5.4 Ongoing Reassessment of Classification Requirements
ASC 815-40
35-8 The classification of a
contract (including freestanding financial instruments and
embedded features) shall be reassessed at each balance sheet
date. If the classification required under this Subtopic
changes as a result of events during the period (if, for
example, as a result of voluntary issuances of stock the
number of authorized but unissued shares is insufficient to
satisfy the maximum number of shares that could be required
to net share settle the contract [see discussion in
paragraph 815-40-25-20]), the contract shall be reclassified
as of the date of the event that caused the
reclassification. There is no limit on the number of times a
contract may be reclassified.
35-11 If a contract permits
partial net share settlement and the total notional amount
of the contract no longer can be classified as permanent
equity, any portion of the contract that could be net share
settled as of that balance sheet date shall remain
classified in permanent equity. That is, a portion of the
contract shall be classified as permanent equity and a
portion of the contract shall be classified as an asset, a
liability, or temporary equity, as appropriate.
35-12 If an entity has more than one contract subject to this Subtopic, and partial reclassification is required, there may be different methods that could be used to determine which contracts, or portions of contracts, shall be reclassified. Methods that would comply with this Section could include any of the following:
- Partial reclassification of all contracts on a proportionate basis
- Reclassification of contracts with the earliest inception date first
- Reclassification of contracts with the earliest maturity date first
- Reclassification of contracts with the latest inception or maturity date first
- Reclassification of contracts with the latest maturity date first.
35-13 The method of reclassification shall be systematic, rational, and consistently applied.
5.4.1 Overview
An entity is required to reassess its classification of both freestanding
equity-linked instruments and embedded features as of each reporting date.
Reclassification is required if an instrument either begins or ceases to meet
all the conditions for equity classification. If reclassification is required,
the entity reclassifies the instrument as of the date of the event that caused
the reclassification at its then-current fair value, and the new classification
is applied prospectively. For this reason, the entity may need to determine the
fair value of the instrument as of the date that reclassification is required,
even if that date is not a reporting date. Prior fair value gains and losses
recognized in earnings are not reversed.
Any of the following could affect an entity’s conclusion about whether an
equity-linked instrument qualifies as equity:
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A strike price adjustment feature that prevented an option or warrant from being indexed to the entity's stock expires or lapses.
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A modification of one of the instrument’s terms or conditions (e.g., the parties amend the terms of a contract to specify that the entity is not required to net cash settle the contract in case it does not have an effective registration statement).
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A lapse in one of the instrument’s terms or conditions (e.g., immediately after an IPO if the terms provide for an adjustment to the settlement terms upon an IPO).
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A change in the reporting entity’s functional currency.
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The number of authorized shares increases or decreases as a result of a vote by shareholders.
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The entity issues previously authorized equity shares.
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The entity enters into commitments that could require it to deliver equity shares (e.g., warrants, options, forwards, share-based payment awards, or convertible instruments).
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The entity has an option to settle the instrument either in shares or net in cash and elects to settle the instrument net in cash.
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An event that is within the entity’s control occurs and triggers a requirement to net cash settle the instrument.
Example 5-6
Reassessment
Entity X issues a warrant on its own common stock. The warrant meets all
conditions for equity classification in ASC 815-40
except for the requirement that the entity has
sufficient authorized and unissued shares to settle the
instrument in shares (see Section 5.3.3).
Accordingly, the warrant is classified as a liability
and accounted for at fair value with changes in fair
value recognized in earnings.
Subsequently, X’s shareholders vote to approve an amendment to its certificate
of incorporation to increase the number of authorized
shares of common stock. Entity X files a certificate of
amendment with its state of incorporation. As a result,
X reassesses its prior conclusion and determines that it
now has sufficient authorized and unissued shares to
cover all its outstanding commitments to issue shares.
Entity X should therefore determine the fair value of
the warrant as of the date that the number of authorized
and unissued shares increased and recognize through
earnings any change in the fair value of the instrument
that had not been previously recognized up to that date.
The updated fair value carrying amount would be
reclassified from liabilities to equity.
A reassessment is required irrespective of whether the event that causes an equity classification condition to be met or no longer met is within the entity’s control (i.e., a reassessment is required once such an event occurs).
At the 2005 AICPA Conference on Current SEC and PCAOB Developments, the SEC
staff reiterated the requirement to continually reassess the classification of
equity-linked instruments. The staff presented an example of a contract that
requires settlement in a variable number of shares and in which the number of
shares to be delivered upon settlement is not limited. The staff concluded that
a company could not classify this uncapped contract within equity and that the
issuance of the uncapped contract could cause other instruments to fail the
criteria to be classified within equity.
