Chapter 6 — Initial and Subsequent Accounting

6.2 Freestanding Instruments Classified as Assets or Liabilities

6.2.1 Initial and Subsequent Measurement

6.2.1.1 General

ASC 815-40

15-8A If the instrument does not meet the criteria to be considered indexed to an entity’s own stock as described in paragraphs 815-40-15-5 through 15-8, it shall be classified as a liability or an asset. See paragraph 815-40-35-4 for subsequent measurement guidance for those instruments. See paragraph 815-40-15-9 for guidance on the interaction with this Subtopic and Subtopics 815-10 and 815-15 for derivative instruments and embedded derivatives.

25-5 Paragraph 815-20-55-33 explains that derivative instruments that are indexed to an entity’s own stock and recorded as assets or liabilities can be hedging instruments.

30-1 All contracts within the scope of this Subtopic shall be initially measured at fair value.

35-1 All contracts shall be subsequently accounted for based on the current classification and the assumed or required settlement method in Section 815-40-15 or Section 815-40-25 . . . .

35-4 All other contracts classified as assets or liabilities under Section 815-40-25 or paragraph 815-40-15-8A shall be measured subsequently at fair value, with changes in fair value reported in earnings and disclosed in the financial statements as long as the contracts remain classified as assets or liabilities (see paragraph 815-40-50-1).

A freestanding equity-linked instrument that does not qualify as equity under ASC 815-40 is classified as an asset or a liability. All freestanding equity-linked instruments that are classified as assets or liabilities must be initially and subsequently measured at fair value, with changes in fair value recognized in net income.

6.2.1.2 Allocation of Proceeds

If a freestanding equity-linked instrument is issued with debt or stock, the issuance proceeds received may need to be allocated between the items. In these circumstances, an entity allocates proceeds to the items that will be measured at fair value on a recurring basis to avoid the recognition of a gain or a loss caused solely as a result of the allocation model. Thus, whether a freestanding equity-linked instrument that is classified as an asset or a liability is issued alone or in conjunction with other financial instruments, the instrument must be initially recognized at fair value.

6.2.1.3 Issuance Costs

Issuance costs are specific incremental costs that are (1) paid to third parties and (2) directly attributable to the issuance of debt, equity, or a freestanding equity-linked instrument. Thus, issuance costs represent costs incurred with third parties that result directly from and are essential to the financing transaction and would not have been incurred by the issuer had the financing transaction not occurred. Examples of costs that may qualify as issuance costs include underwriting fees, professional fees paid to attorneys and accountants, printing and other document preparation costs, travel costs, and registration and listing fees directly related to the issuance of the instrument. Amounts paid to the investor upon issuance, such as commitment fees, origination fees, and other payments (e.g., reimbursement of the investor’s expenses) represent a reduction in the proceeds received, not issuance costs.2

Costs that would have been incurred irrespective of whether there is a proposed or actual issuance transaction do not qualify as issuance costs. For example, in accordance with SAB Topic 5.A (reproduced in ASC 340-10-S99-1), allocated management salaries and other general and administrative expenses do not represent an issuance cost. Similarly, legal and accounting fees that would have been incurred irrespective of whether the instrument was issued are not issuance costs (see AICPA Technical Q&As Section 4110.01). Further, the SEC staff believes that if a proposed issuance is aborted (including the postponement of an issuance for more than 90 days), its associated costs do not represent issuance costs of a subsequent issuance.

Issuance costs attributable to a freestanding equity-linked instrument that is classified in equity should be offset against the associated proceeds in the determination of the instrument’s initial net carrying amount (see SAB Topic 5.A and AICPA Technical Q&As Section 4110.01). However, any issuance costs or other transaction costs attributable to a freestanding equity-linked financial instrument that is classified as an asset or a liability should be recognized in earnings in the period incurred. This accounting is consistent with the guidance in ASC 825-10-25-3 and ASC 820-10-35-9B.

Entities should consistently apply a systematic and rational method for allocating issuance costs among freestanding financial instruments that form part of the same transaction. In limited circumstances, a specific allocation method is prescribed for such costs under U.S. GAAP. Otherwise, the allocation method is based on the specific facts and circumstances. For example, if an entity uses a with-and-without method to allocate proceeds between a freestanding equity-linked instrument that is classified as an asset or liability and another financial instrument that is not remeasured to fair value on a recurring basis, either of the following two methods is generally considered appropriate:

The relative fair value method — The issuer would allocate issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to the allocation of proceeds to debt instruments with detachable warrants in ASC 470-20-25-2 and the guidance in SAB Topic 2.A.6.
An approach that is consistent with the allocation of proceeds — The issuer would allocate issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments.

