Accumulated deficit

Temporary equity

In determining the appropriate recognition of dividends within equity, an entity should consider the state law of the jurisdiction in which it is incorporated. State law may specifically address the equity account from which distributions to stockholders can be made (e.g., surplus, net profits for the fiscal year in which the dividend is paid or the preceding fiscal year, or capital surplus). The entity should also consider the terms of its bylaws, charter, or articles of incorporation for any potentially applicable requirements.

Example 9-18

Recognition of an Increase in Redemption Amount

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.

If a down-round feature is triggered in a convertible preferred share that is classified in temporary equity, the issuing entity is required to recognize a dividend for the value of the effect of the down-round feature in accordance with ASC 260-10-25-1 and ASC 260-10-30-1 (i.e., debit to retained earnings; credit to APIC). As discussed in Section 9.5.8, the SEC staff would object to the classification of the credit to APIC within temporary equity. Therefore, the recognition of a down-round feature that has been triggered will affect reported EPS for the deemed dividend but will not affect the carrying amount of the redeemable preferred share that is classified in temporary equity. Consequently, an entity cannot treat this dividend as an increase to the carrying amount of the instrument when determining the amount of decreases to the carrying amount for recoveries of previous increases to the carrying amount as a result of applying ASC 480-10-S99-3A (see Section 9.5.2.5).

9.5.5.1 Paid-in-Kind Dividends

The terms of some redeemable equity instruments (e.g., preferred stock) include a paid-in-kind (PIK) dividend feature that requires or permits the issuer to satisfy any required dividend payments by issuing additional shares of the same redeemable equity instrument. The following are two types of such PIK dividend features:

On each dividend payment date, the issuer satisfies the dividend payment obligation by issuing additional redeemable equity securities to the holder(s). That is, additional fungible securities are issued.
On each dividend payment date, the issuer increases the liquidation preference of the original equity instrument to reflect the dividend accrued to the benefit of the holder. Economically, other than with respect to potential differences due to the compounding terms of the instrument, the PIK feature has the same effect as delivering additional instruments.

The initial measurement of the additional shares that are issued as PIK dividends depends on whether the PIK feature is discretionary or nondiscretionary:

PIK Feature	Description	Measurement Date for PIK Dividends
Discretionary	A PIK feature is discretionary if either of the following conditions exist: The issuer or the holder can elect a form of payment other than paid in kind (e.g., the issuer has the option to settle dividend payment obligations by either delivering cash or making a payment in kind). In cases in which the convertible instrument or a portion thereof is converted before dividends are accrued, the holder will not always receive the number of equity shares upon conversion as if all dividends have been paid in kind.	The date that the dividends are accrued
Nondiscretionary	A PIK feature is nondiscretionary if both of the following conditions exist: Neither the issuer nor the holder can elect payment of dividends in a form other than in kind. Regardless of the conversion date (whether converted in whole or in part), the holder will always receive the number of equity shares upon conversion as if all dividends have been paid in kind.	The measurement date for the original equity instrument

There are two acceptable views on how to interpret the condition that for PIK dividend payments to be nondiscretionary, the holder must always receive the number of equity shares upon conversion as if all dividends have been paid in kind if the original instrument (or part of it) is converted before accumulated dividends are declared or accrued. An entity should select one interpretation and apply it consistently as an accounting policy election:

View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that would have accrued during the entire life of the security (i.e., to the contractual maturity date).

Under this view, the issuer must know at the inception of the original convertible instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument adjusted for PIK dividends or, if PIK dividends are paid through the issuance of additional convertible instruments, conversion of both the original convertible instrument and any additional convertible instruments. Potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot determine the number of equity shares that will be issued or if the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. In most cases, PIK dividend payments would be discretionary under View A since entities typically do not issue convertible instruments that allow the holder to effectively earn future dividends that would not have accrued on an early conversion.
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that have accrued during the entire period in which the security has been outstanding (i.e., to the conversion date).

Under this view, the holder always receives upon conversion the number of equity shares as if all dividends that have been earned to date are paid in equity shares (i.e., no dividends are payable in cash). If the conversion date falls between periodic contractual dividend dates (i.e., accrual, declaration, or payment dates) and the holder forfeits any dividends that would have accrued from the last dividend date, this forfeiture does not prevent the dividends from being nondiscretionary since they are still not payable in cash.

