Chapter 6 — Initial and Subsequent Accounting

6.1 Freestanding Equity-Classified Contracts

6.1 Freestanding Equity-Classified Instruments

6.1.1 Initial and Subsequent Measurement

ASC 815-40

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 as follows.

Equity Instruments — Permanent Equity

35-2 Contracts that are initially classified as equity under Section 815-40-25 shall be accounted for in permanent equity as long as those contracts continue to be classified as equity. Subsequent changes in fair value shall not be recognized as long as the contracts continue to be classified as equity . . . .

If an entity concludes that a freestanding equity-linked instrument qualifies as equity under ASC 815-40, the entity recognizes the instrument by recording an entry to additional paid-in capital (APIC) in stockholders’ equity in its balance sheet. Such an instrument would be initially measured at its fair value. If the instrument is issued as part of a larger transaction (i.e., one involving multiple units of account), allocation of the transaction proceeds may be necessary. ASC 470-20 requires allocation of proceeds on a relative fair value basis when a debt instrument is issued with equity-classified detachable stock purchase warrants. ASC 470-20-25-2 states:

Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt instrument portion of the transaction. This usually results in a discount (or, occasionally, a reduced premium), which shall be accounted for under Topic 835.

Example 6-1

Initial and Subsequent Measurement

Entity A issues a debt security with a detachable equity-classified warrant for total proceeds of $19.5 million. Entity A does not elect to account for the debt at fair value under the fair value option in ASC 825-10. While the total proceeds approximate the fair value of the package of instruments, at the time of issuance, a third-party valuation specialist estimates the fair value of the debt to be $18 million and the fair value of the warrant to be $2 million. In this case, A allocates $17.55 million of the proceeds to the debt, or $18 million ÷ ($18 million + $2 million) × $19.5 million, and $1.95 million of the proceeds to the warrant, or $2 million ÷ ($18 million + $2 million) × $19.5 million. Accordingly, the initial carrying amount of the debt is $17.55 million and the initial carrying amount of the warrant is $1.95 million.

A relative fair value allocation approach is also appropriate for other types of freestanding equity-classified instruments that are issued together with debt or stock that is not accounted for at fair value on a recurring basis (e.g., a detachable warrant issued with preferred stock). For example, if debt contains an embedded derivative that must be separated under ASC 815-15 (e.g., certain embedded put or call options), the allocation of proceeds between the contract on the entity’s own equity and the debt is performed on a relative fair value basis before the allocation of proceeds between the debt host contract and the embedded derivative.

However, if an entity issues a freestanding equity-classified instrument together with another financial instrument that is subsequently measured at fair value, with changes in fair value recognized in earnings (e.g., debt for which the fair value option in ASC 825-10 is elected), the entity should allocate (1) an amount of the proceeds equal to the fair value of the instrument subsequently measured at fair value and (2) the remaining amount to the equity-classified freestanding instrument. The initial carrying amount assigned to the equity-classified instrument would then be the difference between the total proceeds received and the fair value of the instrument subsequently measured at fair value. This method of allocating proceeds, sometimes referred to as the “with-and-without” method, avoids the recognition of a gain or a loss caused solely by the allocation model. It is similar to the method of allocating the basis of a hybrid instrument between a host contract and an embedded derivative under ASC 815 (see ASC 815-15-30-2). See further discussion in Section 6.2.1.

Connecting the Dots

It is appropriate to allocate the proceeds received to multiple freestanding financial instruments issued as part of a single transaction when the proceeds represent the fair value of the package of financial instruments issued. In this situation, an entity should allocate the proceeds by using one of the two methods discussed above (i.e., the relative fair value approach or the with-and-without method). However, if the entity issues multiple freestanding financial instruments and receives proceeds that differ from the fair value of the package of financial instruments issued (i.e., the transaction is not at arm’s length), the entity must appropriately account for the other rights, privileges, or elements included in the transaction. For example, if an entity issues two freestanding financial instruments to a related party and the price paid exceeds the aggregate fair value of the package of instruments issued, the entity may have received a capital contribution from the investor. Alternatively, if an entity issues multiple financial instruments and receives proceeds that are less than the fair value of the package of instruments issued, the entity may have a recognizable asset or may need to record a dividend or expense. The accounting for proceeds that differ from the fair value of the package of financial instruments issued will depend on the particular facts and circumstances.

