What Management Should Know Before Issuing Equity-Linked Instruments in Financing Transactions

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1 What Management Should Know Before Issuing Equity-Linked Instruments in Financing Transactions October 2012 Table of Contents Navigating through the Guidance 2 ASC 480, Distinguishing Liabilities from Equity 3 ASC 815, Derivatives and Hedging 7 ASC , Debt with Conversion and Other Options 16 ASC S99, Redeemable Preferred Stocks 18 Allocating Proceeds to Financial Instruments Issued in the Same Transaction 20 Ongoing Need for Reassessment 21 Valuation Considerations 22 Disclosure Considerations 23 Closing Thoughts 23 Appendix 24 With the financial turmoil existing in recent years and the attendant difficulty many entities are experiencing in raising funds, it is becoming more common for both debt and equity financing arrangements to include various sweeteners such as warrants, forward contracts to sell or purchase shares and conversion options. These and other instruments that will result in the issuance of shares or cash payments related to the fair value of such shares are hereafter referred to as equity-linked instruments. The accounting for these instruments can be quite complicated because there is a myriad of guidance that needs to be considered in arriving at the right conclusion. The analysis is further complicated by the sophistication of instruments that continue to evolve and by the careful consideration that needs to be given to the agreements for each instrument as well as shareholder rights and related agreements for the underlying shares. It is common for an entity to issue some of these instruments and be unpleasantly surprised by unanticipated and undesirable accounting consequences. These consequences can include liability treatment for warrants, conversion features and certain preferred stock as well as fair value treatment for debt, with ongoing income statement volatility as the liability is continuously adjusted to fair or redemption value. For this reason, it is important for management to be aware of the potential issues when designing such instruments to ensure that they are not surprised by the resulting accounting treatment. The synopsis that follows is intended to be an overview of some of the relevant guidance and should be read in conjunction with the authoritative guidance. Due to the complexity of equity-linked instruments and the relevant accounting guidance, management may want to consider seeking external expertise to assist in the accounting analysis and valuation of the instruments. Some examples of potentially problematic features and the accounting consequences include the following: Warrants and/or convertible debt or preferred stock with an exercise or conversion price that is adjusted downward upon the subsequent issuance of shares of underlying stock at a price that is below the warrant exercise price or the debt/preferred stock conversion price can result in liability treatment and require ongoing fair value measurement for the warrant and conversion features;

2 Warrants that are conditionally redeemable and stock that is mandatorily redeemable generally require liability treatment and ongoing fair value or redemption value measurement; while stock that is conditionally redeemable can require temporary equity treatment; Provisions that require or give the holder the option of net cash settlement for an equity-linked instrument generally result in liability treatment and require ongoing fair value measurement; If an instrument, such as a warrant, is issued in conjunction with debt and/or an embedded derivative is separately recognized, a portion of the proceeds needs to be allocated to the warrants and/or bifurcated derivatives, creating a discount on the debt that needs to be amortized in to interest expense; Instruments that will be settled with a fixed dollar value of shares are generally recorded as liabilities; If the entity does not have sufficient authorized and unissued shares to meet commitments under outstanding contracts, it can result in liability treatment for various equity-linked instruments and require ongoing fair value measurement. Navigating through the Guidance With regards to warrants, the accounting analysis considers whether the warrants are liabilities that will continuously be adjusted to fair value through earnings or will be accounted for as equity, and continuously carried at the initial measurement amount. To make this determination, consideration primarily needs to be given to the Financial Accounting Standards Board ( FASB ) Accounting Standards Codification ( ASC or Codification ) topic 480, Distinguishing Liabilities from Equity and ASC 815, Derivatives and Hedging. Preferred stock may need to be classified as a liability (and adjusted to redemption or fair value), equity or temporary equity, also called mezzanine capital. Additionally, embedded features, such as conversion options for preferred stock and debt, may warrant separate asset or liability fair value recognition as bifurcated derivatives. In addition to the guidance mentioned above for warrants, the guidance in ASC , Debt with Conversion and Other Options, would generally be considered to determine if a cash conversion or beneficial conversion feature exists in convertible debt instruments and must be recognized as a component of equity. Finally, ASC S99-3A, Classification and Measurement of Redeemable Securities, should be considered to determine if preferred stock and any components of convertible debt, otherwise eligible for equity classification, should be presented as temporary equity in the balance sheet. While the temporary equity presentation is only required for public companies, we believe this classification is appropriate for private companies as well. Flow charts are presented in the appendix to assist in navigating through the guidance that is generally pertinent to some of the more common equity-linked instruments, namely warrants, preferred stock and convertible debt or stock. These instruments are also the focus of this article. Given that it is common for financing transactions to include multiple instruments or embedded instruments such as debt, conversion options, stock, and warrants, an important first step is to identify the instruments and embedded features that are involved and determine which of them are freestanding financial instruments as opposed to embedded in another 2