The view selected will not affect the conclusion that PIK dividends are discretionary in cases in which a convertible (or nonconvertible) equity instrument allows either the holder or issuer to choose to pay dividends in cash or in kind. In these circumstances, the PIK dividends would be considered discretionary regardless of whether the entity adopted View A or View B above. In applying the above alternatives to a nonconvertible instrument, an entity should substitute the “redemption date” for the “conversion date.”

9.5.6 Bifurcated Embedded Derivatives

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

e. For host equity contracts (see paragraph 3(b)), the initial amount presented in temporary equity should be the initial carrying amount of the host contract pursuant to Section 815-15-30. . . .

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

For a redeemable equity instrument other than those discussed in (a), (b), and (d) of this paragraph, regardless of the accounting method applied in paragraphs 14 and 15, the amount presented in temporary equity should be no less than the initial amount reported in temporary equity for the instrument. That is, reductions in the carrying amount of a redeemable equity instrument from the application of paragraphs 14 and 16 are appropriate only to the extent that the registrant has previously recorded increases in the carrying amount of the redeemable equity instrument from the application of paragraphs 14 and 15.

Irrespective of whether an embedded feature is bifurcated as a derivative instrument under ASC 815-15 from an equity-classified host contract (e.g., preferred stock), the issuer should evaluate whether any of the temporary equity classification criteria are met for the hybrid contract in its entirety (inclusive of the embedded derivative). However, the initial amount presented in temporary equity is the amount attributable to the hybrid instrument that remains after separation of the embedded derivative in accordance with ASC 815-15-30-2.

Example 9-19

Initial Carrying Amount of Redeemable Preferred Stock With a Bifurcated Embedded Derivative

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).

Example 9-20

Initial Carrying Amount of Redeemable Preferred Stock With a Bifurcated Embedded Derivative That Includes PIK Dividends

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.

ASC 480-10-S99-3A does not specifically address the subsequent measurement of a host contract classified as temporary equity that remains after its separation from an embedded derivative.

Example 9-21

Subsequent Measurement of Host Contract

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.

9.5.7 Convertible Debt With a Separated Equity Component

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

d. For convertible debt instruments that contain a separately classified equity component, an amount should initially be presented in temporary equity only if the instrument is currently redeemable or convertible at the issuance date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the issuance date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the issuance date. . . .

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

d. For convertible debt instruments that contain a separately classified equity component, an amount should be presented in temporary equity only if the instrument is currently redeemable or convertible at the balance sheet date for cash or other assets (see paragraph 3(e)). The portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion at the balance sheet date over (2) the carrying amount of the liability-classified component of the convertible debt instrument at the balance sheet date.FN15 . . .

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FN15 ASR 268 does not impact the application of other applicable GAAP to the accounting for the liability component or the accounting upon derecognition of the liability and/or equity component.

The equity-classified component of a convertible debt instrument that is separated into liability and equity components (see Section 9.3.5) should be evaluated under the temporary equity guidance only if the instrument is currently redeemable or convertible as of the balance sheet date (see Sections 9.4.8 and 9.5.3). However, the issuer would not necessarily present the entire amount of the equity component as temporary equity. The amount of temporary equity is limited to the excess (if any) of “(1) the amount of cash or other assets that would be required to be paid to the holder upon a redemption or conversion . . . over (2) the carrying amount of the liability-classified component of the convertible debt instrument” as of both initial measurement and the subsequent balance sheet dates. (In measuring the liability-classified component, the issuer may appropriately include any bifurcated embedded derivative.)

There is an exception to ASC 480-10-S99-3A(16)(e) (see Section 9.5.2.5) under which an entity is not precluded from reducing the amount of temporary equity below the initial amount reported for the equity component of a convertible debt instrument that is separated into liability and equity components. If the separation of an equity component results in the recognition of a debt discount that is amortized over the life of the debt instrument, for example, the periodic increase in the net carrying amount of the liability component would cause a corresponding reduction in the amount presented in temporary equity for an instrument for which the current redemption amount remains constant (e.g., a convertible debt instrument with a separated equity component that is puttable at par anytime).