It is never appropriate to recognize a financial instrument that represents an obligation or equity of the entity at a negative amount. Furthermore, it is generally not appropriate to recognize no amount for a financial instrument that represents an obligation or equity of the entity.

The initial carrying amount of a freestanding equity-classified instrument also includes the associated issuance costs. When a freestanding equity-classified instrument is issued as part of a transaction that includes the issuance of other financial instruments that are not measured at fair value on a recurring basis, the issuance costs may be allocated on a relative fair value basis in a manner consistent with the allocation of proceeds. Section 6.2.1 further discusses the concept of issuance costs and the accounting when a freestanding equity-classified instrument is issued in conjunction with another financial instrument that is subsequently measured at fair value, with changes in fair value recognized in earnings.

The initial carrying amount of a freestanding equity-classified instrument is not subsequently adjusted to fair value unless, in subsequent periods, the instrument no longer qualifies for equity classification (e.g., the issuing entity no longer has sufficient authorized and unissued shares) and so must be reclassified as an asset or a liability. Special recognition and measurement requirements apply when a down-round feature has been triggered in an equity-classified instrument (see Section 6.1.5).

There may be situations in which a freestanding equity-classified instrument must be classified as temporary equity. In such cases, the classification, measurement, and EPS guidance in ASC 480-10-S99-3A must be applied. See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for more information.

6.1.2 Reclassifications

ASC 815-40

35-9 If a contract is reclassified from permanent or temporary equity to an asset or a liability, the change in fair value of the contract during the period the contract was classified as equity shall be accounted for as an adjustment to stockholders’ equity. The contract subsequently shall be marked to fair value through earnings. If an embedded feature no longer qualifies for the derivatives scope exception under this Subtopic, the feature shall be separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 and Subtopic 815-15 (if all of the criteria in paragraph 815-15-25-1 are met).

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 a freestanding equity-classified instrument is required if the instrument ceases to meet all the criteria for equity classification. If reclassification of a freestanding equity-classified instrument is required, the instrument is reclassified 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 no longer eligible for equity classification, the entity recognizes the adjustment to its current fair value within stockholders’ equity before the reclassification. Subsequent adjustments to fair value while the instrument is an asset or a liability are recognized in the income statement.

6.1.3 Settlements

ASC 815-40

40-1 If contracts classified as permanent equity are ultimately settled in a manner that requires that the entity deliver cash, the amount of cash paid or received shall be reported as a reduction of, or an addition to, contributed capital.

If an entity settles a freestanding equity-classified instrument by delivering or receiving shares in accordance with its original terms, the entity recognizes the shares issued or received within equity in a manner similar to other transactions in its own stock (see ASC 505-10 and ASC 505-30).

Sometimes an entity settles an equity-classified instrument net in cash. For example, a written call option on the entity’s own equity may give the entity the right to settle the instrument either net in shares or net in cash. If an entity settles an equity-classified instrument in accordance with its original terms through a net cash settlement by delivering cash, the amount of cash paid is deducted from APIC. If an entity settles the instrument by receiving cash, the amount is added to APIC.

If an entity repurchases an equity-classified instrument, the repurchase price is generally equal to its fair value. However, if the entity pays an amount in excess of the instrument’s fair value, the excess consideration must be associated with something other than the repurchase. If no other element is identified for which accounting is required under GAAP, the excess consideration is recognized either as a dividend paid to the holder or as an expense. In determining how to recognize the excess consideration, an entity must use judgment and consider the facts and circumstances associated with the repurchase (such as the purpose of the excess payment) and the relationship between the entity and the holder. If an entity is in doubt about how to treat the excess amount, accounting for it as an expense is generally appropriate. For further discussion, see Sections 3.2.4.3 and 3.2.5.2 of Deloitte’s Roadmap Earnings per Share.

If an entity settles an equity-classified instrument under an inducement offer, it should treat as a dividend or expense the additional value provided as a result of the inducement offer, which is calculated as the fair value of all securities and other consideration transferred in the transaction over the fair value of the stock issuable according to the original terms of the contract. For further discussion, see Section 3.2.5.2 of Deloitte’s Roadmap Earnings per Share and Section 12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt.

Special considerations are necessary in the accounting for redemptions of equity-classified instruments indexed to an entity’s preferred stock. For further discussion, see Section 3.2.5.2.2 of Deloitte’s Roadmap Earnings per Share.