3 instrument. This determination can be highly subjective. The Codification defines a freestanding financial instrument as one that is either entered into separately and apart from any of the entity s other financial instruments or equity transactions, or entered into in conjunction with some other transaction and is legally detachable and separately exercisable. Warrants are frequently issued in conjunction with debt or stock issuances and thus the conclusion regarding whether warrants are freestanding often depends on whether they are legally detachable and separately exercisable. Warrants typically are legally detachable and separately exercisable given that the holder can generally exercise a warrant without giving up the debt or stock that it may have received in conjunction with the warrant. With regards to convertible instruments such as debt and preferred stock, while the debt or stock is generally considered to be a freestanding financial instrument, the conversion option embedded in the debt or stock is not. This is because the conversion option is obtained in conjunction with the debt or stock and generally the debt or stock must be given up to receive the common stock or other securities in to which it is convertible. In some cases, this analysis is less straight forward and consideration would need to be given to all the relevant facts and circumstances including whether the agreements were entered into contemporaneously or in contemplation of each other and with the same or related counterparties. The classification as a freestanding instrument will determine the applicability of certain guidance as well as the unit of account at which to value and recognize instruments or embedded features and as such is a critical first step. ASC 480, Distinguishing Liabilities from Equity ASC 480, Distinguishing Liabilities from Equity, primarily originated from FAS 150 and related interpretations. This subtopic establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The guidance applies to freestanding financial instruments, thus reinforcing the importance of this determination. Three types of obligations may require liability treatment under ASC : Mandatorily redeemable financial instruments Obligations to repurchase the issuer s equity shares by transferring assets Obligations to issue a variable number of shares Circumstances under which preferred stock generally falls within the scope of ASC 480 include when it is mandatorily redeemable or in certain circumstances elaborated on below, when it will be settled for a variable number of other shares. Circumstances under which warrants generally fall within the scope of ASC 480 include when the warrants or underlying shares are puttable or mandatorily redeemable as well as in certain circumstances elaborated on below, when the number of shares to be received upon exercise of a warrant is variable. Relevant agreements may or may not use the words mandatorily redeemable and puttable. Regardless of how certain features are labeled, the agreements for warrants and preferred stock and any related agreements including subscription and shareholder s rights agreements should be reviewed carefully for obligations of the issuer to redeem instruments for cash or other assets or rights of the holder to return certain instruments to the issuer for cash or other assets. A discussion of the three types of obligations follows. 3

4 Mandatorily Redeemable Financial Instruments: Mandatorily redeemable financial instruments are defined in ASC as Any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur. In determining if an instrument is mandatorily redeemable, consideration should be given to the following: If redemption is required to occur only upon the liquidation or termination of the reporting entity, the instrument would not be considered mandatorily redeemable. 1 If redemption is to occur upon the death or termination of the holder, the instrument would be considered mandatorily redeemable. 2 Term extension options, provisions that defer redemption until a specified liquidity level is reached, or similar provisions that may delay or accelerate the timing of a mandatory redemption do not affect the classification of a mandatorily redeemable financial instrument as a liability. 3 Redeemable instruments that are convertible in to common shares are generally not considered to be mandatorily redeemable during the period of time they are convertible since redemption is conditional upon the holder not electing to convert. 4 As noted below, if the conversion option is nonsubstantive (conversion price is extremely high in relation to the current share price as an example), it would be disregarded. Nonsubstantive or minimal features are disregarded. There can be a continuous need for reassessment as instruments that are conditionally redeemable upon an event not certain to occur become mandatorily redeemable if the event occurs, the condition is resolved, or the event becomes certain to occur. 6 Effective Date Considerations (ASC ) The effective date of ASC 480 as it pertains to mandatorily redeemable financial instruments issued by nonpublic entities that are not SEC registrants has been deferred indefinitely unless the instruments are mandatorily redeemable on fixed dates for amounts that are either fixed or are determined by reference to an external index. 5 1 ASC ASC ASC ASC ASC ASC and 7 4

5 Mandatorily redeemable financial instruments are measured initially at fair value. For each subsequent reporting period the financial instrument is measured in one of the following two ways: 7 If both the amount to be paid and the settlement date are fixed, the instrument is subsequently measured at the present value of the amount to be paid at settlement, accruing interest cost using the interest rate implicit at inception. If either the amount to be paid or the settlement date varies based on specified conditions, the instrument is subsequently measured at the amount of cash that would be paid under the condition specified in the contact if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost. If a conditionally redeemable instrument becomes mandatorily redeemable, the instrument is adjusted to fair value, reclassified as a liability, with equity reduced, recognizing no gain or loss on the reclassification. 8 Obligations to Repurchase the Issuer s Equity Shares by Transferring Assets: Certain financial instruments other than shares (such as warrants) that embody a conditional or unconditional obligation to repurchase the issuer s equity shares (or are indexed to such an obligation) and require or may require the issuer to settle the obligation by transferring assets are accounted for as liabilities under ASC This is in contrast to the guidance discussed above pertaining to mandatorily redeemable shares whereby the obligation to redeem needs to be unconditional for liability treatment to result under ASC A comparison of the two sections of the codification follows and illustrates the need to determine if the instrument under consideration is a freestanding financial instrument such as a warrant or is instead intertwined with preferred or other shares. This results in an inconsistent accounting treatment that FASB intends to address with its liabilities and equity project in that warrants for puttable shares are generally liabilities (regardless of the number of conditions leading up to the possible transfer of assets) but the underlying shares are not. 10 Comparison of ASC to ASC Applicability Obligation resulting in liability treatment Instrument issued in the form of shares Unconditional Instrument other than a share Unconditional or conditional Warrants recognized as a liability under this section are generally subsequently measured at fair value with changes in fair value recognized in earnings ASC ASC ASC ASC

