5.3 Additional Equity Classification Conditions

5.3.1 Overview

ASC 815-40

25-10

Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in paragraphs 815-40-25-8 through 25-9 and paragraphs 815-40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:

Subparagraph superseded by Accounting Standards Update No. 2020-06.
Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
Subparagraph superseded by Accounting Standards Update No. 2020-06.
Subparagraph superseded by Accounting Standards Update No. 2020-06.

Paragraphs 815-40-25-39 through 25-42 explain the application of these criteria to convertible debt and other hybrid instruments.

25-10A The following conditions are not required to be considered in an entity’s evaluation of net cash settlement (that is, if any one of these provisions is in a contract [or the contract is silent on these points], they should not preclude equity classification, except as described below):

Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.

The fact that an equity-linked instrument specifies that it will be settled in shares or permits the entity to settle in shares does not necessarily justify a conclusion that the entity could not be forced to net cash settle the instrument. With certain exceptions, if there are any circumstances under which the entity could be required to net cash settle the instrument, the instrument cannot be accounted for as equity (see Section 5.2). For an entity to conclude that it cannot be required to net cash settle an equity-linked instrument, the entity must ensure that the conditions in ASC 815-40-25-10 are met.3 These conditions address whether there are circumstances under which the issuer could be forced to net cash settle the instrument.

Connecting the Dots

EITF Issue 00-19 (released before the FASB’s codification of U.S. GAAP) identified an additional condition for equity classification by stating that a “contract requires net-cash settlement only in specific circumstances in which holders of shares underlying the contract also would receive cash in exchange for their shares.” Under ASC 815-40, this condition still applies, but it is not one of the conditions described in ASC 815-40-25-10 (see Sections 5.2.2 and 5.2.3).

The conditions apply even if the contract stipulates either physical settlement or net share settlement. That is, an entity cannot assume that it can physically settle or net share settle an equity-linked instrument unless all the conditions are met irrespective of whether the instrument specifies that it will be share settled.

An entity assesses whether the conditions are met without regard to the likelihood that an event could force the entity to net cash settle the instrument. Accordingly, if there are circumstances under which the entity could be forced to net cash settle the instrument during its term, the instrument is classified as an asset or a liability even if the likelihood is remote that the circumstances will occur.

The entity must continually evaluate whether the conditions are met (see Section 5.4). An equity-linked instrument that initially meets the conditions and qualifies as equity would need to be reclassified out of equity if one or more of the equity classification conditions is no longer met. Conversely, an instrument that does not initially qualify for equity classification is reclassified as equity if it later meets all the conditions for such classification.

An entity is not required to consider the following conditions in determining whether an equity-linked instrument qualifies for equity classification:

The entity is permitted to settle the instrument in unregistered shares.4
No counterparty rights rank higher than shareholder rights.
There is no requirement in the contract for the issuing entity to post collateral at any point for any reason.

While an entity can classify an equity-linked instrument within equity even if the above three conditions are not met, SEC registrants must consider the guidance in ASC 480-10-S99-3A that applies to redeemable equity securities. An equity-linked instrument that does not meet any of the above three conditions would generally need to be classified as temporary equity. For example, assume that an entity must settle an option in shares of common stock that are registered for resale. The fact that this requirement does not affect the evaluation of whether the equity classification conditions in ASC 815-40-25 have been met does not mean that the entity controls the ability to issue registered shares. In the absence of preclearance with the SEC, an entity should classify an equity-linked instrument (including a hybrid financial instrument with an embedded equity-linked feature) as temporary equity if it does not meet one of the three conditions in ASC 815-40-25-10A.

If the issuer cannot be required to deliver any shares to settle the instrument, the conditions that address the entity’s ability to settle in shares do not apply (e.g., that the entity has sufficient authorized and unissued shares). Depending on the instrument’s terms, therefore, scenarios in which those conditions may not apply include the following:

A net-share-settled put or call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
A physically settled call option held by the entity. (If the entity elects to exercise the option, it will receive, not deliver, shares.)
A physically settled written put option embedded in own stock. (If the counterparty elects to exercise the embedded put option, the entity will receive, not deliver, shares.)
A contingent physically settled forward contract to repurchase own stock that is embedded in an outstanding share. (If the contingency is met, the entity will receive, not deliver, shares.)