Connecting the Dots

The Inflation Reduction Act of 2022, which was signed into law on August 16, 2022, imposes a 1 percent excise tax on stock repurchases that occur after December 31, 2022, by publicly traded companies. Specifically, a covered corporation would be subject to a tax equal to 1 percent of (1) the fair market value of any of its stock that it (or certain affiliates) repurchased during any taxable year, with limited exceptions, minus (2) the fair market value of any of its stock that it (or certain affiliates) issued during the taxable year (including compensatory stock issuances). The 1 percent excise tax would also be imposed on acquisitions of stock in certain mergers or acquisitions involving covered corporations.

Because the excise tax is not based on a measure of income, it is not an income tax and thus is outside the scope of ASC 740. While the accounting for taxes paid in connection with the repurchase of stock is not specifically addressed in U.S. GAAP, entities may consider the guidance in AICPA Technical Q&As Section 4110.09, which indicates that direct and incremental legal and accounting costs associated with the acquisition of treasury stock may be added to the cost of the treasury stock. Therefore, it is acceptable for an entity to account for an excise tax obligation that results from the repurchase of common stock classified within permanent equity as a cost of the treasury stock transaction.

Any reductions in such excise tax obligation arising from share issuances would also be recognized as part of the original treasury stock transaction regardless of the nature of the share issuances. Additional considerations are necessary when redemptions of preferred stock result in an excise tax obligation, which would be recognized as a cost of redeeming the preferred stock. The accounting for redemptions of preferred stock differs depending on the classification of the preferred stock as permanent equity, temporary equity, or a liability. An entity that has repurchased both common stock and preferred stock during a taxable period would need to use a systematic and rational allocation approach to account for the effect of share issuances on the excise tax obligation.

6.1.4 Modifications or Exchanges

6.1.4.1 Freestanding Equity-Linked Instruments That Are Classified in Equity Before and After a Modification or Exchange

6.1.4.1.1 Written Call Options

ASC 815-40

Issuer’s Accounting for Modifications or Exchanges of Freestanding Equity-Classified Written Call Options

35-14 The guidance in paragraphs 815-40-35-15 through 35-18 applies to an issuer’s accounting for a modification of the terms or conditions or an exchange of a freestanding equity-classified written call option (for example, a warrant) that remains equity classified in accordance with this Subtopic after the modification or exchange and is not within the scope of another Topic. An entity shall account for the effects of a modification or an exchange in accordance with paragraphs 815-40-35-15 through 35-18. The disclosure requirements in paragraphs 815-40-50-5 through 50-6 and 505-10-50-3 shall apply to a modification or an exchange of a freestanding equity-classified written call option. The guidance in paragraphs 815-40-35-16 through 35-17 does not apply to freestanding equity-classified written call options that are modified or exchanged to compensate grantees in a share-based payment arrangement. An entity shall recognize the effect of such modifications of freestanding equity-classified written call options by applying the requirements in Topic 718; however, classification of the instrument will remain subject to the requirements in this Subtopic.

35-15 An entity shall consider the circumstances of the modification or exchange of a freestanding equity-classified written call option to determine whether the modification or exchange is related to a financing or other arrangement or a multiple-element arrangement (for example, an arrangement involving both debt financing and equity financing). In making that determination, an entity shall consider all of the terms and conditions of the modification or exchange, other transactions entered into contemporaneously or in contemplation of the modification or exchange, other rights and privileges obtained or obligations incurred (including services) as a result of the modification or exchange, and the overall economic effects of the modification or exchange. If the modification or exchange is not within the scope of another Topic, an entity shall apply the guidance in paragraphs 815-40-35-16 through 35-18.

35-16 An entity shall treat a modification of the terms or conditions or an exchange of a freestanding equity-classified written call option as an exchange of the original instrument for a new instrument. In substance, the entity repurchases the original instrument by issuing a new instrument. For transactions recognized in accordance with paragraph 815-40-35-17(c), the effect of a modification or an exchange shall be measured as the difference between the fair value of the modified or exchanged instrument and the fair value of that instrument immediately before it is modified or exchanged. For all other transactions recognized in accordance with paragraph 815-40-35-17, the effect of a modification or an exchange shall be measured as the excess, if any, of the fair value of the modified or exchanged instrument over the fair value of that instrument immediately before it is modified or exchanged. In a multiple-element transaction, the total effect of the modification or exchange shall be allocated to the respective elements in the transaction.