6 Obligations to Issue a Variable Number of Shares: A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares is to be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following: A fixed monetary amount known at inception (e.g., a payable settled with a variable number of the issuer's equity shares). Variations in something other than the fair value of the issuer's equity shares (e.g., a financial instrument indexed to the S&P 500 and settled with a variable number of the issuer's equity shares). Variations inversely related to changes in the fair value of the issuer's equity shares (e.g., a written put option that could be net share settled). 11 The underlying theory behind these criteria is that to be classified as equity and not as a liability, an obligation should expose the holder of the instrument that embodies that obligation to certain risks and benefits that are similar to those to which an owner (that is, a holder of an outstanding share of the entity's equity) is exposed. The FASB has concluded that exposure to changes in the fair value of the issuer's equity shares is a characteristic of an ownership relationship. Therefore, for the purpose of classifying an obligation that requires settlement by issuance of the issuer's equity shares, the distinction between obligations that are liabilities and obligations that are equity is based on the relationship between (a) the value that the holder of the instrument that embodies the obligation is entitled to receive upon settlement of the obligation and (b) the value of the underlying equity shares. In particular, the FASB concluded that for an obligation to be classified as equity, any benefits or risks of changes in the obligation must stem directly from changes in the fair value of the issuer's equity shares and be similar to the risks or benefits that would be realized by a holder of an outstanding equity share in the entity. Some obligations to issue a variable number of shares have contractually fixed monetary values. For example, if an instrument such as a warrant or preferred stock requires settlement by issuance of shares worth $100,000 on the settlement date, the number of shares to be issued varies based on the fair value of those shares at settlement. 12 Regardless of changes in the fair value of the shares, however, the holder is to receive $100,000 of value at settlement. Some obligations to issue a variable number of shares have monetary values that are indexed or otherwise linked to the fair value of the issuer's equity shares, but those monetary values vary inversely with changes in the fair value of the issuer's shares. Because the interest of holders of those instruments are diametrically opposed to those of holders of the issuer's equity shares, the FASB concluded that the issuer's obligations under those instruments could not be considered equity interests and, therefore, must be liabilities (or assets in some circumstances). Certain financial instruments embody obligations that permit the issuer to determine whether it will settle the obligation by transferring assets or by issuing equity shares. 11 ASC Conversely, instruments that are convertible in to other shares at the holder s option (as opposed to being required to be settled by other shares) generally do not fall within the scope of ASC

7 Because those obligations provide the issuer with discretion to avoid a transfer of assets, the FASB has concluded that those obligations should be treated like obligations that require settlement by issuance of equity shares. Financial instruments recognized as a liability under this section are generally subsequently measured at fair value with changes in fair value recognized in earnings unless ASC 480 or another topic provides otherwise. ASC 815, Derivatives and Hedging If an equity-linked instrument does not fall within the scope of ASC 480, consideration would next generally be given to ASC 815, Derivatives and Hedging, to determine if the instrument or any embedded features should be accounted for as a derivative at fair value with changes in fair value recognized through income. This analysis is multi-faceted, in that consideration generally needs to be given to the following: Is the instrument or embedded feature a derivative? Does the embedded derivative require bifurcation or is it clearly and closely related to the host contract? Is the derivative eligible for a scope exception from the requirements of ASC 815 by being indexed to the entity s own stock and classified in stockholders equity? Is the Instrument or Embedded Feature a Derivative? With regards to instruments or features such as warrants and conversion options, the determination of whether the instrument or feature constitutes a derivative often hinges on whether the contract can be settled net. Is It a Derivative? Per ASC , a derivative instrument has all of the following characteristics: One or more underlyings One or more notional amounts or payment provisions Requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors The contract can be settled net by any of the following means: o Its terms implicitly or explicitly require or permit net settlement o It can readily be settled net by a means outside the contract o It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement What Is an Embedded Derivative? The codification defines embedded derivative as Implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument. Thus, amongst other features, embedded derivatives in financing arrangements can include put and call options, conversion options and forward sales or purchase agreements. 7