Depending on the applicable taxation requirements, the separation of an equity component may cause the carrying amount of the liability component under GAAP (the book basis) to be different from the tax basis of the debt that is determined in accordance with ASC 740. In practice, such basis differences will usually result in the recognition of a deferred tax liability under ASC 740 if the tax basis exceeds the book basis after the separation of an equity component. Because the separation of the equity component from the debt creates the basis difference in the debt, the establishment of a deferred tax liability for the basis difference results in a charge to the related component of equity (see ASC 740-20-45-11(c) and ASC 470-20-25-27). Therefore, the temporary equity guidance should be applied to the amount of the equity-classified component before any adjustment for the related tax effects, because the issuer’s deferred tax liability does not affect the amount payable by the issuer to the investor upon any redemption.

If the amount of cash or other assets that the issuer would be required to pay to the holder upon a redemption or conversion on the balance sheet date exceeds the carrying amount of the liability component by an amount greater than the carrying amount of the equity component, the issuing entity should first evaluate whether the carrying amount of the liability component is appropriately stated. If there is no requirement to adjust the carrying amount of the liability component under other U.S. GAAP, the entity can apply either of the following two approaches as an accounting policy since ASC 480-10-S99-3A does not explicitly address this situation:

Limit the amount of temporary equity to the amount allocated to the equity-classified component in accordance with GAAP.
Reclassify an amount from permanent equity (APIC) to temporary equity so that the total of the carrying amounts of the liability and equity components equals the amount of cash or other assets that the issuer would be required to pay to the holder upon a redemption or conversion on the balance sheet date.

In either case, an entity is well advised to provide transparent disclosure.

9.5.8 Convertible Preferred Stock With a Separated Equity Component

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

e. . . . Similarly, the initial amount presented in temporary equity for a preferred stock instrument that contains a beneficial conversion feature . . . should be the amount allocated to the instrument in its entirety pursuant to Subtopic 470-20 less any beneficial conversion feature recorded at the issuance date.

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

e. For a redeemable equity instrument other than those discussed in (a), (b), and (d) of this paragraph, regardless of the accounting method applied in paragraphs 14 and 15, the amount presented in temporary equity should be no less than the initial amount reported in temporary equity for the instrument. That is, reductions in the carrying amount of a redeemable equity instrument from the application of paragraphs 14 and 16 are appropriate only to the extent that the registrant has previously recorded increases in the carrying amount of the redeemable equity instrument from the application of paragraphs 14 and 15.

While ASC 480-10-S99-3A includes specific classification, measurement, and EPS guidance for convertible debt with a separated equity component (see Sections 9.4.8 and 9.5.7), it does not apply to equity-classified convertible stock with a separated equity component (e.g., an equity component that resulted from a modification or exchange that affected the conversion option, a reclassification of the embedded conversion option from a liability to equity, or an equity component that has been recorded as a result of a down-round feature that was triggered). As discussed in more detail in Section 3.2.5.2.4 of Deloitte’s Roadmap Earnings per Share, assuming that the equity component does not result from the recognition of a down-round feature that has been triggered, an entity can elect either of the following two views as an accounting policy related to classifying a separately recognized equity component associated with such an equity instrument:

View A — Classify the equity component in permanent equity.
View B — Classify the equity component in temporary equity.

The classification view applied will affect the measurement and EPS accounting as follows when a convertible preferred stock instrument must be remeasured to its redemption amount under ASC 480-10-S99-3A:

View A — An entity should remeasure the carrying amount of the convertible preferred stock to its current redemption amount (or in accordance with its policy elected under ASC 480-10-S99-3A(15) if the convertible preferred stock is not currently redeemable but it is probable that it will become redeemable) without regard to the amount recognized in permanent equity for the equity component.
View B — An entity considers the aggregate of the carrying amounts of the convertible preferred stock and separately recognized equity component in determining the amount of any measurement adjustment required under ASC 480-10-S99-3A. While the amount reported in temporary equity for the separately recognized equity component is not subsequently adjusted, that amount will indirectly affect the amount of the ASC 480-10-S99-3A measurement adjustment that needs to be made to the carrying amount of the convertible preferred stock reported in temporary equity.