35-17 An entity shall recognize the effect of a modification or an exchange (calculated in accordance with paragraph 815-40-35-16) in the same manner as if cash had been paid as consideration, as follows:

Equity issuance. An entity shall recognize the effect of a modification or an exchange that is directly attributable to a proposed or actual equity offering as an equity issuance cost. For additional guidance see SAB Topic 5.A, Expenses of Offering (paragraph 340-10-S99-1).
Debt origination. An entity shall recognize the effect of a modification or an exchange that is a part of or directly related to an issuance of a debt instrument as a debt discount or debt issuance cost in accordance with the guidance in Topic 835 on interest.
Debt modification. An entity shall recognize the effect of a modification or an exchange that is a part of or directly related to a modification or an exchange of an existing debt instrument in accordance with the guidance in Subtopic 470-50 on debt modifications and extinguishments and Subtopic 470-60 on troubled debt restructurings by debtors.
Other. An entity shall recognize the effect of a modification or an exchange that is not related to a financing transaction in (a) through (c) and is not within the scope of any other Topics (such as Topic 718) as a dividend. Additionally, for an entity that presents earnings per share (EPS) in accordance with Topic 260, that effect shall be treated as a reduction of income available to common stockholders in basic earnings per share in accordance with the guidance in paragraph 260-10-45-15.

35-18 Example 22 (see paragraphs 815-40-55-49 through 55-52) illustrates the application of the guidance in paragraphs 815-40-35-14 through 35-17.

A modification or exchange of a freestanding equity-classified written call option that remains equity classified after the modification or exchange is accounted for by recognizing “the excess, if any, of the fair value of the modified or exchanged instrument over the fair value of that instrument immediately before it is modified or exchanged [on the basis of the substance of the transaction,] in the same manner as if cash had been paid as consideration.” Accordingly, an entity accounts for any incremental fair value provided to the counterparty in a modification or exchange of an equity-classified written call option. The accounting applied depends on the reason for the modification or exchange (e.g., whether other transactions were entered into contemporaneously or in contemplation of the modification or exchange of the option, and whether any other rights or privileges were exchanged). An entity therefore accounts for the effect of the modification or exchange in the same manner as if cash had been paid as consideration. Such effect is measured as the difference between the option’s fair value immediately before and immediately after the modification or exchange. The table below summarizes how to apply this guidance in different scenarios.

Transaction	Accounting for Incremental Fair Value	Guidance
Financing transaction to issue equity (ASC 815-40-35-17(a))	Treat the amount as equity issuance cost.	ASC 340-10-S99-1
Financing transaction to issue debt (ASC 815-40-35-17(b))	If the instrument is held by the creditor, treat the amount as a debt discount. If the instrument is held by a third party, treat the amount as a debt issuance cost.	ASC 835-30
Nontroubled debt modification or exchange (ASC 815-40-35-17(c))	If the instrument is held by the creditor, treat the amount as day 1 cash flow in the performance of the 10 percent test and as a fee paid to the creditor in the accounting for the modification or exchange. If the instrument is held by a third party, treat the amount as a third-party cost in the accounting for the modification or exchange.	ASC 470-50
Troubled debt restructuring (ASC 815-40-35-17(c))	If the instrument is held by the creditor, treat the amount as a fee paid to the creditor. If the instrument is held by a third party, treat the amount as a third-party cost.	ASC 470-60
Other	Treat the amount in accordance with other GAAP (e.g., ASC 606 or ASC 718). If the transaction is not within the scope of other GAAP, recognize as a dividend under ASC 260-10.	Other relevant topics or subtopics

ASC 815-40-35-17 specifies that an entity should recognize as a dividend the effect of a modification or exchange that is not related to a financing transaction and is not within the scope of other GAAP (e.g., ASC 606 or ASC 718). However, an entity cannot assume that dividend recognition is appropriate for a transaction that is not specifically mentioned in ASC 815-40-35-17. Rather, it must carefully consider the related facts and circumstances and the substance of the transaction. Generally, the recognition of an expense is appropriate if the modification or exchange of the option represents compensation for other stated or unstated transaction elements (e.g., a standstill agreement or settlement of litigation). Paragraph BC19 of ASU 2021-04 states:

Additionally, the Task Force noted that if a modification or an exchange is executed in exchange for an agreement by the holder of the written call option to abandon certain acquisition plans, forgo other planned transactions, settle litigation, settle employment contracts, or voluntarily restrict its purchase of shares of the issuing entity or the issuing entity’s affiliates within a stated time period, those rights and privileges obtained, both stated and unstated, or other elements of the transaction should be accounted for according to their substance (that is, as a cost to the issuing entity) rather than as a dividend distribution.