Example 5-7
Continual Reassessment
Entity X issues freestanding warrants that allow the
holder to purchase 1,000 shares of X’s common stock for
$10 per share. The warrants have a 10-year term and are
exercisable at any time. However, the terms of the
warrants specify that if there is a change in control of
X at any time during the 18-month period after the
warrants’ issuance date, the exercise price of the
warrants is reduced to $1 per share.
The warrants are not considered indexed to X’s stock
because the adjustment in the event of a change in
control is inconsistent with the inputs used in the
pricing (fair value measurement) of a fixed-for-fixed
option on equity shares. However, when the provision
that may result in an adjustment to the exercise price
lapses (i.e., 18 months after the issuance date), X
should reconsider, as of that date, whether the warrants
should be treated as indexed to its own stock.
5.4.2 Sequencing Policy
One of the conditions for equity classification is that the entity have
sufficient authorized and unissued shares available after considering all other
commitments that may require it to deliver shares during the maximum period the
instrument could remain outstanding (see Section 5.3.3). Therefore, the entity may need
to reassess its classification of existing equity-linked instruments if it
issues shares, enters into new commitments to deliver shares, or reduces the
number of authorized shares. To determine whether the entity has sufficient
authorized and unissued shares available to share settle equity-linked
instruments being evaluated under ASC 815-40-25, the entity should adopt a
“sequencing policy” (also known as “reclassification policy” or “contract
ordering policy”) as an accounting policy election and disclose such policy
under ASC 235. The sequencing policy should be systematic and rational (i.e.,
understandable and reasonable) as well as consistently applied (i.e., the entity
must use the same sequencing policy for all instruments within the scope of the
guidance).
One acceptable sequencing policy would be for an entity to perform the following
two steps to evaluate whether equity-linked instruments, or portions of such
instruments, should be initially classified as equity or later reclassified from
equity to an asset or a liability:
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Step 1 — Determine whether outstanding equity-linked instruments have overlapping settlement opportunities with respect to their exercise periods or settlement dates.In step 1, the entity determines whether the outstanding commitments to deliver shares have overlapping settlement opportunities with respect to their exercise periods or settlement dates. (For commitments with early settlement date provisions, the entity should consider the earliest possible settlement date.) If the settlement opportunities in the commitments do not overlap, the instrument with the earlier exercise date or settlement date would be considered first with regard to the availability of shares for settlement. If an entity determines in step 1 that two or more commitments have overlapping exercise periods or settlement dates, the entity should proceed to step 2.
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Step 2 — Apply a sequencing policy to determine which equity-linked instruments, or portions of such instruments, if any, qualify as equity.In step 2, the entity applies a sequencing policy under ASC 815-40-35-11 through 35-13 to determine which equity-linked instruments, or portions of such instruments, qualify as equity.ASC 815-40-35-12 lists several permissible methods of reclassification:
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Partial reclassification of all contracts on a proportionate basis.
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Reclassification of contracts with the earliest inception date first (i.e., first in, first out).
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Reclassification of contracts with the earliest maturity date first.
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Reclassification of contracts with the latest inception or maturity date first.
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Reclassification of contracts with the latest maturity date first.
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An entity should also consider any legal priority specified in the contracts’
terms. If an instrument has dedicated shares under a legally enforceable share
reservation clause, the instrument may be exempt from the sequencing exercise if
the dedicated shares would have highest priority, thereby ensuring share
settlement of the contract. In this case, the entity should subtract shares
related to the reservation clause from shares available for equity-settled
instruments before assessing share sufficiency for all remaining instruments.
Because this is a legal, rather than an accounting, consideration, it may
require the involvement of a legal specialist.
5.4.3 Commitments to Deliver a Potentially Unlimited Number of Shares
Some commitments may not explicitly limit the potential number of shares an entity could be required to deliver. In this case, the commitment could result in an obligation to deliver a potentially unlimited number of equity shares upon settlement. Examples of such commitments, which may fall outside the scope of ASC 815-40, include:
- A net-share-settled written put option or forward repurchase contract on an entity’s own stock (see ASC 480).
- An obligation to issue a variable number of shares worth a fixed monetary amount (see ASC 480).
- An obligation to issue a variable number of shares indexed to something other than the entity’s own stock (e.g., the price of gold) (see ASC 480 and ASC 815-40-15-7F).
- Share-settled interest deferral features in certain hybrid debt securities.
When an entity enters into a commitment that may require it to deliver a
potentially unlimited number of shares, it is possible that other equity-linked
instruments no longer meet the condition that the entity has sufficient
authorized and unissued shares to share settle the instrument. Nevertheless, an
entity is not necessarily precluded from classifying any or all of its other
instruments as equity. To determine whether share settlement is within the
entity’s control for equity-linked instruments other than the unlimited
contract, the entity should apply its sequencing policy. Such a policy may
indicate that sufficient authorized and unissued shares are available to share
settle some or all of the equity-linked instruments other than the contract that
does not limit the number of shares.