Those conditions do apply, however, to a physically settled put option held by the entity, since the entity would deliver shares upon exercise. This is the case even though the decision to exercise the option is within the entity’s control (ASC 815-40-25-11).

5.3.2 Settlement Required in Registered Shares

An equity-linked instrument that requires the issuing entity to deliver shares to the counterparty can meet the conditions for equity classification whether the shares to be delivered are unregistered or registered provided that the contract does not explicitly state that an entity must settle in cash if registered shares are unavailable (see ASC 815-40-25-10A(a)).5 However, if the entity must deliver registered shares and the contract meets the indexation and equity classification conditions in ASC 815-40, the equity-linked instrument must be classified in temporary equity unless the entity controls the ability to deliver registered shares. In determining whether it controls the ability to deliver shares, an entity focuses on whether it has the legal ability to deliver the registered shares when settling the instrument. Under the Securities Act of 1933, offers and sales of securities must be registered with the SEC unless a specific exemption from the registration requirements applies. Accordingly, depending on the facts and circumstances, an entity may not be able to settle an instrument by delivering shares unless those shares have been registered with the SEC. As an issuer of shares, however, an entity cannot control whether the SEC will approve the registration of its shares, and even if the entity has an effective registration statement, the SEC may suspend the registration before the equity-linked instrument is settled. Further, the entity cannot control whether its auditor will provide it with an audit opinion or any consents required for share registration. Consequently, if it is unable to deliver registered shares because of such circumstances, the entity must classify the contract in temporary equity even though the contract meets the indexation and equity classification conditions in ASC 815-40.

An entity can classify an equity-linked instrument that requires settlement in registered shares as permanent, as opposed to temporary, equity if one or more of the following apply:

The instrument involves the delivery of shares at settlement that were registered at contract inception and there are no further requirements related to timely filing or registration.
The instrument clearly states that the issuer has no obligation to net cash settle the instrument if it is unable to deliver registered shares (i.e., the contract contains specific language that the entity’s nonperformance or failure to settle the contract is an available option).
The entity will never be required to deliver any shares under the instrument (i.e., upon any settlement, the issuing entity would receive, as opposed to issue, shares).

Connecting the Dots

In practice, it is sometimes difficult for an entity to conclude at contract inception that the shares to be delivered were registered and that there are no further requirements related to timely filing or registering the shares. If securities laws (e.g., the Securities Exchange Act of 1934) require the entity to periodically file (e.g., Form 10-K or 10-Q) and deliver a current, updated prospectus to maintain the shares’ registration, this exception is not available. An entity may need to consult legal counsel to determine whether the exception is available.

In a speech at the 2006 AICPA Conference on Current SEC and PCAOB Developments, Stephanie Hunsaker, then associate chief accountant in the SEC’s Division of Corporation Finance, indicated that the legal analysis of whether there are further requirements related to timely filing or registration may depend on whether the counterparty will make an investment decision upon the instrument’s exercise or settlement. For a warrant, for example, the counterparty may need to make an investment decision regarding whether to exercise the warrant (whereas for a forward contract, the investment decision would be made at contract inception). She said:

During the term of the warrants, the issuer will have to deliver a ‘current prospectus’ to the warrant holders in connection with any exercises by them. These further registration requirements stem from the fact that the holder of the warrant has to make a separate investment decision at the time of the exercise of the warrant and therefore a current prospectus must be delivered to the holder. Initially the issuer will be able to use the prospectus that was declared effective with respect to the unit offering when it sells shares to exercising warrant holders. However, as time passes, the prospectus will be required to be updated to disclose additional information or provide updated financial information. . . .

[A] forward contract requires the holder to purchase shares of common stock on a preset date in the future. . . .