If the modification or exchange involves more than one of the categories identified above (i.e., it involves multiple elements), the amount is allocated among those categories.

6.1.4.1.2 Other Instruments

ASC 815-40 only addresses the accounting for a modification or exchange of a freestanding equity-classified written call option that remains classified in equity after the modification or exchange. In the absence of other directly applicable guidance, when a freestanding equity-linked instrument other than a written call option is modified or exchanged, and such instrument is classified in equity before and after the modification or exchange, an entity would analogize to the guidance in ASC 815-40 to determine whether it is necessary to reflect the modification or exchange for accounting purposes.1 That is, an entity calculates the difference between (1) the fair value of the instrument immediately before the modification or exchange and (2) the fair value of the instrument immediately after the modification or exchange. If the change in fair value is unfavorable to the entity, the entity recognizes such change as an adjustment to the carrying amount of the equity-classified instrument. The entity does not recognize a fair value change that is favorable to it. Thus, the entity does not recognize a gain if either (1) there is a fair value increase and the instrument is a purchased call option on the entity’s own stock or (2) there is a fair value decrease and the instrument is a written call option on the entity’s own stock. However, the entity does recognize any fair value change that is unfavorable to it. For example, if the fair value of a purchased call option declines as a result of a modification or exchange, the entity recognizes that fair value decline in the same manner as a fair value increase that is unfavorable to the entity.

If no other element is identified for which accounting is required under GAAP, the entity must recognize the unfavorable change in fair value either as a deemed dividend paid to the holder or as an expense. In determining how to recognize the unfavorable change in fair value, the entity must use judgment and consider the facts and circumstances associated with the modification or exchange (such as its purpose) and the relationship between the entity and the holder. Such consideration is consistent with the guidance in ASC 815-40 that applies to modifications or exchanges of equity-classified written call options. For further discussion, see Section 3.2.6.4 of Deloitte’s Roadmap Earnings per Share.

Special considerations are necessary in the accounting for modifications or exchanges of equity-classified instruments indexed to an entity’s preferred stock. For more information, see Section 3.2.6.4 of Deloitte’s Roadmap Earnings per Share.

6.1.4.2 Freestanding Equity-Linked Instruments Whose Classification Changes as a Result of a Modification or Exchange

The table below discusses the accounting for a freestanding equity-linked instrument when the classification of the instrument changes in conjunction with a modification or exchange. Note that in the journal entries, it is assumed that the instrument being modified or exchanged is a liability before or after such modification or exchange. If the instrument were an asset, the journal entries would be reversed.

Classification		Accounting
Before Modification or Exchange	After Modification or Exchange	Accounting
Equity	Asset/liability	The entity recognizes an asset or a liability for the fair value of the instrument immediately after the modification or exchange (i.e., taking into account the modification or exchange). The offsetting entry (or entries) will depend on whether any incremental value was transferred to the counterparty as a result of the modification or exchange (i.e., whether any fair value change as a result of the modification or exchange is unfavorable to the entity). The guidance in Section 6.1.4.1 is applied as follows: If no incremental value was transferred to the counterparty, the entity recognizes the offsetting entry in equity and recognizes the following entry: If incremental value that must be expensed was transferred to the counterparty, the entity recognizes the following entry: If incremental value that represents a dividend was transferred to the counterparty, the entity recognizes the following entry: If incremental value that represents something other than an expense or a dividend was transferred to the counterparty, the entity accounts for that element in accordance with the facts and circumstances (i.e., it replaces the amount recognized as an expense or in retained earnings in the above entries with an entry that reflects the substance of the transaction). In all situations, the entity records the asset or liability at fair value and takes into account the impact of the modification or exchange.
Asset/liability	Equity	The entity first adjusts the fair value of the asset or liability immediately before the modification or exchange (i.e., ignoring the impact of the modification or exchange) and recognizes the offsetting entry in earnings. Next, the entity evaluates whether any incremental value was transferred to the counterparty as a result of the modification or exchange (i.e., whether any fair value change as a result of the modification or exchange is unfavorable to the entity). The guidance in Section 6.1.4.1 is applied as follows: If no incremental value was transferred to the counterparty, the entity reclassifies the fair value of the asset or liability to equity. For example, the entity recognizes the following entry: If incremental value that must be expensed was transferred to the counterparty, the entity recognizes the following entry: If incremental value that represents a dividend was transferred to the counterparty, the entity recognizes the following entry: If incremental value that represents something other than an expense or a dividend was transferred to the counterparty, the entity accounts for that element in accordance with the facts and circumstances (i.e., it replaces the amount recognized as an expense or in retained earnings in the above entries with an entry that reflects the substance of the transaction).