If the entity issues an uncapped contract, it would need to reevaluate the
classification of all its other outstanding equity-linked instruments classified
within equity. To do so, the entity may apply the two-step approach described in
Section 5.4.2 to
evaluate whether those other equity-linked instruments, or portions of such
instruments, should be reclassified from equity to an asset or a liability.
(This Roadmap does not take a view on whether an entity is permitted to use an
approach other than this two-step approach when it has issued one or more
uncapped contracts.)
Under the two-step approach, if a commitment that might require delivery of a
potentially unlimited number of shares has an earlier exercise period or
settlement date than the equity-linked instrument being evaluated, then the
instrument being evaluated does not qualify as equity until the contract with
the potentially unlimited number of shares has been settled. If several
equity-linked instruments are currently exercisable and the entity could not be
forced to settle the uncapped contract first, the entity should apply its
sequencing policy to determine which equity-linked instruments, or portions of
such instruments, qualify as equity.
However, equity classification of other equity-linked instruments may be
appropriate under the two-step approach if the other instruments will be settled
before the earliest possible date that the uncapped contract can be settled
(provided that these instruments meet all the criteria for equity
classification), or upon expiration of the uncapped contract. For example, if an
entity has an accounting policy of reclassifying contracts with the latest
inception or maturity date first, equity-linked instruments with an inception or
maturity date earlier than the unlimited contract would remain classified in
equity as long as the entity has a sufficient number of authorized and unissued
shares available to allow delivery under those instruments.
Example 5-8
Two-Step Approach: Latest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the latest maturity date first. Thus, any available shares are allocated first to contracts with the earliest maturity date. Entity A has two million shares of common stock authorized, with 200,000 shares unissued and a stock price of $25.
On January 1, 20X7, A acquires assets from Entity B and, as consideration, enters into a contract to provide a variable number of common shares of its stock to B in the amount of $2.5 million on December 31, 20X7.
On April 1, 20X7, A enters into a written call option contract to sell 150,000 shares of its stock to Entity C at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement, as determined by A. The call option expires on June 30, 20X7.
While the contract with B could require a potentially unlimited number of shares to be delivered by A, if A applies its sequencing policy only to contracts with overlapping settlement opportunities with respect to their exercise periods or settlement dates (as discussed in Section 5.4.2), it does not need to consider the contract with B in determining whether the call option qualifies for equity classification because the contract with B can be settled only after the entire term of the call option.
Under a sequencing policy that reclassifies contracts with the latest maturity date first, available shares are
allocated to contracts in order of increasing maturity dates. That is, the 200,000 available shares are first
compared with the potential share delivery requirement of 150,000 under the written call option contract
that matures on June 30, 20X7, since that contract has the earliest maturity date. Given the greater number
of available shares compared with the share delivery requirement (200,000 vs. 150,000), A would be able to
conclude that there are sufficient shares available to share settle the written call option contract and that it
has 50,000 remaining shares available to share settle other contracts with a later maturity date. Because of
the unlimited contract with B that matures on December 31, 20X7, however, A would be unable under this
sequencing policy to assert that it has any shares available to share settle contracts with a maturity date after
December 31, 20X7. The contract with B is not eligible for equity classification because of the unlimited share
exposure; nor is it eligible for partial classification in equity.
Example 5-9
Two-Step Approach: Earliest Maturity Date First
Entity A has adopted a two-step sequencing policy that reclassifies contracts (from equity to assets or liabilities) with the earliest maturity date first. Thus, any available shares are allocated first to contracts with the latest maturity date. Entity A has two million shares of common stock authorized with 200,000 shares unissued and a stock price of $25.
On January 1, 20X4, A enters into a six-month written call option contract to sell 150,000 shares of its stock to Entity B at a strike price of $35. The contract may be settled by physical settlement, net share settlement, or net cash settlement as determined by A. The call option can be exercised at any time and expires on June 30, 20X4.
On April 1, 20X4, A issues a hybrid convertible debt instrument to Entity C with interest payments due quarterly. Entity A has the option to defer its scheduled interest payment, but such a deferral triggers an obligation to share settle all deferred interest after five years unless previously paid. Since any deferred interest will result in a fixed-dollar payable settled in a variable number of shares, this feature has the potential to result in the issuance of an unlimited number of shares.
Because the exercise period of the written call option (January 1, 20X4, to June 30, 20X4) does not overlap with the earliest possible settlement date of the share-settled interest payment (April 1, 20X9), the 200,000 available shares would first be allocated to the written call option before consideration of the potentially unlimited number of shares associated with the hybrid convertible debt instrument. Entity A would apply its sequencing policy only if the exercise periods or settlement dates overlap.