The conclusion that there are not further timely filing or registration requirements stems from the fact that the investment decision (to purchase common stock in the future under the stock purchase contract) has been made at inception and there is no further investment decision to be made. In effect, there really is just a delayed delivery of the shares underlying the stock purchase contract. [Emphasis added]

In evaluating whether there are further requirements related to timely filing or registration, an entity should consider whether any specific exemption from the SEC’s registration requirements applies. Ms. Hunsaker emphasized that an exemption may be available under Section 3(a)(9) of the Securities Act of 1933 if one class of securities of an issuer is exchanged for a different class of securities of the same issuer as long as no consideration or commissions are being paid.

Further, Ms. Hunsaker stressed that registrants may need to consult with legal counsel:

However, registrants should ensure they have discussed with their legal counsel the availability of the Section 3(a)(9) exemption to their fact pattern, particularly in unusual circumstances such as when it is uncertain if the securities are convertible into those of the same issuer, arrangements which may involve the payment of remuneration for soliciting the exchange, or arrangements where the convertible securities are not potentially immediately convertible into shares of common stock of the registrant and the issuer has not registered all of the shares which could be issued upon conversion at inception along with the convertible debt.

5.3.2.1 Interaction With the Guidance on Registration Payment Arrangements

Sometimes an equity-linked instrument requires the entity to pay cash penalties if it is unable to register the shares underlying the instrument or is unable to maintain an effective registration statement. In this case, the entity should consider whether that penalty provision meets the definition of a registration payment arrangement under ASC 825-20 (see Section 3.2.4). Under ASC 825-20-25-1, a registration payment arrangement that has the characteristics described in ASC 825-20-15-3 is recognized as a unit of account that is separate from the contract subject to the agreement. Thus, an equity-linked instrument that is subject to a registration payment arrangement within the scope of ASC 825-20 is evaluated under ASC 815-40 without regard to the contingent obligation to transfer consideration under the registration payment agreement (ASC 825-20-25-2). In other words, an equity-linked instrument is not necessarily precluded from equity classification because it specifies cash penalties if the entity is unable to register the shares underlying the instrument, as long as the entity is not required to net cash settle the instrument.

If an equity-linked instrument permits the entity to settle by delivering unregistered shares, the instrument can qualify as permanent equity even if it requires the entity to use commercially reasonable best efforts to register any unregistered shares delivered. This is analogous to ASC 815-40-25-28, which states, in part:

Use of the entity’s best efforts to obtain sufficient authorized shares to settle the contract is within the entity’s control.

5.3.3 Entity Has Sufficient Authorized and Unissued Shares

ASC 815-40

25-19 If an entity could be required to obtain shareholder approval to increase the entity’s authorized shares to net share or physically settle a contract, share settlement is not controlled by the entity.

25-20 Accordingly, an entity shall evaluate whether a sufficient number of authorized and unissued shares exists at the classification assessment date to control settlement by delivering shares. In that evaluation, an entity shall compare both of the following amounts:

The number of currently authorized but unissued shares, less the maximum number of shares that could be required to be delivered during the contract period under existing commitments, including any of the following:
1. Outstanding convertible debt that is convertible during the contract period
2. Outstanding stock options that are or will become exercisable during the contract period
3. Other derivative financial instruments indexed to, and potentially settled in, an entity’s own stock.
The maximum number of shares that could be required to be delivered under share settlement (either net share or physical) of the contract.

25-21 When evaluating whether there are sufficient authorized and unissued shares available to settle a contract, an entity shall consider the maximum number of shares that could be required to be delivered under a registration payment arrangement to be an existing share commitment, regardless of whether the instrument being evaluated is subject to that registration payment arrangement.

25-22 If the amount in paragraph 815-40-25-20(a) exceeds the amount in paragraph 815-40-25-20(b) and the other conditions in this Subtopic are met, share settlement is within the control of the entity and the contract shall be classified as a permanent equity instrument. Otherwise, share settlement is not within the control of the entity and asset or liability classification is required.

25-23 For purposes of this calculation, if a contract permits both (a) net share and (b) physical settlement by delivery of shares at the entity’s option (both alternatives permit equity classification if the other conditions in this Section are met), the alternative that results in the lesser number of maximum shares shall be included in this calculation.