8 The following chart lists some common equity-linked financial instruments and provides an indication of whether each criterion would likely be met. Warrant Convertible Debt Conversion Option Underlying Yes, price of the stock Yes, price of the stock Yes, price of the stock Notional Amount/Payment Provision Yes, number of shares Yes, face amount or number of shares Yes, face amount of host instrument or number of shares No or Smaller Initial Net Investment Yes, the investment is generally smaller than what would be required to purchase the shares No, given the proceeds that are received Yes, the debt proceeds are not attributed to the conversion option 13 Net Settlement Generally depends on contract terms and whether the underlying stock can be readily converted to cash N/A Generally depends on contract terms and whether the underlying stock can be readily converted to cash Net settlement can occur in various ways. As an example, the contract may provide for the issuer of a warrant to pay cash to the holder equal to the difference between the fair value of the shares at the exercise date and the exercise price of the warrant. Or, the contract could permit net share settlement such that rather than paying cash to exercise the warrant, the number of shares transferred to the holder upon exercise is reduced to compensate for the exercise price. With regards to convertible debt or stock, contractual net settlement could include a provision for the holder to receive the difference between the value of the convertible instrument and the stock in to which it is convertible without conducting the conversion and disposing of the shares received. Additionally, some convertible instruments also have put options which allow the holder to in effect receive the fair value of the instrument or conversion option in cash. The put option may therefore create net settlement for the conversion option. Lastly, as noted above, net settlement exists if the asset that is delivered (such as the underlying stock) is readily converted to cash. This would be the case if the shares to be received upon the exercise of a warrant or the conversion of debt or stock were actively traded. 13 ASC c 8

9 Is the Asset or Instrument Readily Convertible to Cash? The determination of whether the instrument or asset is readily convertible to cash needs to be considered on an ongoing basis throughout a contract s life. Delisting, an initial public offering or significant changes in the level of trading activity are examples of factors that could influence the conclusion as consideration needs to be given to whether the number of shares that would be delivered in accordance with each individual contract is small relative to the daily transaction volume. Certain restrictions on the sale of stock associated with warrants also affect the determination of whether the shares are readily convertible to cash. (See ASC to 139). The net settlement criterion is met if a contract provides for net share settlement at the election of either party, regardless of whether the net shares received are readily convertible to cash. Example of Net Share Settlement (ASC ) Entity A has a warrant to buy 100 shares of privately held common stock at $10 per share. The warrant permits a cashless exercise whereby it can be settled on a net share basis. If the stock price increases to $20 a share, for example, rather than paying $1,000 cash($10x100) and receiving 100 shares, entity A would receive 50 shares(($20-$10)x100/20) and pay no cash. Penalties for nonperformance may give a contract the characteristic of net settlement if the amount of the penalty is based on changes in the price of the items that are the subject of the contract. Does the Embedded Derivative Require Bifurcation Or Is It Clearly and Closely Related to the Host Contract? If an embedded feature such as a conversion option is deemed to be a derivative, consideration would next be given to whether ASC requires the embedded derivative to be separated from the host contract and accounted for as a derivative. Per ASC , separate recognition would be warranted only if all of the following criteria are met: The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to the requirements of ASC 815 Regarding whether the risk characteristics are clearly and closely related, an option to convert to a specified number of shares of common stock would be considered to be clearly and closely related to an equity instrument but not a debt instrument since changes in the fair value of an equity instrument and interest rates on a debt 9

10 instrument are not clearly and closely related. 14 Thus, the conversion option in conventional convertible debt would meet the first criterion. To determine if a similar conversion option in preferred stock would meet this criterion, consideration needs to be given to whether the preferred stock is more akin to an equity instrument or a debt instrument. A typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument. This analysis is very subjective and consideration should be given to the various substantive features of the instrument such as whether it has a stated maturity/redemption date, stated dividend rate or other rights of a creditor and thus more closely resembles debt, or has a perpetual term and voting or other shareholder rights, and thus more closely resembles equity. Additionally, if a conversion feature is not fixed but rather is adjusted to keep the holder whole, it may have characteristics and risks that are more clearly and closely related to a debt instrument. ASC S99-3 contains the text of an SEC Staff Announcement related to the determination of whether the characteristics of a host contract related to a hybrid instrument issued in the form of a share are more akin to a debt instrument or equity instrument. In addition to conversion options, certain contracts may contain other derivatives that may warrant separate recognition such as put features in a debt agreement that enable the holder to demand repayment or call features that give the issuer the ability to repurchase the debt. Separate guidance is contained at ASC for determining if these options are considered to be clearly and closely related to the debt host contract. While in many cases, call and put features are clearly and closely related to debt host contracts, the determination can be impacted by whether the instrument involves a substantial premium or discount and whether a put or call option is contingently exercisable. Additionally, if the amount paid for repayment or repurchase is based on the price of the option at the date of exercise rather than the principal amount, the option would not be considered to be clearly and closely 15 related. Regarding the second criterion noted above, the conversion option and other embedded derivatives would not need to be bifurcated and recorded at fair value if the entire convertible instrument is carried at fair value through earnings such as under a fair value election or through the application of ASC 480. Regarding the third criterion noted above, ASC c states that the initial net investment for the hybrid instrument is not considered to be the initial net investment for the embedded derivative, Thus, embedded derivatives generally meet the no or smaller initial net investment criterion to be classified as a derivative. Thus, consideration would need to be given to whether there is an underlying, notional amount or payment provision as well as net settlement as described in the preceding section. Is the Derivative Eligible for a Scope Exception from the Requirements of ASC 815 by Being Indexed to the Entity s Own Stock and Classified in Stockholders Equity? If the determination has been made that the instrument is a derivative or contains an embedded derivative that otherwise requires separate recognition, consideration 14 ASC ASC to 43 10