The method used should be applied consistently to similar transactions. Any issuance costs allocated to a freestanding equity-linked instrument that is classified as an asset or liability and subsequently measured at fair value through earnings must be expensed as of the issuance date. For additional discussion of the allocation of issuance costs, see Section 3.3.4.4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

6.2.1.4 Fair Value of Items Measured at Fair Value on a Recurring Basis Exceeds Proceeds

In some circumstances, the initial fair value of the items required to be subsequently measured at fair value exceeds the proceeds received. At the 2014 AICPA Conference on Current SEC and PCAOB Developments, then Professional Accounting Fellow Hillary Salo addressed the allocation of proceeds related to an entity’s issuance of a hybrid instrument when the initial fair value of the financial liabilities required to be measured at fair value (such as embedded derivatives) exceeds the net proceeds received. Her remarks are applicable by analogy to freestanding instruments (e.g., debt issued with detachable warrants) when one or both are measured at fair value with changes in fair value recognized in earnings and the initial fair value of items required to be remeasured at fair value exceeds the amount of the proceeds received. Her comments may also be relevant to proceeds received for the issuance of multiple financial instruments that are less than the fair value of the package of instruments that were issued. Ms. Salo stated, in part:

[T]he staff believes that when reporting entities analyze these types of unique fact patterns, they should first, and most importantly, verify that the fair values of the financial liabilities required to be measured at fair value are appropriate under [ASC 820]. [Footnote omitted] If appropriate, then the reporting entity should evaluate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under [ASC 850]. Lastly, if at arm’s length between unrelated parties, a reporting entity should evaluate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.

In the fact patterns analyzed by the staff, we concluded that if no other rights or privileges that require separate accounting recognition as an asset could be identified, the financial liabilities that are required to be measured at fair value (for example, embedded derivatives) should be recorded at fair value with the excess of the fair value over the net proceeds received recognized as a loss in earnings. Furthermore, given the unique nature of these transactions, we would expect reporting entities to provide clear and robust disclosure of the nature of the transaction, including reasons why the entity entered into the transaction and the benefits received.

Additionally, some people may wonder whether the staff would reach a similar conclusion if a transaction was not at arm’s length or was entered into with a related party. We believe those fact patterns require significant judgment; therefore, we would encourage consultation with OCA in those circumstances.

For a freestanding equity-linked instrument classified as an asset or a liability under ASC 815-40, an entity should determine whether the instrument also falls within the scope of the derivative accounting requirements in ASC 815. If so, an entity would need to provide the disclosures required by ASC 815 for derivatives.

6.2.2 Reclassifications

ASC 815-40

35-10 If a contract is reclassified from an asset or a liability to equity, gains or losses recorded to account for the contract at fair value during the period that the contract was classified as an asset or a liability shall not be reversed. The contract shall be marked to fair value immediately before the reclassification. An embedded derivative that qualifies for the derivatives scope exception upon reassessment under this Subtopic that was separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 shall be reclassified to equity. The previously bifurcated embedded derivative shall not be recombined with its host contract.

An entity is required to reassess its classification of each freestanding equity-linked instrument as of each reporting date (see Section 5.4). Reclassification of an instrument classified as an asset or a liability is required if the instrument begins to meet all the criteria for equity classification (e.g., the entity’s shareholders approve an increase in the number of authorized shares; see Section 5.3.3).

If reclassification is required, the entity reclassifies the instrument as of the date of the event or change in circumstance that caused the reclassification at its then-current fair value. If an instrument is reclassified from an asset or a liability to equity, gains and losses during the period the instrument was classified as an asset or a liability are not reversed, and the adjustment to the instrument’s current fair value is recognized in earnings before reclassification. The reclassification of an embedded equity-linked instrument is performed in accordance with ASC 815 (see Section 6.4).

6.2.3 Settlements

ASC 815-40

40-2 If contracts classified as assets or liabilities are ultimately settled in shares, any gains or losses on those contracts shall continue to be included in earnings.

An entity should record in earnings all changes in the fair value of an equity-linked instrument classified as an asset or a liability. The gains and losses are not reversed upon settlement, even if the instrument is settled in shares. When a freestanding equity-linked instrument is settled, the entity should measure it at its current fair value as of the settlement date and include in earnings any fair value gain or loss that has not been previously recognized. The entity should then derecognize the asset- or liability-classified instrument and recognize the cash received (paid) and shares received (issued), if any. The recognition of these items may also result in a gain or loss that is reported in earnings.

6.2.4 Modifications or Exchanges

A freestanding equity-linked instrument that is classified as an asset or a liability is recognized at fair value, with changes in fair value recognized in earnings. Therefore, a modification or exchange of a freestanding equity-linked instrument that is classified as an asset or a liability before and after the modification or exchange is reflected in the change in fair value of the instrument. Section 6.1.4.2 addresses the accounting for a modification or exchange of an equity-linked instrument that is (1) classified as an asset or a liability before the modification or exchange and is classified in equity after the modification or exchange or (2) classified in equity before the modification or exchange and is classified as an asset or a liability after the modification or exchange.