25-24 If a contract is classified as either an asset or a liability because the counterparty has the option to require settlement of the contract in cash, then the maximum number of shares that the counterparty could require to be delivered upon settlement of the contract (whether physical or net share) shall be assumed for purposes of this calculation.

An equity-linked instrument cannot be classified as equity unless either of the following criteria is met:

The entity currently has a sufficient number of authorized and unissued shares available to share settle the instrument.
The entity is able, without shareholder approval, to increase the number of authorized shares to make a sufficient amount of authorized and unissued shares available to share settle the instrument.

Whether shareholder approval would be required for an increase in the number of authorized shares is a legal determination (e.g., it may differ across jurisdictions). If shareholder approval is required for such an increase (e.g., under corporate law), the instrument cannot be classified as equity unless the entity currently has a sufficient number of authorized and unissued shares available to share settle the instrument. This is because the entity cannot assume that the shareholders will vote for an increase in the number of authorized shares.

If shareholder approval is obtained for an increase in the number of authorized shares, the entity should consider whether equity-linked instruments that previously were classified as assets or liabilities (because the number of authorized shares was insufficient) will need to be reclassified as equity (see Section 5.4).

In assessing whether it has a sufficient number of authorized and unissued shares, an entity does not take into account only the number of its currently authorized and unissued shares. It must also consider how many shares it might be required to deliver under any other commitment to deliver shares during the maximum period in which the equity-linked instrument being evaluated might remain outstanding, including any top-off or make-whole commitments (see Section 5.3.6). Such commitments include not only instruments within the scope of ASC 815-40 but also instruments within the scope of other accounting guidance such as ASC 480 or ASC 718. Examples include warrants, options, forwards, employee stock options, convertible debt, convertible preferred stock, share-settled contingent consideration in a business combination, and share-settled registration payment arrangements.

The entity deducts the maximum number of shares it could be required to deliver during the contract period under such commitments from the number of currently authorized but unissued shares. Equity classification for the instrument being assessed is precluded unless the number of authorized and unissued shares that remains after deduction of all the shares the entity might have to deliver under other commitments exceeds the maximum number of shares that the entity could be required to deliver under the instrument.

If an entity anticipates issuing shares but is not committed to doing so, it would not consider those shares in the calculation, but it would consider them in its periodic reassessment of the classification of equity-linked instruments when the issuances actually occur.

Example 5-4

Sufficient Authorized and Unissued Shares

An entity has issued a warrant that expires in one year. If the holder exercises the warrant, the contractual terms of the warrant require the entity to deliver 20,000 shares of the entity’s stock in exchange for a cash payment of $5 million. Further, the entity determines that (1) it currently has 100,000 authorized shares, of which 40,000 are in issuance, and (2) the maximum number of shares that it could be required to deliver during the warrant’s one-year term because of other commitments (e.g., outstanding convertible debt, employee stock options) is 35,000.

The entity would calculate the number of shares available to share settle the warrant being evaluated as follows:

Calculation and Comparison	Number of Shares
Currently authorized shares	100,000
Less: Issued shares	(40,000)
Less: Maximum number of shares the entity could be forced to deliver during the contract term under other commitments	(35,000)
Equals: Shares available to share settle the contract	25,000
Compare: Maximum number of shares that the entity could be forced to deliver under the contract being evaluated	20,000

The warrant being evaluated is not precluded from equity classification because the entity has a sufficient number of authorized and unissued shares available to share settle the contract. That is, the contract being evaluated would never require delivery of more than 20,000 shares, and the entity has 25,000 shares available to share settle the contract.

In calculating the maximum number of shares that might have to be delivered under an equity-linked instrument that (1) could require the entity to deliver shares and (2) includes a choice of settlement method (e.g., physical settlement, net shares, or net cash), the entity considers which party controls the manner of settlement. If the entity has the option to elect either net share or physical settlement, the entity reflects the alternative with the lesser number of shares in the calculation (i.e., net share settlement), since the entity cannot be forced to deliver the greater number of shares that would be delivered in a physical settlement. If the counterparty can elect the settlement method, the entity reflects the alternative that will require delivery of the greater number of shares in the calculation. If this is the case, the entity incorporates the greater number of shares in the calculation even if the instrument is classified as an asset or a liability (e.g., because the counterparty has the right to elect net cash settlement).