Unless an exception applies (see Section 9.5.2), an issuer is not permitted to reduce the amount of temporary equity below the initially recorded amount even if that amount exceeds the redemption value.

Connecting the Dots

ASC 260-10-30-1 states, in part:

As of the date that a down round feature is triggered (that is, upon the occurrence of the triggering event that results in a reduction of the strike price) in . . . equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance), an entity shall measure the value of the effect of the feature as the difference between the following amounts determined immediately after the down round feature is triggered:

The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.

ASC 260-10 further indicates that the amount calculated in accordance with the guidance above should be recognized as a debit to retained earnings (which reduces the numerator in the calculation of EPS) and a credit to APIC.

On the basis of discussions with the staff in the SEC’s OCA, we understand that the SEC will object if an entity classifies this credit entry as APIC within temporary equity. Therefore, if the convertible preferred stock is subject to remeasurement under the SEC’s temporary equity guidance, any remeasurement adjustments must be made without regard to the amount recognized in APIC (permanent equity) when the down-round feature was triggered. The SEC staff indicated that its view must be applied by SEC registrants even though such application may result in “double-counting” the effect on EPS for a convertible preferred share that is being remeasured to its redemption amount for which a down-round feature has been triggered. In addition, we have confirmed with the OCA staff that this view applies only to convertible preferred stock arrangements that are subject to the down-round guidance in ASC 260. Therefore, we believe that the two alternative views discussed above on the classification of a separately recognized equity component in a redeemable convertible preferred share are still acceptable in all other situations.

9.5.9 Redeemable Equity Instruments Issued With Other Instruments

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

e. . . . Similarly, the initial amount presented in temporary equity for a preferred stock instrument that . . . is issued with other instruments should be the amount allocated to the instrument in its entirety pursuant to Subtopic 470-20 less any beneficial conversion feature recorded at the issuance date.

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

e. For a redeemable equity instrument other than those discussed in (a), (b), and (d) of this paragraph, regardless of the accounting method applied in paragraphs 14 and 15, the amount presented in temporary equity should be no less than the initial amount reported in temporary equity for the instrument. That is, reductions in the carrying amount of a redeemable equity instrument from the application of paragraphs 14 and 16 are appropriate only to the extent that the registrant has previously recorded increases in the carrying amount of the redeemable equity instrument from the application of paragraphs 14 and 15.

When a redeemable equity instrument is issued with other freestanding financial instruments (e.g., a detachable warrant), the issuer allocates the proceeds received between the redeemable equity instrument and the other units of account before applying the temporary equity guidance. In such circumstances, the initial measurement of the redeemable equity instrument is not its initial fair value but rather the amount allocated to the instrument less any bifurcated derivative (see Section 9.5.6).

Depending on the characteristics of the other instruments and their subsequent measurement, different allocation methods apply. If one of the instruments will be subsequently measured at fair value and changes in fair value will be recognized in earnings (e.g., a freestanding derivative instrument within the scope of ASC 815), proceeds are typically allocated on the basis of the instrument’s fair value, and the residual proceeds are allocated to the redeemable equity instrument and any other units of account that are not remeasured at fair value (see Section 3.3.4). If the other units of account are not subsequently measured at fair value, it may be appropriate to allocate proceeds on a relative-fair-value basis.

Unless an exception applies (see Section 9.5.2.5), an issuer is not permitted to reduce the amount of temporary equity below the initially recorded amount even if that amount exceeds the redemption value.

9.5.10 Noncontrolling Interests

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

c. For noncontrolling interests, the initial amount presented in temporary equity should be the initial carrying amount of the noncontrolling interest pursuant to Section 805-20-30. . . .

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

c. For noncontrolling interests, the adjustment to the carrying amount presented in temporary equity is determined after the attribution of net income or loss of the subsidiary pursuant to Subtopic 810-10. . . .

e. For a redeemable equity instrument other than those discussed in (a), (b), and (d) of this paragraph, regardless of the accounting method applied in paragraphs 14 and 15, the amount presented in temporary equity should be no less than the initial amount reported in temporary equity for the instrument. That is, reductions in the carrying amount of a redeemable equity instrument from the application of paragraphs 14 and 16 are appropriate only to the extent that the registrant has previously recorded increases in the carrying amount of the redeemable equity instrument from the application of paragraphs 14 and 15.