11 would next be given to ASC , Contracts in Entity s Own Equity. This section should also be considered for freestanding financial instruments that are potentially settled in an entity s own stock (such as warrants), regardless of whether the instrument has all the characteristics of a derivative instrument. 16 This section of the Codification contains the requirements for an equity-linked financial instrument or embedded feature to be considered indexed to its own stock and classified in stockholders equity and therefore eligible for the scope exception from derivative recognition requirements under ASC The guidance pertaining to whether the contract is indexed to the entity s stock originated from EITF 07-5, Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity's Own Stock, which was effective for annual and interim financial statements issued for fiscal years beginning after December 15, The guidance pertaining to whether the contract is classified in stockholders equity primarily originated from EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. It is a rather involved process to determine if these requirements are met, as follows. ASC outlines a two-step approach for determining whether an instrument is indexed to an entity s own stock. Evaluate the instrument s contingent exercise provisions, if any Evaluate the instrument s settlement provisions To be considered indexed to an entity s own stock, the instrument must pass both steps in this process. An exercise contingency is defined in the codification as a provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity's (or the counterparty's) ability to exercise an instrument and provisions that extend the length of time that an instrument is exercisable are examples of exercise contingencies as well as provisions that make the instrument exercisable. Common provisions include those that allow either party to exercise the instrument upon reaching a certain level of sales or upon the completion of an initial public offering. Exercise contingencies are permitted under ASC A unless they are based on an observable market other than the market for the issuer s stock or are based on an observable index other than an index calculated or measured solely by reference to the issuer s own operations such as sales; earnings before interest, taxes, depreciation, and amortization; net income or total equity of the issuer. Examples of Exercise Contingencies and Analysis Under ASC Company A issues a warrant that becomes exercisable: If it completes an initial public offering or a change of control occurs When it attains cumulative total sales of $100 million If the S&P 500 index increases 500 points within any given calendar year The first two are examples of permissible contingencies, while the third example is not, since it is based on an observable index unrelated to the issuer s own operations. 16 ASC

12 If there are no problematic exercise contingencies, consideration is next given to the instrument s settlement provisions. For an instrument to be considered indexed to an entity s own stock, the settlement amount needs to equal the difference between the fair value of a fixed number of the entity s equity shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the entity. 17 This model is best illustrated with a specific example. The simplest form is an instrument whose only terms are: The holder of the instrument can purchase 10 shares of Company A s stock for $15 per share. This instrument will expire five years from the date of issuance and is exercisable at any time. For the purpose of this illustration, assume that the fair value of the stock on the date of exercise is $25 per share. In this example the settlement amount is $100 or the difference between the fair value of $250 (10 shares multiplied by the $25 per share fair value at the date of exercise) and the fixed exercise price of $150 ($15 per share exercise price multiplied by 10 shares). Since both the exercise price ($15) and the number of shares (10) are fixed, this instrument would meet the settlement provisions criteria. In reality, instruments are rarely this simple as they commonly provide for potential adjustments to either the strike price ($15 in the above example) or the number of shares to be issued (10 shares in the above example) if certain circumstances occur. Therefore these adjustment provisions must be analyzed under ASC regardless of the probability of such adjustments occurring or whether such adjustments are within the entity s control. As is stated in ASC D, an instrument (or embedded feature) with potential adjustments would still be considered indexed to an entity s own stock if the only variables that could affect the settlement amount would be inputs to the fair value calculation of a fixed-for-fixed forward or option on equity shares. The most widely known fixed-for-fixed fair value option model is the Black-Scholes-Merton model. Inputs in to such calculations generally include the entity s stock price as well as the following types of variables: Exercise price Expected term of instrument Volatility of the underlying shares Stock borrowing costs Interest rates Entity s credit spread Expected dividends The ability to maintain a standard hedge position in the underlying shares 17 ASC C 12

13 Examples of Settlement Provisions and Analysis under ASC In each of these examples, the holder of the instrument can purchase 10 shares of Company A s stock for $15 per share. This instrument will expire five years from the date of issuance and is exercisable at any time Example A: The strike price will be reduced by $1 after any year in which Company A does not achieve annual revenues of at least $50 million Example B: If Company A sells shares of its stock for less than $15 per share, the strike price is reduced to equal the issuance price of those shares. If Company A issues any equity-linked financial instrument with a strike price of less than $15 per share, the strike price is reduced to equal the strike price of the newly issued instrument. The potential adjustments to the strike price in these examples are dependent on revenues (Example A) and whether Company A issues new shares at a price below the original $15 per share (Example B). As these occurrences are not inputs to the fair value of a fixed-for-fixed option, the warrants would not be considered indexed to Company A s own stock. Example C: If dividends for any 3-month period differ from the Company s historical rate of $0.10 per share, the strike price will be adjusted to offset the effect of the dividend differential on the fair value of the instrument. Example D: If Company A (a) distributes a stock dividend, (b) executes a stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring dividend, (c) issues shares for an amount below the then-current market price or (d) repurchases shares for an amount above the then-current market price, the exercise price would be adjusted to offset the resulting dilution (except for issuances and repurchases that occur upon settlement of outstanding options or forward contracts on equity shares). The dilution adjustment will be based on a mathematical computation that determines the direct effect that the occurrence of such dilutive events should have on the price of the underlying shares; it does not adjust for the actual change in the market price of the underlying shares upon the occurrence of those events, which may increase or decrease for other reasons. The potential adjustment to the strike price in Example C is not problematic given that dividends would be an input to the fair value of a fixed-for-fixed option. Regarding Example D, ASC to 43 illustrates that such adjustments are not problematic as it is an implicit assumption in standard option pricing models that such events will not occur or that the strike price of the instrument would be adjusted to offset the related dilution. Note carefully the difference between the adjustment to the exercise price in Example B for subsequent issuances at less than the exercise price, which is problematic, in comparison to the adjustment contained within Example D, for subsequent issues at less than the current market price, which is not problematic. ASC contains other useful examples. If the instrument or embedded feature meets the above criteria to be considered indexed to the entity s own stock, consideration is next given to whether the instrument or embedded feature meets the requirements of ASC to be classified as equity. These requirements are elaborated on in the discussion that follows. 13