The classification requirements in ASC 815-40 apply to each equity-linked instrument as a whole unless the instrument permits partial net share settlement. If an equity-linked instrument does not permit partial net share settlement, the whole instrument is classified as an asset or a liability if the entity does not have sufficient shares to share settle the entire instrument. ASC 815-40-35-11 addresses contracts that permit partial net share settlement.

If the issuer cannot be required to deliver any shares to settle an equity-linked instrument, the entity does not need to satisfy the condition that it have sufficient authorized and unissued shares to settle the instrument. Depending on the instrument’s terms, therefore, the condition may not apply to, for example, a purchased call option on the entity’s own equity, in which the entity will receive, not deliver, shares upon exercise.

5.3.3.1 Sequencing Considerations

If an entity concludes that it does not have sufficient authorized and unissued shares to satisfy all its commitments to deliver shares, it should apply a sequencing policy to determine how to allocate any authorized and unissued shares among those commitments. In establishing a sequencing policy, an entity should consider the guidance on reclassification methods in ASC 815-40-35-11 through 35-13 (see Section 5.4). While that guidance addresses “reclassifications,” it is also relevant in the determination of the initial classification of equity-linked instruments. Depending on how authorized and unissued shares are allocated under an entity’s sequencing policy, the entity may conclude that it has a sufficient number of authorized and unissued shares available to share settle the instrument being evaluated.

5.3.4 Contract Contains an Explicit Share Limit

ASC 815-40

25-26 For certain contracts, the number of shares that could be required to be delivered upon net share settlement is essentially indeterminate. If the number of shares that could be required to be delivered to net share settle the contract is indeterminate, an entity will be unable to conclude that it has sufficient available authorized and unissued shares and, therefore, net share settlement is not within the control of the entity.

For equity classification to be appropriate, the number of shares the entity might be required to deliver under the contract must be limited (capped). If determining the maximum number of such shares is not possible, then equity classification is not permitted because it would be impossible to establish whether the entity has a sufficient number of authorized and unissued shares available to settle the instrument in shares. That is, an equity-linked instrument that could require the entity to deliver an unlimited number of shares would not qualify as equity. The number of shares that it expects to deliver is not relevant to this determination, nor is whether there is only a remote likelihood that the entity will deliver more than some specific number of shares.

The SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006) notes that one of the most common causes of improper accounting for a conversion feature embedded in convertible debt or convertible preferred stock is that:

[T]he number of shares issuable upon conversion of the convertible instrument is variable, and there is no cap on the number of shares which could be issued. [Since] there is no explicit limit on the number of shares that are to be delivered upon exercise of the conversion feature, the registrant is not able to assert that it will have sufficient authorized and unissued shares to settle the conversion option. As a result, the conversion feature would be accounted for as a derivative liability, with changes in fair value recorded in earnings each period. Additionally, registrants should note that a variable share settled instrument that results in liability classification may impact the classification of previously issued instruments, as well as instruments issued in the future.

An equity-linked instrument’s terms do not necessarily need to use the words “explicit share limit” — it may be possible for an entity to infer an explicit share limit from the terms. For example, a convertible bond may have a par value of 1,000, a fixed conversion price of $20, and no adjustment provisions that could increase the number of shares that would be delivered. If the par value of 1,000 is divided by the conversion price of $20, it is implied that the entity would never deliver more than 50 shares. Thus, 50 shares would be considered the explicit share limit. If the issuer writes a freestanding call option on its own outstanding shares, the terms of the option contract may similarly establish an explicit share limit. For example, if the written call option has a fixed notional amount of 100 shares and no adjustment provisions, the entity will never deliver more than 100 shares irrespective of whether the contract provides for physical settlement or net share settlement.