S99-3A(22) Noncontrolling interests. Paragraph 810-10-45-23 indicates that changes in a parent’s ownership interest while the parent retains control of its subsidiary are accounted for as equity transactions, and do not impact net income or comprehensive income in the consolidated financial statements. Consistent with Paragraph 810-10-45-23, an adjustment to the carrying amount of a noncontrolling interest from the application of paragraphs 14–16 does not impact net income or comprehensive income in the consolidated financial statements. Rather, such adjustments are treated akin to the repurchase of a noncontrolling interest (although they may be recorded to retained earnings instead of additional paid-in capital). . . .

The initial carrying amount that is recognized in temporary equity for noncontrolling interests is the initial carrying amount determined in accordance with the accounting requirements for noncontrolling interests (including those in ASC 805-10, ASC 805-20, and ASC 810-10). After initial recognition, the issuer applies a two-step approach to measuring noncontrolling interests under the temporary equity guidance on each balance sheet date. First, the entity applies the measurement guidance in ASC 810-10 by attributing a portion of the net income or loss of the subsidiary to the noncontrolling interest. Second, the entity applies the subsequent measurement guidance in ASC 480-10-S99-3A. The noncontrolling interest’s carrying amount is the higher of (1) the cumulative amount that would result from applying the measurement guidance in ASC 810-10 (i.e., the initial carrying amount, increased or decreased for the noncontrolling interest’s share of net income or loss — as well as its share of other comprehensive income or loss — and dividends) or (2) the redemption value.

Under ASC 480-10-S99-3A(16)(e), an issuer generally cannot reduce the amount of temporary equity reported for an instrument within the scope of the temporary equity guidance below its initial carrying amount. However, this limitation does not apply to reductions in the carrying amount of a noncontrolling interest that result from the application of the noncontrolling interest guidance in ASC 810-10. It only applies to reductions in the carrying amount that result from the application of the temporary equity guidance.

Because temporary equity represents equity, changes in the carrying amount of noncontrolling interests classified as temporary equity are accounted for as equity transactions and are not reported in net income or comprehensive income in the issuer’s financial statements (see Section 9.6.3 for a discussion of how such changes affect the calculation of EPS).

9.5.11 Equity Securities Held by ESOPs

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date. . . .

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date.

SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan

S99-4 The following is the text of SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan.

ASR 268 (see also paragraph 480-10-S99-3A) requires that to the extent that there are conditions (regardless of their probability of occurrence) whereby holders of equity securities may demand cash in exchange for their securities, the sponsor must reflect the maximum possible cash obligation related to those securities outside of permanent equity. Thus, securities held by an ESOP (whether or not allocated) must be reported outside of permanent equity if by their terms they can be put to the sponsor for cash. With respect to ESOP securities where the cash obligation relates only to market value guarantee features, the SEC staff would not object to registrants only classifying outside of permanent equity an amount that represents the maximum cash obligation of the sponsor based on market prices of the underlying security as of the reporting date; accordingly, reclassifications of equity amounts would be required based on the market values of the underlying security. Alternatively, the SEC staff would not object to classifying the entire guaranteed value amount outside of permanent equity due to the uncertainty of the ultimate cash obligation because of a possible market value decline in the underlying security.

Provided that “the cash redemption obligation relates only to a market value guarantee feature,” the SEC permits an issuer to elect to measure redeemable equity instruments held by an ESOP at “either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation [of the sponsor] based on the fair value of the underlying equity securities at the balance sheet date.”

This exception should not be applied by analogy. For example, it would not apply when an amount other than the market value guarantee may need to be redeemed by the sponsor for cash or other assets and such redemption could occur upon any event outside the sponsor’s control. If the exception does not apply, the entire carrying amount of the ESOP’s outstanding redeemable shares of stock must be classified in temporary equity.

9.5.12 Share-Based Payment Arrangements

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: . . .

a. For share-based payment arrangements with employees, the initial amount presented in temporary equity should be based on the redemption provisions of the instrument and the proportion of consideration received in the form of employee services at initial recognition. For example, upon issuance of a fully vested option that allows the holder to put the option back to the issuer at its intrinsic value upon a change in control, an amount representing the intrinsic value of the option at the date of issuance should be presented in temporary equity.