6.2.5 Standby Equity Purchase Agreements

A SEPA is an equity-linked instrument for which an entity has the right, but not the obligation, to sell the entity’s common stock to third-party investors over a specified period. The total number of shares that the entity may issue to the investor is capped by either an aggregate dollar amount or an aggregate number of shares. Furthermore, the number of shares that an entity may issue at any particular time during the life of the SEPA is also limited. The price payable by the investor for each share of common stock purchased from the entity is generally discounted (e.g., 97 percent of the volume-weighted average price of the entity’s common stock over a specified period before issuance of the stock). In exchange for its access to capital through the SEPA, the entity typically provides up-front consideration to the investor in the form of cash or shares of the entity’s common stock. Economically, before the entity has elected to sell shares, a SEPA represents a purchased put option on the entity’s own equity. However, once the entity “draws” on the SEPA, the related number of shares issuable constitutes a forward contract to issue common stock. Thus, SEPAs contain both a purchased put option element and a forward share issuance element. As discussed in Sections 4.3.5.8 and 5.2.3.1, generally neither element qualifies for equity classification. Accordingly, entities must recognize an asset or liability for SEPAs. Such asset or liability must be measured at fair value, with changes in fair value recognized in net income.

Because SEPAs do not qualify for classification in equity, an entity must expense as incurred the amount by which any consideration provided to the investor at the inception of the arrangement exceeds the fair value of the asset recognized for the SEPA. This accounting is consistent with the guidance in ASC 825-10-25-3 and ASC 820-10-35-9B.

An entity should recognize at fair value the common shares issued to the investor upon settlement of a SEPA by using the quoted price of the shares on the date of issuance (i.e., P × Q).3 The then-current fair value of the asset or liability for the associated forward share issuance contract must be derecognized in conjunction with the settlement.4 The proceeds received from the investor are reflected and any residual amount must be charged (or credited) to earnings.5 This accounting is consistent with the guidance in ASC 815 that applies upon the settlement of a derivative instrument. It is also consistent with the guidance in ASC 815-40. As stated in Section 6.2.3, when an equity-linked instrument classified as an asset or liability is settled, entities should measure the instrument at its current fair value as of the settlement date and include in earnings any previously unrecognized fair value gain or loss.

In summary, upon settlement of a forward issuance contract element of a SEPA, an entity would recognize in earnings the following amounts:

The gain (loss) for the excess (deficit) of (1) the carrying amount of the asset or liability for the forward issuance contract plus the proceeds received and (2) the fair value of the common shares as of the issuance date.
Any issuance or transaction costs incurred in conjunction with the issuance of the shares.

Example 6-4

Accounting for a SEPA

On January 1, 20X5, Company A enters into a SEPA with Investor B under which A has the right, but not the obligation, to issue up to 1 million common shares to B over the next 18 months. Company A can elect to sell shares to B in increments of 250,000. The purchase price that B pays to A for the shares issued is equal to 97 percent of the VWAP of A’s common stock over the three-trading-day period before A elects to issue shares under the SEPA. The shares are issued 30 days thereafter.

At the SEPA’s inception, A issued 50,000 shares to B (worth $100,000) and paid a $25,000 structuring fee to B as consideration for the right to access capital under the SEPA.

In this example, further assume the following:

The SEPA does not qualify for equity classification.
The initial and subsequent fair value for the purchased put option element of the SEPA is zero. (Note that this assumption is made for simplicity. Entities cannot assume that the fair value of the purchased put option element is zero; they should determine the fair value of the SEPA in accordance with ASC 820.)
On June 30, 20X5, A elects to sell 250,000 shares to B. The purchase price is $533,500 (i.e., VWAP of $2.20 × 250,000 × .97 = $533,500). The initial fair value of the forward contract for this share issuance is a $16,500 liability.
On July 30, 20X5, the 250,000 shares are issued to B. The quoted price of A’s common stock on the settlement date is $2.10. Company A incurs transaction costs of $10,000 in conjunction with such issuance. Immediately before the settlement, the fair value of the forward contract for this share issuance is a $8,500 asset.

The journal entries to account for the SEPA are as follows:

January 1, 20X5

To record the SEPA at inception.

June 30, 20X5

To record a liability for the forward contract to issue shares under the SEPA.

July 31, 20X5

To adjust the forward contract to issue shares under the SEPA to its fair value immediately before settlement.

To record the settlement of the shares issued under the SEPA to the investor.

To record transaction costs incurred in conjunction with settlement.

In this example, before transaction costs, there is an aggregate gain of $8,500 related to the forward contract to issue shares under the SEPA. Had the share price stayed the same or increased between June 30, 20X5, and July 30, 20X5, there would have been an aggregate loss on the shares issued under the forward contract. In all cases, any transaction costs incurred in conjunction with settlement of the forward contract must be recognized in earnings as incurred.

Footnotes

Depending on the relationship between the issuer and the investor, amounts paid to the investor could represent a dividend or other distribution as opposed to an issuance cost. An entity should use judgment and consider the particular facts and circumstances when determining what these amounts represent.

This represents the settlement amount of the contract under ASC 815-40. Initial recognition of the shares issued at the quoted price multiplied by the quantity is consistent with the accounting for settlements of derivatives under ASC 815 and ASC 820.

An entity generally initially recognizes a liability for this element. However, it is possible for the forward share issuance contract to become an asset before settlement.

The amount charged (or credited) to earnings includes any issuance or transaction costs incurred in conjunction with the issuance of the shares.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.