Many equity-linked instruments require adjustments to the number of shares to be delivered upon the occurrence or nonoccurrence of a specified event (e.g., an antidilution adjustment that specifies that the number of shares will be increased in case of a stock split). A contractual provision that increases the number of shares to be delivered upon the occurrence or nonoccurrence of an event is not inconsistent with this condition if the event that triggers the adjustment is within the entity’s control. If the triggering event is outside the entity’s control (e.g., a merger or a consolidation), the instrument may still meet this condition if the event causes the instrument to be settled and all holders of the underlying shares receive the same form of consideration (see Section 5.2.3.3).

If the issuer cannot be required to deliver any shares to settle the instrument, the condition that the instrument contains an explicit share limit does not apply. (Alternatively, the instrument could be analyzed as having a share limit of zero since the entity could not be required to deliver any shares.) Depending on the instrument’s terms, therefore, the condition may not apply to, for example, a purchased call option on the entity’s own equity in situations in which the entity would receive, not deliver, shares upon exercise.

An equity-linked instrument may contain a clause that limits the holder’s ability to exercise and beneficially own more than a specified percentage of the issuer’s outstanding shares (e.g., the counterparty cannot exercise an option contract if it owns or would obtain more than 4.99 percent of outstanding shares). Such a cap does not qualify as an explicit share limit since the counterparty can sell the shares it holds before exercise and any shares it receives upon exercise.

If the entity is able, without shareholder approval, to increase the number of authorized shares to make a sufficient number of authorized and unissued shares available to share settle an equity-linked instrument, the requirement that the instrument must contain an explicit share limit does not apply because the entity could not be forced to cash settle the instrument (see Section 5.3.3).

Including an explicit share limit in a contract’s terms solely to meet the condition that the instrument have such a limit would not preclude a conclusion that the instrument is a fixed-for-fixed forward or an option on the entity’s equity shares (see Section 4.3.2).

5.3.4.1 Interaction Between the Sufficient Share and Explicit Share Limit Conditions

ASC 815-40

25-27 If a contract limits or caps the number of shares to be delivered upon expiration of the contract to a fixed number, that fixed maximum number can be compared to the available authorized and unissued shares (the available number after considering the maximum number of shares that could be required to be delivered during the contract period under existing commitments as addressed in paragraph 815-40-25-20 and including top-off or make-whole provisions as discussed in paragraph 815-40-25-30) to determine if net share settlement is within the control of the entity. A contract termination trigger alone (for example, a provision that requires that the contract will be terminated and settled if the stock price falls below a specified price) does not satisfy this requirement because, in that circumstance, the maximum number of shares deliverable under the contract is not known with certainty unless there is a stated maximum number of shares.

If an entity determines that an equity-linked instrument contains an explicit share limit (i.e., it satisfies the condition in ASC 815-40-25-26), the entity can then compare that share limit with the number of available shares. If there is a share limit but it exceeds the number of available shares, the instrument fails to meet the condition in ASC 815-40-25-19. In this case, the entity classifies the instrument as an asset or a liability. On the other hand, if there is a share limit and the number of available shares exceeds that limit, the instrument potentially qualifies for equity classification if the other conditions for equity classification are met.

5.3.4.2 Equity-Linked Instrument With Share Limit and Best-Efforts Arrangement

ASC 815-40

25-28 This paragraph addresses a contract structure that caps the number of shares that must be delivered upon net share settlement but would also provide that any contract valued in excess of that capped amount may be delivered to the counterparty in cash or by delivery of shares (at the entity’s option) when authorized, unissued shares become available. The structure requires the entity to use its best efforts to authorize sufficient shares to satisfy the obligation. Under the structure, the number of shares specified in the cap is less than the entity’s authorized, unissued shares less the number of shares that are part of other commitments (see paragraph 815-40-25-20). Use of the entity’s best efforts to obtain sufficient authorized shares to settle the contract is within the entity’s control. If the contract provides that the number of shares required to settle the excess obligation is fixed on the date that net share settlement of the contract occurs, the excess shares need not be considered when determining whether the entity has sufficient, authorized, unissued shares to net share settle the contract pursuant to paragraph 815-40-25-20. However, the contract may provide that the number of shares that must be delivered to settle the excess obligation is equal to a dollar amount that is fixed on the date of net share settlement (which may or may not increase based on a stated interest rate on the obligation) and that the number of shares to be delivered will be based on the market value of the stock at the date the excess amount is settled. In that case, the excess obligation represents stock-settled debt and shall preclude equity classification of the contract (or, if partial net share settlement is permitted under the contract pursuant to paragraph 815-40-35-11, precludes equity classification of the portion represented by the excess obligation).