Section 6.2.4 addresses the accounting for a modification or exchange of an equity-linked instrument that is classified as an asset or a liability before and after a modification or exchange.

6.1.5 Down-Round Features

ASC Master Glossary

Down Round Feature

A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.

A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.

ASC 260-10

05-1A An entity may issue a freestanding financial instrument (for example, a warrant) with a down round feature that is classified in equity. This Subtopic provides guidance on earnings per share and recognition and measurement of the effect of a down round feature when it is triggered.

Financial Instruments That Include a Down Round Feature

25-1 An entity that presents earnings per share (EPS) in accordance with this Topic shall recognize the value of the effect of a down round feature in an equity-classified freestanding financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) when the down round feature is triggered. That effect shall be treated as a dividend and as a reduction of income available to common stockholders in basic earnings per share, in accordance with the guidance in paragraph 260-10-45-12B. See paragraphs 260-10-55-95 through 55-97 for an illustration of this guidance.

30-1 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 an equity-classified freestanding financial instrument and an 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.

30-2 The fair values of the financial instruments in paragraph 260-10-30-1 shall be measured in accordance with the guidance in Topic 820 on fair value measurement. See paragraph 260-10-45-12B for related earnings per share guidance and paragraphs 505-10-50-3 through 50-3A for related disclosure guidance.

35-1 An entity shall recognize the value of the effect of a down round feature in an equity-classified freestanding financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) each time it is triggered but shall not otherwise subsequently remeasure the value of a down round feature that it has recognized and measured in accordance with paragraphs 260-10-25-1 and 260-10-30-1 through 30-2. An entity shall not subsequently amortize the amount in additional paid-in capital arising from recognizing the value of the effect of the down round feature.

45-12B For a freestanding equity-classified financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) with a down round feature, an entity shall deduct the value of the effect of a down round feature (as recognized in accordance with paragraph 260-10-25-1 and measured in accordance with paragraphs 260-10-30-1 through 30-2) in computing income available to common stockholders when that feature has been triggered (that is, upon the occurrence of the triggering event that results in a reduction of the strike price).

Special recognition and measurement requirements apply each time a down-round feature in a freestanding equity-classified instrument is triggered (i.e., the entity sells shares of its stock for an amount less than the currently stated strike price or issues an equity-linked financial instrument with a strike price below the currently stated strike price); see Section 4.3.7.2 for a discussion of the definition of a down-round feature. These requirements also apply to equity-classified convertible preferred stock but not to convertible debt. Further, issuers that do not present EPS in accordance with ASC 260 are not required to apply the guidance. If an entity that is not required to present EPS elects voluntarily to disclose EPS in its financial statements, however, the guidance applies.

When the strike price of an equity-classified instrument is reduced in accordance with the terms of a down-round feature, the issuer is required to determine the amount of value that was transferred to the holder through the strike price adjustment, but the issuer does not use the change in the fair value of the entire instrument to compute that amount. Instead, the issuer calculates the amount of value transferred by comparing the fair values of two hypothetical instruments whose terms are consistent with the actual instrument, except that the instruments do not contain a down-round feature. The strike price of the first hypothetical instrument equals the strike price of the actual instrument immediately before the strike price reduction. The strike price of the second hypothetical instrument equals the strike price immediately after the down-round feature is triggered. The value transferred is the difference between the fair values of the two hypothetical instruments. The issuer determines those fair values on the basis of the conditions immediately after the down-round feature is triggered by using the fair value measurement guidance in ASC 820.

Further, the issuer recognizes the value transferred as a reduction of retained earnings and as an increase in APIC (i.e., as a deemed dividend). The transfer of value is reflected as a deduction to income available to common stockholders in the basic EPS calculation.