S99-3A(16) [Subsequent measurement.] The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15:

a. For share-based payment arrangements with employees, the amount presented in temporary equity at each balance sheet date should be based on the redemption provisions of the instrument and should take into account the proportion of consideration received in the form of employee services (that is, the pattern of recognition of compensation cost pursuant to Topic 718).FN14. . .

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FN14 See also the Interpretative Response to Question 2 in Section E of Section 718-10-S99.

SEC Staff Accounting Bulletins

SAB Topic 14.E, FASB ASC Topic 718, Compensation — Stock Compensation, and Certain Redeemable Financial Instruments [Reproduced in ASC 718-10-S99-1]

Facts: Under a share-based payment arrangement, Company F grants to an employee shares (or share options) that all vest at the end of four years (cliff vest). The shares (or shares underlying the share options) are redeemable for cash at fair value at the holder’s option, but only after six months from the date of share issuance (as defined in FASB ASC Topic 718). Company F has determined that the shares (or share options) would be classified as equity instruments under the guidance of FASB ASC Topic 718. However, under ASR 268 and related guidance, the instruments would be considered to be redeemable for cash or other assets upon the occurrence of events (e.g., redemption at the option of the holder) that are outside the control of the issuer. . . .

Question 2: How should Company F apply ASR 268 and related guidance to the shares (or share options) granted under the share-based payment arrangements with employees that may be unvested at the date of grant?

Interpretive Response: Under FASB ASC Topic 718, when compensation cost is recognized for instruments classified as equity instruments, additional paid-in-capitalFN82 is increased. If the award is not fully vested at the grant date, compensation cost is recognized and additional paid-in-capital is increased over time as services are rendered over the requisite service period. A similar pattern of recognition should be used to reflect the amount presented as temporary equity for share-based payment awards that have redemption features that are outside the issuer’s control but are classified as equity instruments under FASB ASC Topic 718. The staff believes Company F should present as temporary equity at each balance sheet date an amount that is based on the redemption amount of the instrument, but takes into account the proportion of consideration received in the form of employee services. Thus, for example, if a nonvested share that qualifies for equity classification under FASB ASC Topic 718 is redeemable at fair value more than six months after vesting, and that nonvested share is 75% vested at the balance sheet date, an amount equal to 75% of the fair value of the share should be presented as temporary equity at that date. Similarly, if an option on a share of redeemable stock that qualifies for equity classification under FASB ASC Topic 718 is 75% vested at the balance sheet date, an amount equal to 75% of the intrinsicFN83 value of the option should be presented as temporary equity at that date.

Question 3: Would the methodology described for employee awards in the Interpretive Response to Question 2 above apply to nonemployee awards to be issued in exchange for goods or services with similar terms to those described above?

Interpretive Response: See Topic 14.A for a discussion of the application of the principles in FASB ASC Topic 718 to nonemployee awards. The staff believes it would generally be appropriate to apply the methodology described in the Interpretive Response to Question 2 above to nonemployee awards.

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FN82 Depending on the fact pattern, this may be recorded as common stock and additional paid in capital.

FN83 The potential redemption amount of the share option in this illustration is its intrinsic value because the holder would pay the exercise price upon exercise of the option and then, upon redemption of the underlying shares, the company would pay the holder the fair value of those shares. Thus, the net cash outflow from the arrangement would be equal to the intrinsic value of the share option. In situations where there would be no cash inflows from the share option holder, the cash required to be paid to redeem the underlying shares upon the exercise of the put option would be the redemption value.

Special considerations apply in the measurement of share-based payment arrangements under the SEC’s temporary equity guidance. For such arrangements, the amount presented in temporary equity at initial recognition and each balance sheet date is “based on the redemption provisions of the instrument and the proportion of consideration received in the form of employee services” (i.e., the measurement of such arrangements consider not only the redemption value, but also the proportion attributed to the requisite employee services rendered to date). See Section 12.4.7 of Deloitte’s Roadmap Share-Based Payment Awards for further discussion.