Chapter 4 — Mandatorily Redeemable Financial Instruments

4.4 Reclassifications

4.4.1 Ongoing Reassessment

ASC 480-10

25-5 A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.

25-7 If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.

55-10 The guidance that follows discusses the requirement in paragraph 480-10-25-7 for reclassification of stock that becomes mandatorily redeemable. For example, an entity may issue equity shares on January 2, 2004, that must be redeemed (not at the option of the holder) six months after a change in control. When issued, the shares are conditionally redeemable and, therefore, do not meet the definition of mandatorily redeemable. On December 30, 2008, there is a change in control, requiring the shares to be redeemed on June 30, 2009. On December 31, 2008, the issuer would treat the shares as mandatorily redeemable and reclassify the shares as liabilities, measured initially at fair value. Additionally, the issuer would reduce equity by the amount of that initial measure, recognizing no gain or loss.

55-11 For another example of a conditionally redeemable instrument, an entity may issue preferred shares with a stated redemption date 30 years hence that also are convertible at the option of the holders into a fixed number of common shares during the first 10 years. Those instruments are not mandatorily redeemable for the first 10 years because the redemption is conditional, contingent upon the holder’s not exercising its option to convert into common shares. However, when the conversion option (the condition) expires, the shares would become mandatorily redeemable and would be reclassified as liabilities, measured initially at fair value.

55-12 If the conversion option were nonsubstantive, for example, because the conversion price is extremely high in relation to the current share price, it would be disregarded as provided in paragraph 480-10-25-1. If that were the case at inception, those preferred shares would be considered mandatorily redeemable and classified as liabilities with no subsequent reassessment of the nonsubstantive feature.

An entity should reassess in each reporting period whether any of its equity-classified shares have become mandatorily redeemable financial instruments. If circumstances change, a share that previously did not meet the definition of a mandatorily redeemable financial instrument may subsequently meet it. For example, a perpetual share that is required to be redeemed in cash upon the occurrence of an event that is not certain to occur (e.g., a deemed liquidation event) would not initially meet the definition of a mandatorily redeemable financial instrument, because redemption is conditional. If the event subsequently becomes certain to occur so that redemption becomes unconditional, the share would begin to meet the definition of a mandatorily redeemable financial instrument and should be reclassified as a liability unless a specific exception from liability classification applies.

Examples include:

The expiration of a substantive conversion option in a preferred share with a stated redemption date on which the issuer is required to redeem the share for cash (see ASC 480-10-55-11). The share would be reclassified as a liability on the expiration date of the conversion option.
The holder’s exercise of a physically settled put or redemption option in a perpetual preferred share that makes redemption certain to occur. That share would be reclassified as a liability on the option exercise date and remain a liability until the redemption date. (Redemption would continue to be considered conditional, however, if the issuer has the right to reject the redemption request under the redemption option without penalty.)
The issuer’s exercise of a physically settled call or redemption option embedded in a perpetual preferred share that makes redemption certain to occur. The share would be reclassified as a liability on the option exercise date.
The occurrence of an event (e.g., an IPO or change of control) that triggers the mandatory redemption of a perpetual preferred share for cash (see ASC 480-10-55-10 for an example). The share would be reclassified as a liability upon the occurrence of the event.

Reclassification is also required if the terms of a share are modified so that it begins to meet or ceases to meet the definition of a mandatorily redeemable financial instrument. However, the modification must be legally binding. An agreement in principle to change the contractual terms of an instrument may not be legally binding (e.g., if it allows either party to walk away without recourse).

A share might have to be reclassified as a liability even if the period until the required redemption date is short. For example, when an entity gives an irrevocable notice to purchase an outstanding redeemable share, it should consider whether the share must be reclassified as a mandatorily redeemable financial instrument.

An instrument for which redemption is not certain to occur does not meet the definition of a mandatorily redeemable financial instrument. For instance, a preferred share might contain an option for the issuer to redeem the preferred share for cash and an option for the holder to convert the share into common stock. In such a scenario, even if the issuer notifies the holder of its intent to exercise the redemption option, the share would not meet the definition of a mandatorily redeemable financial instrument if the holder has the ability to convert the preferred stock into common stock before the redemption date.