The counterparty to an equity-linked instrument may be reluctant to accept an explicit share limit that caps the gain it could make on the instrument. In this case, the entity may agree to (1) deliver the shares that are in excess of the limit (the number of which becomes fixed as of the instrument’s settlement date) only once authorized, unissued shares become available, and (2) use its best efforts to obtain such shares. In this situation, the entity does not need to consider the excess shares in determining whether it has sufficient authorized and unissued shares to net share settle the instrument because it cannot be forced to deliver those shares.

However, if the contract specifies that the entity will deliver a variable number of shares equal in value to that of the excess shares determined as of the settlement date, the excess obligation is considered stock-settled debt. In this case, the instrument must be classified as a liability either for the part that exceeds the explicit share limit (if the contract permits partial net share settlement) or in its entirety (if it cannot be partially net share settled or otherwise does not meet the conditions for equity classification). Once the monetary amount of the stock-settled debt becomes fixed as of the instrument’s original settlement date, that obligation is outside the scope of ASC 815-40 under ASC 815-40-15-3(e) and is instead accounted for as a liability under ASC 480 (see Section 2.3 of this Roadmap and Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).

5.3.5 No Required Cash Payment if Entity Fails to File on a Timely Basis

ASC 815-40

25-29 The ability to make timely SEC filings is not within the control of the entity. Accordingly, if a contract permits share settlement but requires net cash settlement in the event that the entity does not make timely filings with the SEC, that contract shall be classified as an asset or a liability.

If an equity-linked instrument must be net cash settled in the event that the entity does not file reports with the SEC on a timely basis, the instrument cannot be accounted for as equity. In the evaluation of whether this condition is met, the likelihood of the entity’s being unable to file in a timely manner is irrelevant.

The reason for this requirement is that the ability to file reports with the SEC in a timely manner is not solely within the entity’s control. For example, an entity cannot control whether its auditor will provide it with an audit opinion that is required in filing the entity’s annual financial statements. Some filings may require the consent of the entity’s auditor or third-party experts.

An equity-linked instrument might require the entity to make a cash payment for failing to file financial statements with the SEC or other body in a timely manner (e.g., an amount in cash equal to 2 percent of the instrument’s exercise price on the day of a failure to file and on every 30th day thereafter until the date such failure is cured). Such penalty payments do not preclude equity classification since they do not cause the instrument to be settled (see Section 5.2.3.7).

Connecting the Dots

Under ASC 815-40-25-10(d), one of the conditions for equity classification is that there must be no required cash payment — except for penalty payments — if the entity fails to file in a timely manner. Although the exception for penalty payments is discussed solely in the context of payments for an entity’s failure to file financial statements on a timely basis, it is acceptable to apply this exception to other cash payments that are (1) akin to penalty payments as opposed to a partial settlement of the contract and (2) not made in conjunction with the settlement of the contract (i.e., the equity-linked instrument must continue to exist after the payment is made). If a cash payment is required in connection with the settlement of an equity-linked instrument, the exception for penalty payments does not apply and the contract cannot be classified in equity.

A requirement that the entity use its best efforts to make timely filings is within its control and would not preclude equity classification.

Some hybrid financial instruments specify that the entity will pay cash penalties or additional interest if the entity does not file on a timely basis. For example, a convertible debt instrument may indicate that additional interest is payable if the entity fails to file reports in a timely manner. Such a feature may be attributed to the hybrid instrument and evaluated separately as an embedded derivative provided that the penalty paid does not vary on the basis of the value of the conversion option. Accordingly, it would not disqualify the conversion option from being classified as equity.