In addition, an entity that applies the special recognition and measurement guidance in ASC 260 to a down-round feature that was triggered during the reporting period must, under ASC 505-10-50-3A, disclose (1) the fact that the down-round feature has been triggered and (2) the amount of value transferred.

Example 6-2

Down-Round Feature

On January 1, 2017, Entity A grants warrants to Investor X to acquire A’s common shares. The warrants have an exercise price of $3.00 per share, subject to adjustment if A issues new shares of its common stock. If A issues new shares of its common stock for less than $3.00 per share, the exercise price is adjusted to that issue price. In accordance with ASC 815-40, A evaluated the warrants and concluded that they should be classified in equity since (1) they are considered indexed to the entity’s own stock if the down-round provision is disregarded and (2) settleable in the issuer’s shares. On July 1, 2017, A issues new shares of its common stock to Investor Y at a price of $2.50 per share. Accordingly, the exercise price of the warrants is adjusted from $3.00 to $2.50.

On July 1, 2017, A would determine the value transferred to X as the difference between the fair values of two hypothetical instruments with terms similar to those of the actual warrants, except that the instruments contain no down-round feature. The only difference between the two hypothetical instruments is that one has an exercise price of $2.50 and the other has an exercise price of $3.00. Entity A would recognize the value transferred as a reduction in retained earnings, with an offsetting increase to the carrying value of the warrants in APIC. The amount would also be reflected as a reduction to the income available to common stockholders in the basic EPS calculation.

Because the amount of the value transferred reduces income available to common stockholders in the basic EPS calculation, an entity may be required to adjust the diluted EPS calculation. In calculating diluted EPS, an entity applies the treasury stock method if the option or warrant is dilutive. Under the treasury stock method, options and warrants are assumed to be exercised as of the beginning of the period. An entity therefore assumes that options or warrants are exercised before the trigger of the down-round feature. Accordingly, as noted in ASC 260-10-55-97, the amount of value transferred that has been deducted from basic EPS is added back to income available for common stockholders in the calculation of diluted EPS if the option or warrant is dilutive. ASC 260-10-45-25 notes that warrants or options have a dilutive effect under the treasury stock method if the options or warrants are in-the-money (i.e., “the average market price of the common stock during the period exceeds the exercise price of the options or warrants”).

ASC 260-10

Example 16: Equity-Classified Freestanding Financial Instruments That Include a Down Round Feature

55-95 Assume Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share and that Entity A presents EPS in accordance with the guidance in this Topic. The warrants have a 10-year term, are exercisable at any time, and contain a down round feature. The warrants are classified as equity by Entity A because they are indexed to the entity’s own stock and meet the additional conditions necessary for equity classification in accordance with the guidance in Subtopic 815-40 on derivatives and hedging—contracts in entity’s own equity (see paragraphs 815-40-55-33 through 55-34A for an illustration of the guidance in Subtopic 815-40 applied to a warrant with a down round feature). Because the warrants are an equity-classified freestanding financial instrument, they are within the scope of the recognition and measurement guidance in this Topic. The terms of the down round feature specify that if Entity A issues additional shares of its common stock for an amount less than $10 per share or issues an equity-classified financial instrument with a strike price below $10 per share, the strike price of the warrants would be reduced to the most recent issuance price or strike price, but the terms of the down round feature are such that the strike price cannot be reduced below $8 per share. After issuing the warrants, Entity A issues shares of its common stock at $7 per share. Because of the subsequent round of financing occurring at a share price below the strike price of the warrants, the down round feature in the warrants is triggered and the strike price of the warrants is reduced to $8 per share.

55-96 In accordance with the measurement guidance in paragraphs 260-10-30-1 through 30-2, Entity A determines that the fair value of the warrants (without the down round feature) with a strike price of $10 per share immediately after the down round feature is triggered is $600 and that the fair value of the warrants (without the down round feature) with a strike price of $8 per share immediately after the down round feature is triggered is $750. The increase in the value of $150 is the value of the effect of the triggering of the down round feature.

55-97 The $150 increase is the value of the effect of the down round feature to be recognized in equity in accordance with paragraph 260-10-25-1, as follows:

Additionally, Entity A reduces income available to common stockholders in its basic EPS calculation by $150 in accordance with the guidance in paragraph 260-10-45-12B. Entity A applies the treasury stock method in accordance with paragraphs 260-10-45-23 through 45-27 to calculate diluted EPS. Accordingly, the $150 is added back to income available to common stockholders when calculating diluted EPS. However, the treasury stock method would not be applied if the effect were to be antidilutive.