An instrument that previously did not meet the definition of a mandatorily redeemable financial instrument is reclassified as of the date it meets it. Thus, if a conditionally redeemable financial instrument in the form of a share became unconditionally redeemable after the balance sheet date, but before the financial statements were issued or available to be issued, an entity would not classify it as a liability as of the balance sheet date. However, the entity may be required to disclose the subsequent event in accordance with ASC 855-10-50-2 to keep the financial statements from being misleading.

4.4.2 Accounting for Reclassifications

ASC 480-10

30-2 If a conditionally redeemable instrument becomes mandatorily redeemable, upon reclassification the issuer shall measure that liability initially at fair value and reduce equity by the amount of that initial measure, recognizing no gain or loss.

When a conditionally redeemable financial instrument becomes a mandatorily redeemable financial instrument (see Section 4.1), the issuer reclassifies it from the equity to liabilities category at its current fair value as of the date of the reclassification. No gain or loss should be recognized in the income statement upon reclassification because the reclassification is considered a distribution to an owner. However, under the SEC guidance in ASC 260-10-S99-2, the reclassification of an equity-classified preferred security as a liability (e.g., a preferred share becomes mandatorily redeemable) is treated as a redemption of equity by issuance of a debt instrument in the calculation of EPS. In accordance with ASC 260-10-S99-2, because the reclassification is accounted for as the issuance of a new debt instrument to redeem the old equity instrument (see Section 9.7.1), previously recognized equity issuance costs would not be expensed through the income statement but rather recognized as part of the adjustment to EPS for the redemption of the preferred stock.

If the instrument was previously classified in temporary equity under ASC 480-10-S99-3A, the issuer may need to adjust its method of measuring the instrument, because ASC 480-10-25-30-2 requires the instrument to be initially measured at fair value as of the reclassification date, and ASC 480-10-S99-3A permits certain accounting policies that are not available under ASC 480-10-35. Unlike paragraph 15 of ASC 480-10-S99-3A, for example, ASC 480-10-35 does not permit an entity to apply an accounting policy of measuring the instrument at the amount of cash that would be paid if settlement occurred as of the reporting date if the redemption date and the redemption amount are both fixed.

Example 4-8

Reclassification of Preferred Stock From Equity to a Liability

Company D has outstanding preferred stock with the following terms:

The preferred stock is automatically converted into common stock at a conversion price of $25 per share in the event that D effects a qualified IPO within the next five years.
If D does not effect a qualified IPO by the end of the fifth year from the issuance date, the preferred stock becomes mandatorily redeemable in five years.

Company D should not classify the preferred stock as a liability under ASC 480 before the fifth year from the issuance date if it concludes that the conversion upon a qualified IPO is a substantive feature. Furthermore, while D is required to classify the preferred stock within temporary equity under ASC 480-10-S99-3A, it should not remeasure the preferred stock to its redemption amount as long as the occurrence of a qualified IPO by the end of year five is more than remote (see Section 9.5.4.3).

However, if a qualified IPO does not happen by the end of year five, the preferred stock becomes a mandatorily redeemable financial instrument for which reclassification as a liability is required under ASC 480. In this circumstance, in accordance with ASC 480-10-30-2, D should reflect the reclassification by measuring the liability initially at fair value and reducing equity by the same amount without recognizing a gain or loss. This reclassification is treated in the same manner as any other extinguishment of preferred stock under ASC 260-10-S99-2. Therefore, the difference between the initial fair value amount recognized for the preferred stock upon reclassification as a liability and the net carrying amount of the preferred stock (which should be adjusted under other applicable GAAP, including ASC 480-10-S99-3A if applicable, immediately before such reclassification) reflects a charge (or credit) to net income in arriving at income available to common stockholders.

For further discussion of the EPS impact of a reclassification, see Sections 3.2.2, 3.2.3.5, and 3.2.4.4 of Deloitte’s Roadmap Earnings per Share.

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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.