14 The settlement methods associated with the instruments generally drive whether or not the instruments will be eligible for equity classification and are described as follows: Physical settlement The holder of the contract delivers the full stated amount of cash for warrant exercise or convertible instrument, for exercise of conversion option to the issuer, and the issuer delivers the full stated number of shares to be received upon exercise of the warrant or conversion of the convertible instrument to the holder. Net share settlement - The issuer issues shares to the holder in exchange for the warrant or convertible instrument that are equivalent in fair value to the total shares to be received less the exercise or conversion price. Net cash settlement - No shares are exchanged. For a warrant, the issuer would transfer cash to the holder equal to the value of the shares to be received upon exercise, less the exercise price. For a convertible instrument, the issuer would transfer cash to the holder equal to the value of the shares to be received upon conversion less the value of the instrument to be converted. Balance sheet classification is generally based on the concept that contracts that require net cash settlement are assets or liabilities and contracts that require settlement in shares are equity instruments. If the contract provides the company with a choice of net cash settlement or settlement in shares, settlement in shares is assumed. If the contract provides the holder with a choice of net cash settlement or settlement in shares, net cash settlement is assumed. Consideration should be given to whether settlement alternatives have the same economic value or whether one of the settlement alternatives is fixed or contains caps or floors. In those situations, the accounting for the instrument (or combination of instruments) should be based on the economic substance of the transaction. For example, if a freestanding contract, issued together with another instrument, requires that the issuer provide to the holder a fixed or guaranteed return such that the instruments are, in substance, debt, the issuer should account for both instruments as liabilities, regardless of the settlement terms of the freestanding contract. 18 The discussion that follows is based on additional conditions that must be met for equity classification that are contained within ASC to 38. It should be noted however that these requirements and related interpretative guidance at ASC to 6 do not apply to conventional convertible debt. By definition, conventional convertible debt includes those instruments for which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer). The meaning of conventional convertible debt has been defined in ASC to 42. Instruments that contain standard antidilution provisions, such as those that result in adjustments to the conversion ratio in the event of an equity restructuring transaction (as defined in ASC 718, Stock Compensation) that are designed to maintain the value of the conversion option, would not preclude a conclusion that the instrument is convertible into a fixed number of shares. Also, convertible preferred stock with a mandatory redemption date may qualify for the exception, if the economic characteristics indicate that the instrument is more akin to debt than equity. (Note: If the preferred stock is more akin to equity than 18 ASC

15 debt, an equity conversion feature generally would be clearly and closely related to that host instrument and as such, wouldn t warrant separate recognition as a derivative. (ASC provides guidance on this determination). If the instrument is not conventional convertible debt, the following equity classification requirements from ASC are relevant. Contracts that include any provisions (regardless of probability of being invoked) that could require net-cash settlement cannot be accounted for as equity unless the holders of the underlying shares also would receive cash in the same circumstances or if the payment of cash is only required upon the final liquidation of the entity. Because of this, the following are additional conditions that must be met for a contract to be classified as equity which are elaborated on in ASC : Settlement of the contract with unregistered shares is permitted or there are sufficient shares registered at the inception of the instrument and there are no further timely filing or registration requirements Entity has sufficient authorized and unissued shares at the classification assessment date to cover the maximum number of shares that could be required to be delivered during the contract period under existing commitments for the instrument under evaluation and certain other instruments potentially settled in stock The contract contains an explicit share limit such that the maximum number of shares that could be required to be delivered to settle the contract can be determined for the purpose of concluding there are sufficient authorized and unissued shares If a contract requires cash payments in the event that an entity does not make timely filings with the SEC, this could be problematic since the ability to make timely filings is not considered to be within the control of the entity. Consideration should generally be given to the magnitude of the penalties as if they are potentially onerous, the entity could be economically compelled to redeem the instruments for cash Cash-settled top-off or make-whole provisions are problematic unless they can be net share settled, and, as noted above, the maximum number of shares that could be delivered is fixed and sufficient authorized and unissued shares exist The contract cannot give the holder rights in bankruptcy that are of a higher priority than the holders of the stock underlying the contract There cannot be a requirement to post collateral (other than the maximum shares that could be delivered under the contract) If the contract has settlement alternatives that require the entity to pay net cash when the contract is in a loss position but receive (a) net stock or(b) either net cash or net stock at the entity's option when the contract is in a gain position, it could not be classified as equity. Conversely, a contract that requires the entity to receive net cash when the contract is in a gain position but pay net stock or either net cash or net stock at the entity's option when the contract is in a loss position could generally be accounted for as an equity instrument. 15