6.1.6 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance

ASC 470-20

25-20A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value (in accordance with Topic 820) and recognized as an issuance cost, with an offset to additional paid-in capital in the financial statements of the entity.

30-26A At the date of issuance, a share-lending arrangement entered into on an entity’s own shares in contemplation of a convertible debt offering or other financing shall be measured at fair value in accordance with Topic 820.

35-11A If it becomes probable that the counterparty to a share-lending arrangement will default, the issuer of the share-lending arrangement shall recognize an expense equal to the then fair value of the unreturned shares, net of the fair value of probable recoveries, with an offset to additional paid-in capital. The issuer of the share-lending arrangement shall remeasure the fair value of the unreturned shares each reporting period through earnings until the arrangement consideration payable by the counterparty becomes fixed. Subsequent changes in the amount of the probable recoveries should also be recognized in earnings.

Under ASC 470-20-25-20A and ASC 470-20-30-26A, equity-classified own-share lending arrangements executed in contemplation of a convertible debt issuance (see Section 2.9) are recorded initially at fair value and recognized as a debt issuance cost with an offset to APIC in the entity’s financial statements. The terms of a share-lending arrangement entered into in contemplation of a convertible debt issuance typically require an entity to issue its common shares to a counterparty (e.g., the bank) in exchange for a nominal processing fee. The processing fee is significantly less than the fair value of the shares and is typically less than a market fee that would be charged in a share-lending arrangement that was not entered into in contemplation of a convertible debt issuance. To promote the issuance of the debt, the issuer may sometimes accept less than the market rate on the share-lending arrangement. The fair value of the share-lending arrangement will be determined on the basis of the difference between the contractual processing fee and a market-based fee that would typically be charged for lending such shares, adjusted as necessary to reflect the nonperformance risk of the share borrower.

Example 6-3

Initial Accounting for Own-Share Lending Arrangement

Issuer A issues convertible debt at par for cash proceeds of $250 million. The stated interest rate on the debt is 2.5 percent per annum. The debt is due five years from the issuance date and is convertible into A’s equity shares at the holder’s option. Issuer A determines that it is not required to recognize the conversion option in the debt separately as a liability or in equity.

In contemplation of the convertible debt issuance, A executes a share-lending arrangement with Bank B to help ensure the successful completion of the debt offering, and A receives $100,000 for the arrangement (which is also the par amount of the shares issued). However, the fair value of the arrangement is $15 million. Issuer A evaluates the share-lending arrangement under ASC 470-20 and ASC 815-40 and determines that it qualifies as equity.

On the date on which both the debt issuance and the share-lending arrangement occur, A makes the following journal entry:

Unless the issuer elects to account for the debt at fair value under the fair value option in ASC 825-10, it amortizes any discount (or reduced premium) on the debt created by the recognition of the own-share lending arrangement as a debt issuance cost by using the effective interest method. The amount recognized in equity is not remeasured as long as (1) the share-lending arrangement qualifies as equity under ASC 815-40 and (2) it is not probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration).

ASC 470-20-35-11A states that if it becomes probable that the counterparty to a share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration), the issuer must recognize an expense equal to the fair value of the unreturned shares adjusted for the fair value of any probable recoveries. The offsetting entry for the expense is to APIC.

Even when a share-lending arrangement is classified in equity, it is appropriate to record an expense because the issuer is suffering a loss from the counterparty’s failure to satisfy its obligation to return the loaned shares. Under the contractual terms, the shares (or an equivalent amount of consideration) should have been returned to the issuer, but as a result of the counterparty credit risk, the issuer is instead receiving something of lesser or no value. The amount of the loss (i.e., the fair value of the unreturned shares adjusted for probable recoveries) is remeasured in each period (e.g., for changes in the fair value of the unreturned shares) until the consideration payable becomes fixed. The issuer recognizes changes in the amount of the loss in earnings with an offset to APIC. For discussion of the EPS accounting consequences of own-share lending arrangements, see Section 8.5 of Deloitte’s Roadmap Earnings per Share.

Footnotes

The guidance in ASC 815-40 is similar to the modification guidance in ASC 718, which was applied in practice before ASC 815-40 addressed this issue.

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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.