5.3.6 No Cash-Settled Top-Off or Make-Whole Provision

ASC 815-40

25-30 A top-off or make-whole provision would not preclude equity classification if both of the following conditions exist:

The provision can be net share settled.
The maximum number of shares that could be required to be delivered under the contract (including any top-off or make-whole provisions) is both:
1. Fixed
2. Less than the number of available authorized shares (authorized and unissued shares less the maximum number of shares that could be required to be delivered during the contract period under existing commitments as discussed in paragraph 815-40-25-20).

If those conditions are not met, equity classification is precluded.

ASC 815-40 — Glossary

Make-Whole Provision

A cash payment to a counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due. While the exact terms of such provisions vary, they generally are intended to reimburse the counterparty for any losses it incurs or to transfer to the entity any gains the counterparty recognizes on the difference between the following:

The settlement date value
The value received by the counterparty in subsequent sales of the securities within a specified time after the settlement date.

Top-Off Provision

See Make-Whole Provision.

Some equity-linked instruments contain make-whole or top-off provisions that reimburse the counterparty if it incurs a loss on the sale of the shares it will receive upon settlement of the instrument. The counterparty to an equity-linked instrument (e.g., a warrant, a written call option, or a convertible instrument) may seek to include such a provision to ensure that it does not stand to lose from declines in the stock price following its exercise of the instrument.

The existence of a top-off or a make-whole provision precludes equity classification for the entire equity-linked instrument unless both of the following conditions are met:

The entity has the right to net share settle the make-whole or top-off obligation.
The maximum number of shares that is required to settle the instrument (including the top-off or make-whole provision) is both:
- Fixed (i.e., there is an explicit share limit).
- Less than the number of available authorized and unissued shares after deduction of the maximum number of shares for which delivery could be required during the contract period under other commitments (i.e., the entity has sufficient authorized and unissued shares to share settle the make-whole or top-off provision).

Example 5-5

Top-Off Provision

An entity writes a net-share-settled call option on 1,000 of the entity’s common shares. The entity has the right to settle the call option by delivering unregistered shares. On a per-share basis, the option’s settlement amount equals the difference between the quoted stock price on the settlement date and $46. The option contains a top-off provision that specifies that if the holder sells the shares it receives upon settlement of the option and such sale occurs within 10 days of option settlement, the holder will receive a variable number of shares equal in value to the excess, if any, of (1) the stock price used in settling the option divided by (2) the price at which the holder subsequently sells the shares. The entity has the right to settle the top-off provision in unregistered shares. The option also specifies that under no circumstances will the entity deliver more than 1,000 shares to satisfy both the option settlement and the top-off provision. The entity has 2,000 authorized and unissued shares available.

On the option’s settlement date, the quoted stock price is $50. Because the option is net share settled, the holder receives a variable number of the entity’s shares equal in value to $4,000, or 1,000 × ($50 – $46); that is, 80 shares ($4,000 ÷ $50). Ten days later, the holder sells the shares in the market for $40 per share and incurs an aggregate loss of $800, or 80 × ($50 – $40). Under the top-off provision, therefore, the entity delivers an additional number of shares to the counterparty equal in value to $800. At a stock price of $40, the entity delivers an additional 20 shares ($800 ÷ $40) to the counterparty to satisfy the top-off provision.

Even though this option contains a top-off provision, the option is not precluded from equity classification since the entity has the right to net share settle the top-off provision, and the maximum number of shares it might be required to deliver is both fixed and less than the available authorized and unissued shares. If the entity can be forced to net cash settle the top-off provision, however, the entire option is classified as a liability.

Footnotes

The conditions in ASC 815-40-25-10 do not apply to certain conversion options embedded in a convertible debt instrument (see Section 5.5).

An equity-linked instrument can qualify as equity even if it must be settled in registered shares unless the instrument explicitly states that the entity must cash settle it if registered shares are unavailable; however, the entity may be required to classify the instrument as temporary equity (see Section 5.3.2).

In practice, equity-linked instruments generally do not contain provisions that explicitly require cash settlement if the entity is unable to deliver registered shares.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.