16 If a derivative instrument, embedded derivative requiring bifurcation, or a freestanding financial instrument that is potentially settled in an entity s own stock but does not have all the characteristics of a derivative (such as a warrant to purchase stock that is not publicly traded and does not otherwise meet the derivative criteria of net settlement) does not meet the requirements to be considered indexed to the entity s own stock and classified in shareholders equity, it would be recognized as a liability (or asset in some cases) at fair value, with subsequent changes in fair value recognized in the statement of operations. ASC , Debt with Conversion and Other Options The next step for convertible debt, and in some cases preferred stock, is to consider the guidance in ASC to determine if a cash conversion feature would necessitate partial classification as equity or if a beneficial conversion feature exists and must be recognized (assuming that the conversion option doesn t warrant separate recognition as a derivative). The Cash Conversion subsection of ASC provides guidance on the accounting for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement). This guidance does not apply to convertible preferred shares that are classified in equity (or temporary equity) but does apply to mandatorily redeemable financial instruments that are classified as liabilities under ASC This guidance does not apply to convertible debt instruments that require or permit settlement in cash (or other assets) upon conversion only in specific circumstances in which the holders of the underlying shares would receive the same form of consideration. 19 For those instruments subject to this guidance, an amount that would otherwise be classified as a liability is classified in equity and is determined by measuring the fair value of a similar liability (including any embedded features other than the conversion option) that does not have an associated equity component and subtracting it from the initial proceeds ascribed to the convertible debt instrument as a whole. This would impact the amount of discount or premium on the debt instrument and ongoing amortization or accretion. 19 ASC

17 Illustration of Accounting for Cash Conversion Feature Assume entity A issues notes for proceeds of $1 million that can be converted at any time into a specified number of shares. Upon conversion, entity A has the option to settle the if converted value in cash, common stock or any combination of the two. If the conversion option does not require separate accounting as a derivative because it meets the requirements for a scope exception by being indexed to the entity s own stock and classified in stockholder s equity, the accounting would be governed by ASC Assume the fair value of the notes ignoring the conversion rights is estimated to be $600,000 at the issuance date. The entry to record the issuance would be as follows, ignoring deferred tax considerations: Cash $1,000,000 Debt discount 400,000 Debt $1,000,000 Additional paid in capital 400,000 The discount would be amortized in to interest expense over the expected life, using the interest method. The amount allocated to additional paid in capital for the conversion rights would not be adjusted for changes in fair value or otherwise, assuming the conversion option continued to qualify for the exception from derivative requirements. (Separate topic follows on the ongoing need for reassessment). ASC also provides for equity treatment of certain beneficial conversion features that are in the money at the date of issuance or become beneficial upon the occurrence of a future event, such as an initial public offering (assuming that the conversion option doesn t warrant separate fair value treatment under ASC 815 or is not within the scope of the cash conversion subsection of ASC discussed above). The amount of the beneficial conversion feature is generally determined at issuance as the intrinsic value of the conversion option and is accounted for as additional paid-in-capital. In circumstances in which convertible securities are issued with other detachable instruments, such as warrants, the issuer must first allocate the proceeds between the convertible instrument and the detachable instruments before computing the value of the beneficial conversion feature. 20 This computation in effect creates a beneficial conversion feature for an instrument for which the conversion price was set to be at market on the issuance date. An illustration follows. Convertible debt with detachable warrants is issued for proceeds of $1 million (equal to the face amount of the debt). Conversion price is set at $10 per share, which equals the fair value of the underlying stock on that date. Fair values are determined to be $750,000 for the debt and $250,000 for warrants. Value of shares ($1 million/$10 conversion pricex$10 fair value) $1,000,000 Proceeds allocated to debt 750,000 Difference, intrinsic value of conversion option $250, ASC

18 If the convertible security provides more than one method of determining the conversion rate, then the computation should be made using the conversion terms that are most beneficial to the investor. 21 If the convertible instrument has a stated redemption date, the resultant discount should be amortized from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs. 22 The discount is amortized to interest expense if a debt instrument and to retained earnings if an equity instrument (or paid in capital if there is a deficit in retained earnings). If a security that becomes convertible only upon the occurrence of a future event outside the control of the holder or a security is convertible from inception but contains conversion terms that change upon the occurrence of a future event, any contingent beneficial conversion feature is measured using the commitment date 23 stock price but not recognized in earnings until the contingency is resolved. Changes to the conversion terms that would be triggered by future events that are not controlled by the issuer are accounted for as contingent conversion options, with the intrinsic value recognized if and when the triggering event occurs. Recognition is as paid in capital with a corresponding discount to the convertible instrument that must be subsequently amortized as interest expense. ASC S99, Redeemable Preferred Stocks ASC S99, Redeemable Preferred Stocks, which was issued by the Securities and Exchange Commission (SEC), should be considered by SEC registrants to determine if redeemable preferred stocks that otherwise met the criteria for equity classification should be reported as a separate component of temporary equity versus permanent equity. This guidance is also relevant for determining the classification of amounts associated with convertible debt that are otherwise classified as equity, if any. The guidance at ASC S99 specifies that redeemable stock is any type of equity security, including common or preferred capital stock, which has any of the following characteristics: It is redeemable at a fixed or determinable price on a fixed or determinable date or dates It is redeemable at the option of the holder It has any condition for redemption which is not solely within the control of the issuer without regard to probability ASC S99 provides examples of when temporary versus permanent equity classification is appropriate. These examples illustrate that redemption based on majority vote by the board of directors or shareholders may not be within the issuer s control and that events such as maintaining compliance with debt covenants, achieving earnings targets and having a registration statement declared effective by the SEC by a designated date are not within the issuer s control. Determining whether an equity instrument is redeemable at the option of the holder or upon the occurrence of an event that is solely within the control of the issuer can be complex. 21 ASC ASC ASC

19 Accordingly, all of the individual facts and circumstances surrounding events that could trigger redemption should be evaluated. The possibility that any triggering event that is not solely within the control of the issuer could occur (without regard to probability) would require the instrument to be classified in temporary equity. The SEC requires that a redeemable equity instrument is not to be included in amounts reported as total stockholders' equity; rather, it should be reported between long-term debt and stockholder's equity, without a subtotal that might imply it is a part of stockholders' equity. This type of classification is sometimes referred to as "temporary capital" or "mezzanine capital. The equity-classified component, if any, of a convertible debt instrument should be considered redeemable and classified as temporary equity if at the balance sheet date it is currently redeemable or convertible for cash or other assets. If the equityclassified component is considered redeemable, the portion of the equity-classified component that is presented in temporary equity (if any) is measured as the excess of (a) the amount of cash or other assets that would be required to be paid to the holder upon redemption or conversion over (b) the current carrying amount of the liability-classified component of the convertible debt instrument. For example, if the convertible debt instrument is currently redeemable at the option of the holder for $1,000 in cash, and the liability-classified component of the instrument is carried at $950 on the balance sheet, $50 of the equity-classified component should be presented as temporary equity. The initial carrying amount of redeemable preferred stock should be its fair value at date of issue. Where fair value at date of issue is less than the mandatory redemption amount, the carrying amount should be increased by periodic accretions, using the interest method, so that the carrying amount will equal the mandatory redemption amount at the mandatory redemption date. The carrying amount is also periodically increased (through a charge to retained earnings) for dividends that have not been declared but will be payable under the redemption features, or for which ultimate payment is not solely within the control of the registrant (e. g., dividends that will be payable out of future earnings). A currently redeemable equity instrument subject to this guidance should be carried on the balance sheet at an amount not less than the maximum redemption price, based on conditions that exist at the balance sheet date. If an equity instrument is not redeemable currently (for example, because a contingency has not been met), but it is probable that the instrument will become redeemable (for example, when the redemption depends solely on the passage of time), either of the following accounting methods can be used: Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates and accounted for as such. 19

20 Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying value of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument. If an equity instrument is not redeemable currently (for example, because a contingency has not been met), and redemption is not probable, subsequent adjustment is not necessary until redemption is probable. In that case, disclosure should be made of why redemption is not probable. There should be consistent application of the accounting method selected, along with appropriate disclosure of the selected policy in the footnotes to the financial statements. Moreover, disclosure of the redemption value of the equity instrument as if it were currently redeemable is required for SEC registrants that elect to accrete changes in redemption value over the period from the date of issuance to the earliest redemption date. Allocating Proceeds to Financial Instruments Issued in the Same Transaction It is common for various financial instruments to be issued at the same time in a financing transaction, which as noted above, complicates the accounting as the conclusion for each instrument is often impacted by the highly subjective analysis of whether the individual instruments are freestanding. Additionally, it is necessary to allocate the total proceeds received from the transaction to the individual instruments or bifurcated derivatives. The method of allocating the proceeds will differ based on whether there are bifurcated derivatives that would be recorded at fair value or any of the instruments are required to be measured at fair value. For example, if convertible debt and warrants are issued as part of the same transaction for total proceeds of $1 million, the allocation of proceeds under two different scenarios follows (assume that the fair value of the debt is $1 million, including $100,000 attributable to the conversion option and the value of the warrants are $200,000): Scenario 1 Warrants are classified as equity and no separate recognition is required for the conversion option Fair Value Allocated Proceeds/ Initial carrying amount Convertible debt $1,000,000 $833,333(a) Warrants 200, ,667 Total $1,200,000 $1,000,000 (a) Represents the net amount. Assuming the face amount is $1 million, this would be recorded as $1 million of debt with a discount of $166,667 that is accreted to interest expense using the effective interest method. In this scenario, since fair value measurement is not required for any instrument or embedded feature, the proceeds are allocated to each financial instrument based on the respective instrument s proportionate fair value (allocated proceeds = instrument fair value/total fair value x total proceeds) ASC

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